In this present day and age, many people are looking for a safe means of investment where they’ll receive consistent returns.
Rental real estate has been lauded by many as one of the most dependable investment vehicles, as it provides passive income and a hedge against inflation. It also provides a number of tax benefits that can lower your overall costs and increase your annual returns.
Yet, as with any other form of investment, you first need to evaluate whether it is viable. One of the ways to do this is by calculating the Return on Investment. The ROI is a ratio of profitability that measures the returns you will receive on a property as a percentage of the investment costs.
In this article, we’ll take a closer look at rental property investment and have an in-depth discussion on how you can calculate the expected ROI. This information is vital in helping you find the right investment property that will facilitate long-term wealth.
The Different Forms of Investment Property
Before you dive into real estate investment, you need to know the type of properties available in the market.
Some of the options for rental investment include single-family homes, multi-family properties, apartment buildings, duplexes, triplexes, quadruplexes, and townhouses, among others. All these properties have different requirements and provide varying returns.
In addition, a property investor can decide on whether to offer short or long-term rental properties. Both these options have their advantages and setbacks.
However, as a real estate investor, you should select that which aligns with your aspirations and provides you with the best return on investment.
The Information You Need to Determine the ROI
There are certain specific details that you need to calculate an investment property’s ROI. Finding the property’s ROI will guide your investment decision by letting you know whether the potential profits are favorable.
Here are some of the things you need to know when calculating a rental property’s ROI:
Information on the Property Itself
This involves all the specifics of the rental property. Details may include the property value, the location, the square footage, the number of rooms, the operating costs, and more.
Information on the property will give you a broad understanding of what you’re investing in and the current market value. You’ll also need to take note of any necessary renovations.
Details on the Mortgage
If you’re planning on using debt to finance your property acquisition, you need to know the lender’s terms. This includes details on the loan such as the repayment period, the required down payment, the lender’s interest rates and the closing costs.
The Expected Rental Income
The property’s rental income is one of the main factors that determine your level of returns. It goes without saying that a high rental income is preferable. However, you will need additional information on the expected vacancy rate and other potential sources of income.
The Monthly Operating Expenses
You’ll also need to find out how much it costs to run the property on a month-to-month basis.
This includes costs such as repair and maintenance, monthly utilities and amenities such as water bills, monthly dues for the homeowner’s association and the cost of hiring a property manager.
The Annual Costs
These costs only accrue once a year and they may include payments for the insurance cover and the yearly tax obligations.
The yearly costs can be combined with the monthly costs to find the total annual costs of running the property. You’ll need to figure this out before getting a tenant to sign the rental agreement.
How to Determine the ROI for a Rental Property
After finding out all the necessary details on the property, you need to calculate the expected return on investment. To do this effectively, there are some metrics that are necessary for you to calculate. These figures include the following:
The Annual Cash Flow
Cash flow refers to the expected sum of yearly returns after covering all the expenses and debt. It is calculated by subtracting the outstanding debt from the net operating income. This metric indicates how much your profit will be at the end of each year.
The Net Operating Income
The net operating income, or NOI, is an indicator of how much your rental property earns on a monthly basis. The NOI can be calculated by subtracting the operating expenses from the monthly gross income.
You should note that the gross income is not limited to the rent, but it may also include other sources of income associated with the property.
The Capitalization Rate
The Cap Rate provides an estimate of the returns on your investment property.
This figure can be calculated by dividing the annual net operating income by the purchase price of the property. Investors use the cap rate as a basis for comparing different investment opportunities.
The Cash-On-Cash Return
An investment property’s cash-on-cash return is the ratio between the after-tax annual cash flow and your initial cost of investment. The initial costs may include the down payment for the property, the closing costs and the possible renovation costs. Real estate investors use this figure to measure the performance of a property.
Calculating the ROI
With the Net Operating Income and the value/ cost of the property, you should be able to calculate the ROI.
ROI = Net Operating Income/ Value of the property or Cost of Acquisition
In general, the recommended return on investment is above 10%. Yet, some investors may be willing to accept an ROI of between 5% to 10%.
The acceptable level of returns for a rental property mainly depends on your goals as an investor as well as how much you’re willing to spend on the property.
As a property investor, there are certain details you need to know before purchasing a rental property. The ROI is a great indicator of what to expect in terms of a property’s performance. However, you should also look out for other hidden expenses that may potentially lower your investment returns.
Here at JMAX Property Management, we have a deep understanding of the workings of rental property investment.
Our professional team has great experience in helping Roanoke and Salem property investors in maximizing their returns. Get in touch with us today to find out how we can take your property investment to the next level.