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SHOW NOTES FOR EPISODE 198: WHAT IS A GOOD ROI FOR YOUR RENTAL PROPERTY
Being aware of the potential financial returns of an investment property is the driving force behind a purchase. But how can you find out the financial return of a rental property? Through its ROI (Return-on-Investment), of course! But what exactly is ROI? And what is a good ROI for rental property? In today’s Fun Facts Friday podcast, Bill will take a look at ROI, how it can help you assess the value of a property and how to know what a good ROI is for your rental property.
What does ROI mean?
ROI, short for return on investment, is the standard metric used to evaluate the returns on any investment. This standard is very comprehensive. It takes many important variables into account including annual rental income, property price, and the expenses of the real estate property. When these variables are put together in an equation, ROI looks like this:
ROI = (Annual Rental Income – Expenses and Costs) / The Property Price
Here’s what the variables mean:
- Annual Rental Income: This is exactly what it sounds like. The annual rental income is simply the gross rental income an investment property generates in a year. It is calculated by multiplying the monthly rental income by 12 or by multiplying the weekly rental income by 52.
- Expenses and Costs: Every rental property comes with different expenses and costs, some are recurring and others aren’t. ROI takes all expenses and costs, whether they are property taxes or the costs for new furniture, into account.
- Cost of Property: To truly understand how well a property is doing, its profit (or rental income) must be compared to its price. Without doing this, a real estate investor may be deceived into thinking a rental property is performing well, even if it generates high income. But if this income is compared to its price (or fair market value) and is insignificant, the investment property is actually not performing as believed.
What is a good ROI for a rental property?
Well, you have to look at the question “What is a good rate of return on any investment?” This is a subjective question. For example, a person earning .75% in a savings account may think a return on investment of 2% sounds great. Of course, the banks love to tout the great return of special savings account that are yielding a “high 1 or 2% return” because their basis of comparison is themselves But is it really a “good” rate of return. This can certainly be a topic of debate.
Only you can determine what is good return for you.
Now that you know how to calculate ROI for a rental property, the next question must be asked: “How do I know what is a good ROI is for a rental property?” The answer is pretty straight forward, but for clarity, we’ll illustrate it with a ROI calculation example.
Let’s say you own a pretty successful rental property. It is occupied for most or all of the year, it’s attracting good tenants, and its maintenance functions are smooth. It also has a high monthly rental income of $3,775. The property’s fair market value is $275,000. This all sounds great, but is the property really providing a good return on investment? To find out, we’ll need to calculate its ROI.
Since the monthly rental income is $3,775, the property’s annual rental income is $45,300. Its annual expenses, which include taxes, repairs, renovations and more, add up to let’s say $2,000. What’s the ROI for this rental property?
ROI = (Annual income of $45,300 – expenses of $2,000 – that’s $43,300). Now you divide the $43,300 by the property price of $275,000 and you get 0.157 or 15.7%
So, harkening back to the original question: What is a good ROI for a rental property? Again, the term “good,” as used in this question, is relative or subjective. Most people’s second question would be, “Good as compared to what?” So, if you are an investor, you would look at the ROI as it compares to other investments out there that you could potential put your funds – right? For example, “What’s the average return of stocks, bonds, index funds, mutual funds, annuities… and, don’t forget — Bitcoin?” Obviously, there is another factor here that we have to consider when trying to assess what is good? As you seek out comparable investments you can’t ignore the risk aspect! Investing in treasury bonds or index funds can’t really be compared to investing in Bitcoin. The risk is much higher for Bitcoin as it is when compared to say, mutual funds.
That’s why when you look at a rental property, which is a “tangible asset” – something you can see, feel, touch and own, and has a historically proven value unlike a stock, that can totally lose its value and be worth nothing. Real estate will always be worth something, and historically, it will always go up. But to best identify what is a good real estate investment it’s best to compare with other real estate investments – to see what other similar real estate investments are yielding. Sure you can say, “Well, my Vangard index funds, which are fairly low risk, have been yielding 8% for the last 3 years. And compared to that, the 15.7% yield of my rental property is very good.” And that’s a viable comparison. But if you look at what other similar rental properties are pulling in, you can get a pretty good idea of what id good, too.
The answer to our example is the same answer to our question. A 15% ROI for a rental property is considered good.
How Does ROI Differ With Financing
Great! We now know what is a good ROI for rental property.
One more issue, however, has not been addressed. How does ROI change depending on the method of financing? What is a good ROI for a rental property if the method is different?
Their are different ways to calculate ROI for rental property when you look at how you are financing a property purchase.
There are two main methods of financing a property: purchasing it with cash or through a mortgage. As a result, ROI calculations can differ as well.
Let’s look first at purchasing your property with cash
If you can somehow purchase a rental property entirely in cash, then calculating ROI is not too difficult. All you will need to do is use the ROI formula as in the previous example.
ROI = (Gross Annual Rental Income – Expenses and Costs)/The Property Price
So, taking our example, “what is the ROI for a rental property when paying fully in cash?” The answer still remains 15.7%, as the same equation is used.
But Let’s Look at Using a Mortgage
If you, like the vast majority of real estate investors, decide to invest with a mortgage, calculating ROI has a slight tweak. The result is what’s called the “out of pocket method” or, what is commonly called “Cash on Cash” return. In this ROI calculation:
Out of Pocket ROI or Cash on Cash = Annual Cash Flow / Total Cash Invested
On the surface, it may seem that this form of the ROI equation is very different from the other one used for cash purchase. The reality is, however, that these calculations are almost the same. In fact, the out of pocket ROI contains a broader definition that could be applied to cash purchases.
This formula uses annual cash flow instead of the difference between gross annual rental income and expenses and costs. Why? Annual cash flow is merely an extension of the difference, as it also takes mortgage payments into account. The other change in the out of pocket ROI or cash on cash calculation is using total cash invested instead of property price. That’s because the real estate investor has not fully paid down the property when using a mortgage. Instead, when an investment property is fully paid for in cash, the total amount invested is simply its property price.
So, what is a good ROI for rental property when using the out of pocket method? The answer remains to be 15%. The difference is, however, that it is much easier to reach this percentage. Since the total cash invested tends to be much less than the property price (as in cash purchases ROI), the overall ROI is lower. An example will make this easier to understand.
Let’s use our previous example
To calculate our rental property’s annual cash flow, take the difference between the annual rental income of $45,300, minus annual expenses of $2,000 per month or $24,000 for the year, minus a monthly mortgage payment of $1,111 or $13,332 annually, equals an annual cash flow of $7,968. The property price is $275,000.
If the property is fully purchased in cash:
ROI = $43,300 / $275,000 = 0.157 = 15.7%
If the property is purchased with a mortgage and 25% down or $55,000, plus $9,625 in closing costs, has been paid back:
To get the Out-of-Pocket ROI or Cash-on-Cash Return, you take the annual cash flow of $7,968, divided by the total cash invested $64,625 , and that equals .123 or 12.3% – still a strong return
CORRECTION TO THE ABOVE EXAMPLE (5/15/18):
One of our listeners, Scott M. Clay, pointed out that our expenses differed between the two examples above. In the “Cash Only” example, we said annual expenses were $2,000 and in the “Financed” example we said annual expenses were $24,000 (12 times the other example). So, to be consistent in the comparison, we made the “financed” example $2,000, just like the “Cash Only” example. Therefore, HERE IS THE CORRECTED response:
To get the Out-of-Pocket ROI or Cash-on-Cash Return, you take the annual cash flow of $29,968, divided by the total cash invested $64,625 , and that equals 46.3% – a very strong return!
Conclusion
Purchasing investment properties with a mortgage generates a significant ROI. And you have to look at the fact that, instead of buying one property for $275,000 paying cash, or financing it with $25% down, you can buy FOUR properties at $50,000 each with a mortgage and 25% down, plus closing costs, and yield an even more significant return-on-investment – plus the tax advantages and all the equity. That’s the power of leverage. Even though a property is fully paid for when purchasing with cash, leveraging your investment dollar can get you an even bigger bang for your buck.
Knowing what is a good ROI for a rental property is important for real estate investors. There are few investments out there that can match the returns of rental real estate.
Here are a few related podcasts and blog articles you might also want to listen to or read:
191: Rental Property Analysis Simplified With Frank Gallinelli
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2 comments. Leave new
This was the first episode of your podcast I listened to and I really enjoyed it. I look forward to more episodes.
However, I’m puzzled by the expenses that were used in the examples. In the “Cash Only” deal expenses are $2,000 per year but in your “Finance” deal they are $2,000 per month (or $24,000 per year). If the “Finance” deal expenses were the same $2,000 per year as the “Cash Only” deal then the ROI goes way up:
$45,300 – 2,000 – 13,332 = 29,968 of annual cash flow
$29,968/64,625 = 46.3% ROI
Am I missing something?
Scott,
Thank you very much for discovering and pointing out that error in our podcast and the show notes. You are 100% right, the $2,000 in expenses was not consistent between the two examples, and YES, the ROI for the finance example is, in fact, much higher at 46.3%, not 12.3%.
As a result, we have posted the correction on our website show notes and hope to correct the audio as well (although that’s a bit more complicated).
We do a lot through the Old Dawg’s REI Network, what with two podcasts and a blog article every week. Sometimes we don’t always have the opportunity to proof and review as carefully as we would like to. It helps when listeners, such as yourself, take the time to help us out.
Thanks for taking the time to listen to our podcast and for digging a little deeper.
Best,
Bill