- August 28, 2020
- Posted by: Editor
- Category: Advice
Renting out properties is a viable business and a great way to build wealth over time. As an investor, it is very important to know how the rate of return on a rental property is calculated. This determines the efficacy of your investments in real estate.
Return on investment is an investment metric used to estimate and evaluate the performance of an investment to compare the performance of a number of different investments. ROI measures the amount of return on a particular investment, relative to the investment’s cost. A high ROI means the investment’s gains compare favourably to its cost. Here, we take a look at methods for calculating the rate of return on your rental property.
Rate of Return on a Rental Property Calculation: Simple Formula
For example, as an investor you paid in N1,500,000 in an investment property, and the total profits you made from your investment sum up to N1,700,000.
The simple rate of return formula is:
ROI = (Gain from Investment – Cost of Investment)/Cost of Investment
Then the return on investment is:
ROI = (N800,000 – N500,000)/N500,000 = 0.6 = 60%
Keep this formula in mind when going into investment. The other methods for calculating the rate of return includes the Capitalization Rate and the Cash on Cash Return. This is also subject to the mode of payment while investing.
The Capitalization Rate Calculation
Cap rate is the ratio between a property’s net operating income (NOI = Rental Income – Operating Expenses) and its purchase price. The formula for calculating the cap rate is:
Cap Rate = NOI/Purchase Price × 100%
The capitalization rate is used to measure the profitability of an investment property.
The capitalization rate is used by investors when the rental property is paid fully in cash. It is most often used to compare similar real estate investments
For example, if you bought a rental property and paid N36,000,000 in cash, N360,000 in closing costs, and N3,240,000 for remodelling, which makes your total investment in the rental property N7,200,000
Let’s say your gain for one year when your tenants pay in is N3,500,000 for rent every year. For a more realistic ROI, we will deduct N500,000 from that cash flow per year to cover other expenses such as property insurance, maintenance, property management, etc. Thus, your annual return would be N3,000,000
Now, to calculate the rental property’s ROI, follow the previous cap rate formula and divide the annual return (N3,000,000) by the total investment you initially made (N7,200,000).
Cap Rate = (N3,000,000/N7,200,000) x 100% = 41.7%
This means that your rental property’s rate of return is 41.7%.
Rate of Return on a Rental Property Calculation: Cash on Cash Return Calculation
Real estate investors use this method when they take a mortgage or loan to pay for the real estate investment property. The cash on cash return of a rental property is the ratio of the property’s annual NOI and the total amount of cash actually invested in the investment property. So, the formula for calculating the cash on cash return is as follows:
Cash on Cash Return = (Annual Cash Flow/Total Cash Invested) × 100%
Assume you bought the above mentioned N36,000,000 rental property, but instead of paying in cash, you put a 20% down payment and took a mortgage. Your costs are:
- N7,200,000 for the down payment (N36,000,000 purchase price x 20%)
- N400,000 for closing costs
- Same N3,240,000 for remodelling
As a result, your total cash invested is N10,840,000 (N7,200,000 + N400,000 + N3,240,000).
Let’s assume for this example, the yearly interest payment is a total of N1,160,000. Assuming your tenant pays N3,500,000 every year, you will have a cash flow of N2,340,000 per month (N3,500,000 rent – N1,160,000 mortgage payment) which is your net annual income, or return.
Next, use the cash on cash return formula and divide the annual cash flow by the total cash actually invested to determine the rate of return on investment (ROI).
Cash on Cash Return = (2,340,000/10,840,000) x 100% = 21.6%.
This is your rental property’s rate of return.
What Is a Good Rate of Return on a Rental Property?
The easiest way to answer this question is “it depends”- on the size of the rental property, the location, the risk associated with the investment, etc. Different experts will give you different answers, generally the average rate of return on investment is anything above 15%.
When calculating the rate of return on a rental property using the cap rate calculation, many real estate experts agree that a good ROI is usually around 10%, and a great one is 12% or more. Conversely, when using the cash on cash return calculation to measure the rate of return on a rental property, real estate experts disagree on what is considered a good ROI. Some say that anything in the range 8-12% is good, while others would not invest in a rental property if it doesn’t promise them 20% return on investment.
Conclusion
As a land owner or an investor, you should be familiar with how to measure the rate of return on a rental property. Depending on how you buy the rental property – either fully in cash or by putting a down payment and taking a mortgage – you can calculate the rate of return using the cap rate calculation or the cash on cash return calculation.