Most of the world’s billionaires made their wealth through real estate. The long-term property appreciation rates, a monthly recurring income, and a myriad of tax incentives can boost your wealth significantly.
For new investors, knowing where to start can prove daunting. Luckily, no matter the age or experience, real estate investing is for anyone and everyone. When investing in real estate and considering rental properties, there are plenty of things that you must be aware of. Among these things is the property type and the return on investment (ROI).
Types of Rental Investment Properties
There are different types of rental properties you can invest in. Including, single-family homes, condominiums, vacation homes, apartments, duplexes, and multi-family units. When starting out, investing in a single-family home is usually the best bet. Generally speaking, it can help you learn the ropes of being a landlord without much pressure.
How to Calculate the ROI on an Investment Property
As already mentioned, the main advantage of renting out a property is the monthly cash flow. Once you have found a potential property, how will you be able to tell whether it’s a good investment? By calculating the potential ROI!
The ROI of an investment property is what determines whether an investment will be profitable or not. To calculate the ROI of an investment property, you’ll need to factor in certain basics. The basics are as follows.
- Property Details: You’ll need to know the value of the property, as well as things like square footage and number of bedrooms.
- Mortgage Details: This would include things like the down payment, loan terms, and interest rate.
- Anticipated Vacancy Rates: Vacancy rates have a direct impact on the ROI of an investment property. A high vacancy rate will mean less income for you. The vice versa is also true.
- Prevailing Rental Rate: You’ll also want to do a comparative market survey to get an idea of what the prevailing monthly rent is for the neighborhood.
- Rental Expenses: Similar to the rental rate, you’ll also want to find out what expenses you should expect. Rental expenses will obviously have an impact on how much income you make.
With all this information in mind, the following are the metrics to help you calculate the ROI on an investment property.
1. Cash Flow
Cash is king – this still holds true when it comes to determining whether an investment will be profitable or not. Cash flow is simply the money that’s left over every month after you have paid all the operational expenses.
Operational expenses include things like property taxes, property management fees, mortgage payments, vacancy costs, and repairs and maintenance costs.
Suppose, for instance, that you rent out your property for $1,200 a month and that monthly expenses sum up to $550. In such a case, your cash flow would be $650.
2. Cash on Cash Return (CoC)
This is another key metric that can help you calculate the ROI of a property investment. It is simply a ratio of the annual cash flow to the initial cash out of pocket. It’s calculated by the annual cash flow divided by the actual cash you’ve invested upfront..
For an illustration, let’s use the same figures from our previous example. Annual cash flow would be $650 x 12 = $7,800. And let’s assume that the initial cash invested upfront is $80,000 (closing costs + down payment + renovation costs). In such a case, the CoC 7,800/$80,000 = 9.75%.
Most experts are of the opinion that a good CoC return of between 7 and 10 percent is good. Of course, the higher it is, the better for your bottom line.
3. Net Operating Income (NOI)
This is a similar metric to cash flow. Such that, it measures the rental income (plus other income) versus the vacancy costs and operating expenses. The only thing that NOI doesn’t factor that cash flow does are the mortgage expenses. NOI = (rental income + other income) – (vacancy costs + operating expenses).
Supposing the vacancy cost is $50 and maintenance is $200, from our initial figures, the monthly NOI would therefore be equal to $950. $1200 – ($50 +$200).
4. Capitalization Rate
Also known as cap rate, capitalization rate is an estimated rate of the return on an investment property. It’s similar to cash on cash return in certain ways. To calculate the cap rate, you’ll need to divide the net operating income (NOI) by the property’s value. (Cap rate = NOI/Property’s Value).
If the annual NOI is $11,400 (950 x12), and that the value of the investment is $100,000, then the cap rate would be equal to 11.4%. Generally speaking, a property with a cap rate ranging between 8-and 12% is considered a good investment. But just like other ROI calculations mentioned above including cash on cash return, what’s “good” is dependent upon a variety of factors.
5. Annual Gross Rent Multiplier
Also known as GRM, this metric can help a budding investor measure a rental investment’s value. That is, help you determine whether an investment is worthwhile or not.
To calculate the GRM of an investment property, you’ll need to divide the property’s value by the gross rental income. A “good” GRM depends heavily on the type of rental market in which your property exists.
There you have it – 5 metrics you can use to determine the ROI on a property investment. Sometimes a property might look great and seem like a worthwhile investment, but it may end up not being profitable for you. The only way to determine whether a property investment is worthwhile or not is by doing the math.
But if you still find this daunting, Five Star Property Management can help. We’re a full-service property management company specializing in managing rental properties in Pocatello and Chubbuck. Get in touch to learn how we can help!