Numerous individuals focus on multiple income sources. Rentals are the most common example. It is the most reliable and consistent source of income. It also has tax benefits and long-term implications. Investment decisions depend upon ROI. 

ROI calculates the return on the investment. It measures an investment’s profit potential or loss through negative cash flows. It considers the revenues and expenditures related to the property and discounts it to the present value. ROI calculations help the investors either to invest or avoid investment within the project.

ROI calculations are essential for the investors when they make decisions to invest, as also the performance evaluations of the property. It helps the investor to calculate the net cash flow in terms of today from the project. When the ROI has a positive value, it will generate profit. The project would be at a loss if it had a negative value.  

Methods to Calculate ROI on Rental Property

Some fundamental methods that can be used to calculate ROI are given below. Valuers use investment property calculators for this purpose to achieve. This detailed blog post covers rental property ROI calculation methods.

ROI Calculation

ROI cash flows could be calculated by taking the revenue and subtracting the annual operating cost related to the property and dividing it by the value of investment or mortgage value. This simple formula would help to calculate the return on investment. Operating costs related to the property include repair and maintenance fees, security, taxes, insurance installments, and other expenses related to daily operations. 

For instance, your rental property’s average monthly rent is $1,500, with annual gross rent being $18,000: ($1,500 x 12). Now sum up all the costs related to the business operations, and it might be $6,000 in this example. 

To find out the ROI, deduct expenses from the total revenue. Cash flow can be calculated using figures from the previous steps: $18,000 gross rent – $6,000 operating expenses = $12,000.

Then divide the net cash inflow by the amount invested to calculate cash flow ROI. Suppose that you have paid a total of $55,000 as an investment. Cash flow ROI = $12,000 / $55,000 x 100 = 21.82%. Thus the ROI on investment is 21.82%. 

Cash-on-Cash Return

Cash-on-cash return is the key financial metric to calculate the ROI of a given investment in a property. This metric helps the investors to know about the cash flows that might be generated from the investment. Simply, it reveals the net revenue generated from the property after deducting all the costs related to the property. These costs include taxes, repair and maintenance charges, mortgages, and management fees related to the property.

For example, an investor purchases a property for $100,000, and annual rentals are $15,000. The revenue of $15,000 is divided by $100,000 and then multiplied by 100. In this case, the answer is a 15% cash-on-cash return from the property.

The cash-on-cash return gives investors information about the profitability they might earn from their investments. This calculation considers the costs related to the property and provides a more reliable and accurate answer.

A higher percentage shows that the return on investment is higher than the lower percentage. A good return depends on numerous factors such as geographic location, the area covered, property condition, etc. 

Cap Rate

The cap rate is the short name used for the capitalization rate. This is one of the fundamental techniques that investors and property management use for the return on their investment. In this technique, the net operating income from the property is divided by the total investment or purchase cost. The answer is then converted into a percentage for better interpretation.

It shows the investors the capacity of the property to generate a return for the investor. The lower the capitalization rate, the lower the property’s profitability. The Cap rate also helps the investor decide to invest or leave the project.

The higher the Cap rate, the more the return on investment will be. An excellent positive return on investment depends on numerous factors such as geographic location, the area covered, property condition, etc. 

Net Operating Income

The Net Operating Income (NOI) is the most vital financial metric to know the returns the investor can achieve on an investment. This metric can be calculated by dividing the net operating income by the investment undertaken. The net active income deducts the operational expenses along with the vacancy losses.

This metric is more detailed and gives more reliable data for decision-making. Considering vacancy losses it provides a clearer picture of the investment. It also reveals how quickly the property could recover the amount invested within the property. 

2% Rule

The last technique or approach explained in this article is the 2% rule. These are the most simple rules and are easy to understand. An investment is considered to have a positive return when the return on rentals is 2% or above the 2% value of the investment amount. For this to calculate, the monthly rentals are divided by the total investment and multiplied by 100. The investment is considered fruitful if the answer is 2% or above.

This rule is broadly used in investment management and helps the investment in its decision-making process. In some cases, the investor initially charges lower rentals and then increases it over time to have a good return on its investment. 

Finding a Good Return

Return on investment in rental properties has a slow rate of return, but it is considered the most reliable and long-term source of income. The ideal rate of return is determined by the purchase price, rental income, mortgage costs, occupancy and vacancy rates, and operating expenditures. When looking for a good return, take financial advice from the experts. 

Conclusion

The ROI calculation is an essential factor in investment decisions. The investors use the above-mentioned techniques, such as cash flow ROI, cash-on-cash return, cap rate, and net operating income. The increase in profitability of the investment is also dependent upon the investors’ risk appetite and financial goals. It is most advisable for business investors to know the current market trend and conditions. A financial advisor might also help you accurately calculate return on investment to help you make informed investment decisions.