Calculating Return on a house for rent

18 Replies

Hello all, I have a numbers based question that I can't quite figure out. I currently own my home and have a mortgage on the property. I am looking at potentially buying a new home and renting out my current residence. Since I purchased it in 2010, I have a low interest rate and overall payment. Is ROI the appropriate metric to use in this situation? If so what is the best way to figure it out? Or is there another formula I should be using to help me decide what to do?

I am not sure exactly what you are asking. Why wouldn't you use the actual costs to figure your ROI?

If you purchased your home at a lower rate and have a lower payment, you can use that payment as an estimator for what your ROI would be if converting to a rental because it is the actual cost. Why wouldn't you think you could use that?

@Cara Lonsdale I'm not sure I follow you.

For the sake of clarity, my current payment is $1930 and I estimate I could get $2700 in rental income per month. If I purchase a new property and put 50K in as a down-payment it leaves me with an approximate new mortgage payment of $2350. So in this scenario I'm investing 50K and getting a return of about 4200/yr. (1930+2350)-2700 = 1580.  1930-1580 = 350. 350*12 = 4200.

Does this mean my ROI is just 4200/50K? so like 8.4%.

@Peter S. is the missing link here that you are REFINANCING your current property, with the aim to rent it out @ $2700 per month? Then using the cash out from the refinance as a down payment on your next property?

First, I would keep the numbers separate. What is your cash out refinance costing you besides a more hefty PITI? I did not see any other costs, e.g. vacancy, CAPEX, maintenance, utilities, etc. This will add to your $2350 per month PITI and that will definitely hit your numbers.

I don't know if your numbers are right, honestly I'm missing your overall formula above. Again, I'd take each property seperately, work out the P&L for each, and see if the numbers make sense. To me it looks like you're about to take a loss on property 1 with a higher PITI and other expenses eating into any available cash flow. We don't see the numbers for the second property, which might be helpful.


Sorry if this isn't helpful - I just don't quite understand the ROI metric here since you aren't selling your property. Cash flow, cash on cash return, cap rate -- I think these are better indicators whether or not this works. But I certainly defer to more experienced investors if I am missing something.

Hi @Peter S. !

Let's just compute the cash flow and ROI for the one house you're looking to potentially rent out (your current home).

Let's try this:

Estimated Rent - $2700

Current payment - $1930

Taxes/Insurance - what is it?

Maintenance - some people put in a little per month to account for this

Vacancy - some people put this in too, in case you're house is leased for the full year

Take your rent and subtract all the other figures to get your estimated monthly "cash flow". This is the amount of money that goes into your pocket for that house each month after the bills and expenses have been paid. 

If you want the ROI, divide your yearly cash flow by the total amount invested, and there you have it. @Antoine Martel made a suggestion to use one of the BP calculators, that's a good idea. But typically, I don't compute ROI on multiple houses together, we just do it one house at a time.

Hope this helps!

Thanks, 

Van

Van Blackman, Real Estate Agent in Illinois (#475176182)
(713) 301-7630
Originally posted by @Van Blackman :

Hi @Peter S. !

Let's just compute the cash flow and ROI for the one house you're looking to potentially rent out (your current home).

Let's try this:

Estimated Rent - $2700

Current payment - $1930

Taxes/Insurance - what is it?

Maintenance - some people put in a little per month to account for this

Vacancy - some people put this in too, in case you're house is leased for the full year

Take your rent and subtract all the other figures to get your estimated monthly "cash flow". This is the amount of money that goes into your pocket for that house each month after the bills and expenses have been paid. 

If you want the ROI, divide your yearly cash flow by the total amount invested, and there you have it. @Antoine Martel made a suggestion to use one of the BP calculators, that's a good idea. But typically, I don't compute ROI on multiple houses together, we just do it one house at a time.

Hope this helps!

Thanks, 

Van

 Yep, doing it one house at a time is how we like to do it as well. 

Return On Investment (ROI)

I am still unclear on what your goal is here, but I am honestly trying to help you achieve it with the info you have provided.

First, you gave me the current property payment = $1,930.  Let's call this Property A

Then I am guessing the 2nd property payment is $2,350?  Let's call this Property B

Then I concluded that you can rent out Property A for $2,700.

You did not provide a rental rate for Property B.

You also did not include expenses for either property.

You also didn't clearly explain how you came up with the $50K (or maybe I missed it).  So, I assume that you already have that money saved.

So, to figure the ROI you are looking for you need ALL of the elements in the formula above. ALL of the rental income (Gain from the Investment) - ALL expenses including repairs, maintenance, rehab and mortgage payments (Cost of Investment) and divide it by the $50K (Cost of Investment)

My question for you, is are you sure you aren't looking for the cap rate?

The cap rate is the ratio of Net Operating Income (NOI) to property asset value. So, for example, if a property recently sold for $1,000,000 and had an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or10%

I hope that helps!


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@Van Blackman  

Estimated Rent - $2700 on property B

Current payment - $1930 this includes taxes and insurance and is the total monthly payment

Maintenance - House was built in 2010 so I'm using only 5% for this number - $135/mo

Vacancy - Estimating 8% on this so $216/mo

Thanks @Cara Lonsdale

Property A is my current home. My total monthly payment is $1,930. I believe I can rent this for $2700/mo

Property B is a home I'm interested in purchasing and will live in. It will be completed in March of this year. I estimate that my total monthly payment will be $2350. This assumes I put ~10% downpayment on this property or ~46-50K. This is liquid cash I currently have. 

I don't include any expenses on the new property since it will be brand new. On property A I am looking at ~350/mo to set aside for maintenance and potential vacancy. 

Perhaps ROI isn't the best metric to use in this case? Basically i'm trying to determine if purchasing property B and renting out property A will be a good opportunity to acquire another property in an appreciating market while still be able to cash flow.

Or does this look like to slim of a margin to make it work?

Peter -- I think you might be making a mistake in calculating your numbers for cash flow (which is ultimately the important number here). You are executing a rental on your current property, and wish to take liquid cash and purchase another property. All well and good.

You are then saying for property A, my PITI is 1930, my expenses (vacancy/maintenance) is 350, so total expenses is 2280. You are renting for 2700. Your cash flow is 420 per month. However, what about capital expenditures on property 1? Does the furnace, roof, flooring, appliances, etc, in need of replacement soon? What happens if you're hit with a 10k bill for something like that in the near future? Would you have the reserves on hand to take care of that? Some landlords build that into their expenses and divert money per month for that, which eats into cash flow, but covers you when the bill actually comes. What about other expenses, e.g. utilities the landlord has to pay?

Assuming you've covered those in your expenses, if you truly made $420 per month cash flow and the property is a SFH, I'd say its a good deal. What did you purchase the home for? You can find your cap rate by dividing your yearly income by the purchase price. 10% cap rate seems to be standard for most folks, but ultimately not the only qualifying number.

Based on what I am seeing you have no intention on renting out property B, it is a home for you to live in, correct? So you're trading up so to speak, on a more expensive property, utilizing liquid cash for a new home?

Ultimately, could you do better by staying in property A, buying a multifamily property using liquid cash, and making far better cash flow per month? For instance, if you found a multifamily property with the same PITI, add in your expenses and capex, to the tune of say, 3000 per month...and then rent it out for 4000 per month? Now your cash flow is $1000 per month, 12,000 per year(versus $420 on property A), you've kept the same monthly payment that you have now on your current property (cash that stays in your pocket), and you can far more easily calculate COCR, Cash Flow, Cap Rate, ROI, etc, on a property that's working for you far better than renting out your existing property.

By the way, I don't talk about this like I don't know where I am coming from -- I rented out my first home (property A) for meager cash flow while my wife and I purchased our "forever home" which has a higher monthly cost via PITI. Long story short, I rented out property A for 3 years and just sold it for a bit of profit...to do exactly what I told you to do. I'm investing in a cheaper multi-family property that should net around $500 per month cash flow, my cash on cash return is 10.5%, and my cap rate is 21%.

While I think people invest for many reasons, one of mine is the right numbers and cash flow. Property A did not have the right numbers and cash flow, long term, at least for me.

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I think some people here are confusing ROI with cash on cash return. There's a difference. And when you're just looking at cash on cash return, you're shortchanging the real return you get with buy and hold investing - SIGNIFICANTLY.

That being said, I think the poster is co-mingling the two homes and their values a little off as well.

You mentioned the 50k you're putting into the new home. At no point would that help you figure out whether keeping your current home as a rental is providing the returns.

If you want to calculate your returns, you should look at how much equity you have in your current home. Determining whether you should make your current home a rental or not is based on how much your return would be which is based on how much cash you'd actually walk away with if you were to sell it instead of renting it.

So lets say your house is worth 300k and you owe 220k. If you sell it, you may have to put in another 10k to get it retail ready and you'll end up with closing costs and realtor fees of say 20k?  So you'll walk away with 50k.

That is option A. Sell your current residence and pocket 50k.

Option B is keep your current house and rent it out. What does that return on that 50k?
1) Net rental income. 2700 for rent, with 1920 for PITI. Assuming you're going to self manage, thats 800/mo gross profit. Minus 200/mo for repairs and 250/mo for vacancy, that leaves 350/mo in net profit? or 4,200/yr.
2) Income is tax free.  If you have a 300k house, you will now be able to depreciate the house. Assuming you can get by calling land 20k, that would give you 280k divided by 27.5 years so 10k/yr in depreciation. You would basically offset the rental income of 4,200 against that so it would be 100% tax free. Plus you'd get an additional 6k tax writeoff on your regular income as well.  Maybe another 1,200 in tax refund?

3) Principal paydown. On a 200k+ loan in year 8, I'm guessing your principal paydown is roughly 400/mo?  Thats another 4800/yr you're making on principal paydown.

4) Appreciation. Lastly, appreciation. On a 300k house if you're getting typical appreciation of 3 to 4% a year, you're looking at 9k to 12k a year in that. Again, I'm guessing on the numbers for home value and mortg amount but based on rent and loan payment, I'm hoping I can at leave give you an idea of what the return actually is. 

So what is your real return on that 50k that you could pocket were you to sell versus what it would earn you as a rental.
1) Rental income - 4,200/yr

2) Tax benefits - 1,200/yr

3) Principal paydown - 4,800/yr

4) Appreciation - 10k/yr

Thats a total of 20k/yr that is getting added to your net worth every year. If you were to sell the house and pocket the 50k and put it in the stock market, could you match that return?

And thats only the return in the early going. Rents go up. principal paydown on a loan goes up. Appreciation goes up as 3 to 4% of 300k is 9k to 12k. In 10 years, that house may be worth 400k, and then you're looking at 12k to 16k in appreciation a year.

There's a reason why buy and hold is one of the absolute greatest wealth generators in investing you'll ever find. It does mean dealing with tenants so its not as easy as picking a stock and watching it. But you won't find a better return on anything out there when comparing it to buy and hold real estate.

Originally posted by @Joe Papp :

Peter -- I think you might be making a mistake in calculating your numbers for cash flow (which is ultimately the important number here). You are executing a rental on your current property, and wish to take liquid cash and purchase another property. All well and good.

You are then saying for property A, my PITI is 1930, my expenses (vacancy/maintenance) is 350, so total expenses is 2280. You are renting for 2700. Your cash flow is 420 per month. However, what about capital expenditures on property 1? Does the furnace, roof, flooring, appliances, etc, in need of replacement soon? What happens if you're hit with a 10k bill for something like that in the near future? Would you have the reserves on hand to take care of that? Some landlords build that into their expenses and divert money per month for that, which eats into cash flow, but covers you when the bill actually comes. What about other expenses, e.g. utilities the landlord has to pay?

Assuming you've covered those in your expenses, if you truly made $420 per month cash flow and the property is a SFH, I'd say its a good deal. What did you purchase the home for? You can find your cap rate by dividing your yearly income by the purchase price. 10% cap rate seems to be standard for most folks, but ultimately not the only qualifying number.

Based on what I am seeing you have no intention on renting out property B, it is a home for you to live in, correct? So you're trading up so to speak, on a more expensive property, utilizing liquid cash for a new home?

Ultimately, could you do better by staying in property A, buying a multifamily property using liquid cash, and making far better cash flow per month? For instance, if you found a multifamily property with the same PITI, add in your expenses and capex, to the tune of say, 3000 per month...and then rent it out for 4000 per month? Now your cash flow is $1000 per month, 12,000 per year(versus $420 on property A), you've kept the same monthly payment that you have now on your current property (cash that stays in your pocket), and you can far more easily calculate COCR, Cash Flow, Cap Rate, ROI, etc, on a property that's working for you far better than renting out your existing property.

By the way, I don't talk about this like I don't know where I am coming from -- I rented out my first home (property A) for meager cash flow while my wife and I purchased our "forever home" which has a higher monthly cost via PITI. Long story short, I rented out property A for 3 years and just sold it for a bit of profit...to do exactly what I told you to do. I'm investing in a cheaper multi-family property that should net around $500 per month cash flow, my cash on cash return is 10.5%, and my cap rate is 21%.

While I think people invest for many reasons, one of mine is the right numbers and cash flow. Property A did not have the right numbers and cash flow, long term, at least for me.

Thanks Joe, I think this makes a lot more sense to me now. In this particular case the home is only 8 yrs old so while I don't expect any major repairs to come due anytime soon, I have other reserves that I could use in that event. 

Using suggestion for cap rate I get just under 10% since I'd have an income of (2700*12=32400) and a purchase price in 2010 around 330K.

I like the idea of multi-family as well, the biggest challenge with that is the financing. Definitely something I'd like to look into in the future.

Conventional mortgages for multifamily properties are permanent "conforming" loans offered by traditional banks and lending institutions. These mortgages are long-term with terms between 15-30 years. Conventional mortgages can finance multifamily properties between 2-4 units but can't finance 5+ units. So financing a 2-4 unit building would be just like financing a SFH

Do not ever include principal pay down and appreciation in calculations. Those, as all investors know, do not exist until the property is sold and actual dollars realised. Until then markets climb and fall, fortunes are made and lost on paper only.

Adding those number into the equations is done only to sell to perspective newbies that have no concept of investing in real estate.  Math is not based on speculation.

Originally posted by @Steve Jellen :

Conventional mortgages for multifamily properties are permanent "conforming" loans offered by traditional banks and lending institutions. These mortgages are long-term with terms between 15-30 years. Conventional mortgages can finance multifamily properties between 2-4 units but can't finance 5+ units. So financing a 2-4 unit building would be just like financing a SFH

 Hi Steve,

I should have clarified what I meant by financing. I understand the rules are the same for 2-4 unit property as SFH, it's just the 20% min down payment that doesn't work for me right now.

Originally posted by @Thomas S. :

Do not ever include principal pay down and appreciation in calculations. Those, as all investors know, do not exist until the property is sold and actual dollars realised. Until then markets climb and fall, fortunes are made and lost on paper only.

Adding those number into the equations is done only to sell to perspective newbies that have no concept of investing in real estate.  Math is not based on speculation.

My investment account and continuing RE purchases states otherwise. There are many ways to extract equity from RE appreciation. I have extracted more equity from appreciation in the last 3 years than I have made cash flow on all of my LTR units this century (not counting the STR units in the cash flow but counting them in the extracted equity) and it is not close.

I do realize that if interest rates rise the options to extract equity become less palatable.

I also recognize coastal So Cal is not the typical RE market.

Finally I recognize some of my appreciation gains have been forced appreciation significantly aided by market appreciation.

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