Have you ever heard the old saying that 90% of millionaires created their wealth in part due to investing in real estate? This was first said by Andrew Carnegie more than 100 years ago, but it seems it still has some truth to it today.
If you’re trying to figure out how to make your money work for you, you’ve probably been busy researching all of the different investment vehicles that offer the greatest amount of potential reward with the lowest amount of risk.
Real estate has been a very popular way to invest money over the last half a century. However, you’ll need to run the numbers to make sure that a prospective property you are looking at will give you the return you are looking for.
Are you wondering how to use a rental property calculator to determine the ROI on an investment? If so, stick with us and we’ll take a look at everything you need to know.
What Is ROI?
ROI stands for return on investment. This is a measurement of how much profit is made from an investment. ROI is a percentage of how much money is made when related to how much the investment cost.
This is one of the best ways to understand how efficiently and effectively the money put towards an investment are being used in order to turn a profit. When you can calculate the ROI of a potential investment, it can let you determine whether or not it’s a smart choice to put money towards said investment.
ROI can be used in relation to any kind of investment. This includes a savings account, stocks, bonds, or real estate. However, it can be more difficult to determine the ROI for a piece of real estate because there are more movable variables that can be manipulated easily.
How to Calculate ROI: The Formula
The basic formula for calculating the gain or profit on any investment requires that you take the total ROI and subtract the initial cost.
In order to find the ROI, you first take the net profit and then divide it by the initial cost. For example, say that you buy a stock for $2,000 and sell it two years later for $3,200. The net profit is $1,200, which you find by subtracting 2,000 from 3,200.
Then, you divide 1,200 by 2,000 in order to find the ROI. In this example, the ROI would be 0.6 or 60%.
Calculating ROI on a Real Estate Investment
While the formula listed above seems quite simple, it can get a bit more complicated when it comes to real estate investments. A number of variables, including methods of figuring leverage and maintenance and repair expenses can impact your ROI.
Determining ROI For Cash Transactions
It is typically fairly straightforward to determine your ROI if you buy your rental property outright with cash. Here is an example of a cash transaction real estate investment:
- You purchase a piece of real estate for $150,000
- The closing costs were $1,500 and you put $8,500 into remodeling, making your total investment $160,000
- Every month, you collect $1,000 in rent
When you look at the property a year later, you find that:
- For twelve months you earned a total of $12,000
- Your expenses for the property totaled $2,000 for the year
- Your annual return was $10,000 ($12,000-$2,000)
In order to calculate the ROI of the property, you would take the annual return and divide it by the total investment. In this example, you would divide $10,000 by $160,000. This leaves you with an ROI of 6.25%.
Determining ROI For Financed Transactions
If you are planning on getting financing for your property investment, determining the ROI is a bit more complicated.
If we take the same example as above, let’s say that the $150,000 property was obtained through financing rather than purchased with cash.
- You put down a 20% downpayment of $30,000 ($150,000 x .02)
- The closing costs were $2,500, as it’s common for closing costs to be higher with a mortgage
- You put $8,500 into remodeling
- Your out of pocket expenses totaled $40,000
On top of that, there are additional ongoing costs when you have a mortgage loan:
- In this instance, you took out a 30-year loan with a 3.5% interest rate, giving you a $539 monthly mortgage payment on the $120,000 loan you took out
- Your additional expenses for the property are $2,000 a year, making your monthly expenses $705.67 when combined with the mortgage
- You receive $1,000 a month in rental income
- Your monthly cash flow is $294.33 (1,000-705.67)
When you look at the property a year later, you have made $12,000 in rental income. Your annual return, which is found by multiplying $294.33 by 12 months, is $3,531.96.
From here, you can now calculate the ROI. You will divide the annual return by your total initial out-of-pocket expenses. Above we determined these were $40,000.
By dividing 3,531.96 by 40,000, you find that the ROI on this investment is 8.82%.
Are you wondering how to apply for a rental loan? You can learn about the steps here.
Considering Home Equity When It Comes to ROI
Sometimes, real estate investors will also include the equity of the home into the ROI equation. Equity is the total outstanding loan amount subtracted from the market value of the property. In order to access equity, you have to sell your home.
This complicates the calculation even further. You will have to look at the mortgage amortization schedule for the loan to find out how much of your mortgage payments have gone to principal rather than equity.
The amount of equity you have earned in the property can be added to the amount you determined for your annual return. In our example, you would have paid $2,498.52 towards the principal after one year.
This means that you can add $2,498.52 to the annual return to get $6,030.48. Then, you can take this figure and divide it by your initial out-of-pocket expenses to find the ROI. In this example, the ROI would be 15.07% when factoring in the equity.
(Are you wondering about the BRRRR method of real estate investing? Check out this handy guide to learn more.)
How to Calculate ROI With a Rental Property Calculator
You can find many different rental property calculator tools online. These tools allow you to enter in a number of different values to easily determine your ROI without having to do the math yourself. Rental property calculators will typically include:
- Purchase price
- Closing cost
- Whether you are using a mortgage to purchase the property
- The monthly rent you’re receiving
- The vacancy rate
- Operating expenses including property tax, insurance, maintenance, and other expenses
These tools will often also tell you the capitalization rate in addition to the ROI.
(Curious about the different types of financing available for property investment? Check out this article.)
Property Investment: How to Invest in Real Estate
There are a lot of different ways to invest in real estate, and it doesn’t necessarily include purchasing a physical property. Over the last 50 years, real estate has become a very popular investment vehicle. Let’s take a look at some of the different ways you can use real estate to grow your wealth.
Rental Properties
When you purchase a rental property, you are becoming a landlord. This can be a great way to produce income, build equity, and grow your wealth. However, you’ll want to consider what it entails to be a landlord before hopping in.
Some landlords choose to hire property management in order to handle all of the details of owning a rental property. Even so, you’ll still be liable if something goes wrong. If you don’t hire property management, you might find that the 24/7 job of taking care of tenants and a property aren’t up your alley.
With risks, though, can come great rewards. Owning and operating rental properties can give you one of the best ROIs when compared to other forms of real estate investment.
Flipping Houses
People who flip houses aren’t making a long-term investment. Instead, they are buying a home either that they believe can be sold for a profit with some repairs or that is in a rapidly rising market.
This can be a risky endeavor but it can also be quite profitable when done right. In order to be successful, it’s important to be knowledgeable about the local real estate market as well as renovations and repairs. Having a network of contractors and real estate professionals that you know well can be very helpful if you plan to flip houses.
REIGs
Real estate investment groups (REIGs) are a way to own a rental property without dealing with the issues that can come along with being a landlord. They are kind of like small mutual funds for rental properties.
In this form of real estate investing, you can invest in one or multiple units of self-contained living space in a building owned by a company. This company is responsible for management and maintenance in addition to filling vacancies and advertising. They receive a percentage of the monthly rent in exchange for these services.
REITs
Investing in a real estate investment trust (REIT) is a lot more like investing in the stock market. In fact, REITs are bought and sold on major exchanges just like ETFs and stocks. This can be appropriate for investors who are looking for regular income but don’t want to deal with being a rental property owner.
There are also opportunities for appreciation when it comes to REITs. This also has the benefit of being highly liquid, which can’t be said of other forms of real estate investing.
Is It Better to Pay Cash or Get Financing When It Comes to Real Estate Investment?
When you learn more about real estate investing, you’ll find that most investors use some sort of financing in order to purchase properties. However, some investors do pay cash upfront. Which is the smarter way of investing your money?
There are certainly some benefits to paying cash. These include being able to make more attractive offers to buyers, protecting yourself from market downturns and vacancies, and avoiding the stress and trouble of the mortgage process.
There are also drawbacks to a cash investment. For one, it can reduce the tax benefits. Additionally, it can tie up your money in one property, therefore reducing your asset diversification. It can also be a lot harder to get started in property investment if you’re trying to buy a property entirely in cash.
Using financing, on the other hand, can allow you to diversify your portfolio more because it doesn’t tie up all of your cash. It also allows you to scale faster if that’s what you’re going for. Many find that inflation works in your favor when you purchase using financing rather than cash, as well.
If you are willing to take on a bit more risk, you can reap more rewards when you use a mortgage or other financing to purchase rental property. Basically, by using leverage to your advantage, you can potentially supercharge your return on investment when you use financing.
Is It Time For You to Begin Your Journey Into Property Investment?
One of the incredible benefits of using real estate to earn income and grow your wealth is the power of leverage it affords. When you take out a mortgage to buy a rental property, you can use other people’s money to build your wealth. There aren’t many opportunities like that out there!
After you have used a rental property calculator or done the math the old-school way, you are in a much better position to determine whether or not a certain property will give you the type of returns you are looking for.
Are you wondering what your options are when it comes to rental loans? If so, you can learn more here.
