How to calculate ROI on rental property

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Property is one of the investment tools that people can use to invest their money and make a profit. In many ways, real estate is a safer investment than investing in securities. Moreover, such an investment is not only safer but also more understandable to those people who have never experienced the world of investing.

There are two ways you can make money from buying properties. In the first case, you make money by renting out properties.
In the second case, you earn money by investing in properties in order to sell them and earn on the price difference.

In most cases, investors combine these two goals, planning to make money on rentals, but also counting on the property continuing to rise in price.

In any case, you need to measure the return on investment, and the best measure for this purpose is return of investments (ROI).

What is return of investments (ROI)?

ROI shows how much profit you get from an investment. Return on investment is a key indicator to understand how profitable it is to invest money in a particular investment. It means that you can assess how rational it is to invest in a particular project.

In general, ROI can be used for any investment, regardless of the specific instrument. It can be stocks, securities, a deposit in a bank or properties.

The calculation of ROI for properties depends on several factors, primarily on how you pay for the property: in cash or by financing with a mortgage.

What is the ROI formula

As return of investments is a ratio, it’s calculated in percentage terms.​

The original formula of ROI looks like:

ROI = (Gain on investment – Cost of investment)/Cost of investment

Also, the formula may look like:

ROI = Net profit/Cost of investment

What are the pitfalls in calculating ROI for rental properties?

The ROI formula looks easy enough, but there are many pitfalls that you must take into account when calculating ROI for rental properties. Here are just a few examples. You have to take into account repair costs, property maintenance costs, property tax costs, and other expenses.

How to calculate ROI on rental property paid in cash

First, let’s look at the ROI for rent property paid in cash. This is easier than calculating ROI for properties financed by a mortgage.

Let’s make some assumptions:

  • You buy a property for $100,000 and invest $8,000 in repairs and $2,000 in closing costs.
  • The rent is $1,000 each month.
  • The overhead (utilities, taxes, insurance) is $400 per month.

Now let’s calculate net gain for investment and cost of investment one year later.

  • The cost of investment will be $110,000.
  • You will make $12,000 on the lease.
  • Your overhead will be $4,800
  • Net gain would be $7,200

Now, let’s calculate ROI. To do this, you should divide Net gain by the cost of investment. ROI would be $7,200/$110,000 = 0.0655 or 6.55%

How to calculate ROI on rental property financed by mortgage

This calculation is more difficult, as you should calculate expenses on mortgage financing.

Let’s make some assumptions:

  • The down payment on the mortgage was $30,000 (or 30% of the original amount).
  • You invested $8,000 in repair and paid $3,500 as closing costs (as for mortgage-financed deals they’re always higher). $11,500 in total.
  • Your total expenses were $41,500
  • The rent is $1,000 each month.
  • The overhead (utilities, taxes, insurance) is $400 per month.
  • You took a mortgage with a 3% fixed interest rate for 30 years. Your monthly payment would be $427
  • The monthly net gain would be $1,000 – $827 = $173
  • The net gain for the year would be $2076

Now, lets calculate ROI. To do this, we need to divide net gain by innitial cost of investment.

ROI = $2076/$41,500 = 0,050 (or 5%)

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