No matter what assets you invest in, your return on investment (ROI) is the metric that matters. ROI shows how profitable an investment is compared to purchase and operating costs. When investing in real estate, there are ways you benefit that aren’t reflected in pure profits.
But for the sake of evaluating a property’s potential prior to purchase and assessing performance throughout your tenure as owner, keeping an eye on ROI is critical.
The Importance of ROI When It Comes to Your Rental Property
ROI refers to your profit made on an investment as a percentage of its cost. But it’s not just for portfolio analysis after the fact! One of the best things you can do before buying a property is to estimate the costs and ongoing expenses compared to potential rental income. You can make this comparison through comps or against numbers from similar properties in your portfolio.
Regardless, estimating a realistic ROI allows you to see very quickly whether any given rental property is worth your time.
How to Calculate ROI
ROI is calculated by dividing your net profit (rental income minus ongoing costs) by the initial cost of the investment. ROI is a profitability ratio, so you will take your result and convert it into a percentage.
To be completely accurate, the costs you include must be comprehensive. While some types of investments, like stocks, may only have the cost of the initial purchase and maybe fees associated with portfolio management and transactions, real estate is a bit more complex.
If you’re not careful, ROI for rental properties can be easily skewed through the exclusion of certain variables.
Because rental properties are not one-and-done transactions, there are complexities in mapping long-term ROI. And even then, there will be a difference between calculating ROI for properties acquired with all-cash and those utilizing lender financing.
...When Buying with Cash
The first numbers to combine are closing costs and the amount paid for the property. From there, calculate the annual return for the year (this can be done for portfolio review or for future projections). The annual return will include:
- Earned rental income
- Ongoing expenses including property taxes, maintenance and repairs, and other bills.
Subtract your expenses from the annual gross income. To then get your ROI, you will divide that annual return by the total amount of the investment.
...When Using Lender Financing
When you’re dealing with financing, you’ll want to add your downpayment, closing costs, and remodeling expenses, along with any other out-of-pocket costs associated with the property acquisition. Then, consider what you’ve borrowed and its interest rate – this will determine your monthly principal and interest payment on the mortgage.
Add that to other ongoing costs like water, taxes, insurance, etc. Your cash flow is your monthly rental income minus monthly expenses. Multiply this number by twelve to get your annual return.
Your ROI is then determined by dividing your annual return by those initial out-of-pocket expenses.
Some investors add their home equity into those calculations. To do this, look at your amortization schedule. Only the amount paid towards the principal of the loan builds equity. You may add that amount to your annual return and use it in your ROI calculations.
Mortgage vs. Cash Acquisitions
You will find that your ROI will be lower in all-cash transactions simply due to the higher initial costs. A higher ROI comes from financing simply because investors are leveraging someone else’s money. They don’t put as much of their cash into the initial investment.
Of course, those who pay in all cash will have a larger annual return, as there will be no mortgage payment to subtract from earned rental income. Leverage does increase ROI, but investors may not be able to fully enjoy their newfound passive income. At the same time, this leverage does make scaling one’s portfolio easier.
Ultimately, it’s a matter of preference.
The ROI of a Property Sale
Buy-and-hold investors will make their ongoing profits from rental income. However, as we mentioned, this isn’t the only source of income or value. When we talked about equity as part of ongoing ROI calculations, we must clarify: the reason some investors do not include it in their ROI calculations is that equity is not liquid. You must sell the property to see it turned into cash.
To calculate this ROI, you’re not just looking at the initial investment and sales price, but the costs associated with the sale: repairs, maintenance, advertising, real estate agent commission, appraisal costs, etc. If there’s an outstanding mortgage, it must be paid off, too.
When you sell can play a major role in your ROI. Buy-and-hold investors have the luxury of waiting for the right moment – ideally in a seller’s market – to execute their exit strategies. Just remember that you’ll have to anticipate capital gains taxes when you sell a property.
Which Costs Factor In?
Real estate investors have plenty of costs to consider as they work out their ROI metrics. The important thing is that you’re consistent in what you factor in and what you exclude. The clearest picture forms when you account for all your expenses – but this isn’t always practical when all you want is a quick snapshot of anticipated ROI.
Here are some of the costs you’ll want to consider:
Costs of the initial investment:
- Your downpayment or cash offer
- Closing costs
- Property inspection costs
- Renovation costs
Ongoing costs to subtract from gross income:
- Property taxes
- Insurance costs
- Maintenance & management
- Water or any utilities you cover
- Passive income taxes
You should also expect additional costs related to resident turnover, including:
- Professional cleaning
- Painting, landscaping, repairs, etc.
- Periodic renovations
- Marketing and advertising
What's Considered Good ROI?
As a rule of thumb, most experts suggest aiming for an ROI of 8 to 12%. Others will suggest investors try to match or beat the S&P 500’s average of 10%. This, too, comes down to investor needs and strategy. What one investor deems as a “good” return might not be good for you – listen to your advisor and adjust your expectations based on your investment goals.Your actual ROI will vary based on market, year, associated investment risk, etc. Looking for a specific percentage alone will not tell you if an investment is good; consider its context and full value – a value that may or may not be quantifiable.
Cap Rate vs. ROI vs. Cash-on-Cash Returns
ROI is not the only valuable metric in real estate investment. There are multiple ways to measure profitability. It depends on what you really want to know!
ROI – As we’ve established, this is a profitability ratio that calculates how much profit is made from an investment as a percentage of its total cost. It takes into account the whole cost of an investment property and can help investors gauge performance. Both buy-and-hold investors and fix-and-flippers can benefit from ROI. It is the universal metric for any investment.
Cash-on-Cash Return – Otherwise known as a cash yield, your cash-on-cash return measures pre-tax cash earned against the total amount of cash you’ve invested. It effectively tells investors how much they’ve earned back on their out-of-pocket investment expenses. It’s valuable in determining your financing methods, projected property performance, and the long-term potential in multiple rental properties. You’ll see it used interchangeably with ROI, but where ROI looks at the total investment, cash-on-cash returns are returns relative to out-of-pocket expenses.
Cap Rate – Your cap rate doesn’t account for mortgage payments, but investors may want to calculate it anyway. It measures a property’s rate of return by dividing net operating income by the current property value. These are mostly used for quick property comparisons and on multifamily and commercial properties. It is calculated by dividing NOI (net operating income) by the property’s value and multiplying it by 100.
All three metrics are used for measuring potential and existing profitability: just in slightly different ways and for different needs.
What's Holding Your ROI Down?
Your investment property’s ROI is not set in stone.
The more time you go without residents in your rental, the lower your ROI drops. Having reliable residents that renew their leases should be your top priority. There are ways to accomplish this, but it ultimately comes down to your due diligence. Your ability and willingness to learn, research, and invest in key services such as property management and contractors, is where you make all the difference in the world. Do your research. Work with the right people in the right markets.
When there’s no cash flow coming in from your rental property, you still eat regular expenses. That pushes your profitability into the negative! While turnover is inevitable, knowing how to minimize it and handle it smoothly will keep your ROI where it needs to be.
As a real estate investor, you’ve got to set goals that a realistic, specific, timely, and evolving. It’s hard to get the most out of anything if you don’t know exactly what you’re after. What are your long-term wealth-building ambitions? What’s your baseline for acceptable monthly cash flow for your properties? How many properties do you plan to own in the next five, ten, or twenty years? What markets do you want to be in?
Communicating these goals to your managers and advisors is key. They can help you get what you want out of your existing properties while also finding rentals that truly fit into your portfolio.
It was once a common belief that owning a home was an investment. In a sense, this is true: but your personal residence isn’t likely to shoulder the full weight of your wealth-building needs. Not unless you purchased a California beach house in the 1960s!
The average homeowner is rarely on top of property maintenance as they should be. That property maintenance, however, is required for rental properties. Maintenance does two things: it prevents small, relatively affordable fixes from becoming costly undertakings.
Some big fixes might even disrupt property occupancy!
It’s worth it to invest in property management and maintenance teams. They preserve the value of your investment – both in terms of equity and rental rates. Don’t make the mistake of penny-pinching in the short term. Cutting these corners will damage your ROI in the long run more than it will save you month-to-month.
Investing in the Wrong Things
Every investor must use their resources wisely. One of the major expenses in your rental property is in its renovations – be they the initial overhaul or later additions. However, these renovations have diminishing returns after a certain point. You want to invest your money where it will be reflected in both your home equity and what you can charge for rent.
There are two main things to consider here:
#1 – Renovating with your market and comps in mind.
Your rental property doesn’t exist in a bubble. The properties in your neighborhood, your comps, impact the value of your property. If you over-renovate, then you’ll struggle to get what your property is really worth because it does not match up with your market. The same goes for rent! Who are the people living in your market? What’s their household income look like? What can they afford? What are other owners charging?
If you renovate without minding your need to stay competitive, you can throw your ROI off kilter.
#2 – Renovating for longevity, not luxury.
As a real estate investor, the goal is not the make your rental property a high-end masterpiece. Some owners make the mistake of prioritizing luxury, trendy, or purely aesthetic renovations. While there is something to be said for the aesthetic appeal of a property, it’s not as important as designing for longevity. Choose materials that are durable. Your property will see plenty of wear-and-tear before it’s all said and done.
Not only do luxury upgrades have diminishing returns, but they can be more fragile and temperamental than sturdier materials.
12 Things Real Estate Investors Can Do to Boost ROI
Maximizing your investment property’s ROI isn’t all about cutting expenses. There are expenditures well worth the cost!
1. Provide Excellent Service
Retaining your residents is the top priority when looking to maximize your property’s ROI. That starts with the level of service you’re providing. If you don’t already have a dedicated property management team, get one. Not only does a reputable, attentive property management team help catch issues before they cause major problems, find reliable residents, and keep your business running smoothly, but they greatly expand your portfolio capacity. On your own, you can only handle so much.
Excellent, consistent service across all your properties is what will keep your residents renewing time and time again.
2. Choose Your Market Wisely
The current climate of U.S. real estate market may lend a false sense of security to investors. Properties are still gaining value and rent, particularly for single-family rentals. But this wasn’t always the case and it won’t always be the case. If you want to make the most of your return on investment, target your markets well.
There’s something in the real estate business called the 2% rule – this is a “rule” that says investors should make monthly rental income that is at least 2% of the property price. In some markets, this is a realistic metric. In others, not so much! Part of the problem is that following this rule can lead inexperienced investors into extremely challenging markets: namely, areas where properties (and rental income) are cheap. These places tend to attract less stable residents, more environmental risks, and greater maintenance and repair demands.
Your market should first and foremost be stable. It needs a pattern of sustained rental demand. And your properties? Don’t go for cheap. Aim instead for the properties with long-term potential.
3. Perform Efficient Upgrades
Small, targeted property improvements can significantly impact your monthly rental income, which is where you increase your profitability. The key is to use renovations that are relatively affordable but offer a high impact on long-term value and cash flow. Think fresh paint, new hardware, and durable, attractive flooring. It doesn’t have to be a huge undertaking to make a big difference.
The steps you take to “freshen up” your properties will keep you ahead of the competition.
4. Keep Up the Property
Pair your new upgrades with diligent maintenance and care. While your residents are responsible for keeping their rental home clean, your crew carries the responsibility of maintenance and general care. Set the stage with open, attentive communication between the residents and management. This will make them feel more comfortable with alerting the right people about any problems with the property.
An agile response not only builds rapport with your residents, but it means you minimize the cost of the problem.
5. Utilize Digital Services
Technology affords investors a whole host of opportunities to save (and earn!) money. Think digital spaces that will help you monitor the competition, platforms for gathering rent payments automatically online, and digital locks for your properties to save on making keys and calling locksmiths. Your ROI isn’t limited to one property – it’s your whole portfolio, too. The better you can streamline your processes, the more capacity you’ll have for strategy, scaling, and making the most of what you have.
6. Stay Competitively Priced
Rental comps keep you grounded. Rental rates are on the rise. While you don’t want to arbitrarily raise your prices, you should be able to stay competitive – if not premium – based on the level of service and excellence you provide for your residents. At the end of the day, you don’t want to leave money on the table. Don’t sell your property short of its market value just to undercut your competitors!
7. Value Diligent Resident Screening
Resident retention is essential in protecting your ROI. But those residents must be worth retaining. As the property owner, you should hire property managers with a focused and effective procedure for vetting rental applicants. Again, your property management is your ultimate defense. They will make or break your rental success. It’s worth your while to make an investment in quality, reputable professionals.
8. Leverage the Pros
Speaking of the professionals…
It may seem counterintuitive to pay more to increase the return on your investment. But with rental properties, you’ve got to consider the long game first. Turnkey partners, portfolio advisors, property managers…these are all professionals you can invest in to help manage your properties and build your investment portfolio.
Inexperienced investors particularly benefit. Leveraging the experience of others allows you to succeed in real estate investment without making any of the costly errors beginners often make. While you might pay more, you’ll also make the most of your income and property equity.
9. Minimize Tax Liability
Taxes eat into your gross income. That, in turn, affects your ROI. In real estate, some of your biggest benefits are found in your taxes. Partner with a CPA with experience in real estate investment. They’ll be able to help you utilize all the exemptions and benefits available to you. Then, remember other tax strategies...
You’ve got to plan ahead to reap the benefits. The 1031 Exchange, for example, allows investors to trade a like-kind property for another, tax-deferred. Investing through certain accounts, like a self-directed IRA (SDIRA), also allows you to defer capital gains taxes.
10. Manage Your Debt
Responsible debt management is an asset to any investor. When you mind your debt-to-income ratio and take steps to protect and increase your credit score, you increase the likelihood of securing a favorable interest rate. As interest rates have risen above 6% after the all-time low of a few years ago, keeping your rates as low as possible is crucial.
Find a lender you trust and build a relationship with them.
11. Take Advantage of Refinancing Options
While right now might not be the best time to refinance, keep the option in mind for the future. As rates change or your credit score improves, you can negotiate a better interest rate with your lender. That interest rate greatly impacts your ROI. Only the principal paid increases your equity in the property – not the interest. Though you can write it off on your taxes, it’s better to lower the interest paid to begin with.
12. Look to the Long-Term
Finally, you’ve got to think in terms of the big picture. Rental properties don’t succeed on the cheap. It might seem counterintuitive to pay more upfront, but you want to target properties with the greatest long-term appreciation potential. Focus on up-and-coming areas as well as established, desirable neighborhoods. Utilize excellent service providers. It might cost more, but you’ll gain in the end. You’ll both earn and preserve equity in your properties while also incentivizing residents to stay – and pay – for a quality rental experience.
ROI alone is an easy metric to calculate. For the real estate investor, what matters is what you do with your measures of success. Take your ROI and other valuable investment KPIs and view them through your unique goals and context. From there, you can devise the best strategy to achieve your best financial future.
Leverage the experience of a company that values your ROI!