Return On Investment (ROI)
What Is Return on Investment?
Return on investment can be used for any investment—stocks, bonds, or a piece of real estate. Calculating a meaningful ROI for a residential property can be challenging because calculations can be easily manipulated, and certain variables can be included or excluded.
How to Calculate Return on Investment
The return on investment formula measures the rate of return by subtracting the current value of the investment from the initial value of the investment and dividing it by the initial value. The ROI formula is:
- (Current investment value - initial investment value) / Initial investment value
- Investment return / Investment cost
Types of ROI
However, there are other return measures that are used to assess an investment's profitability:
- The return on equity is a profitability measure that’s used on a company-wide level and not for specific investments. It’s calculated as net income divided by the average shareholder’s equity. This measures how well the company is using its assets.
- The internal rate of return determines the profitability of an investment or project—however, calculating it is a bit more involved than ROI. To find the IRR, one must use trial-and-error or a software program to find the interest rate that makes the net present value of all future cash flows equal to zero.
Calculating ROI on Rental Properties
ROI for Cash Transactions
- You paid $250,000 in cash for the rental property.
- The closing costs were $10,000 and remodeling costs totaled $25,000, bringing your total investment to $285,000.
- You collect $1,500 in rent every month.
- You’ve earned $18,000 in rental income.
- Expenses, including property taxes and insurance, totaled $2,500.
- Your annual return was $15,500.
ROI for Financed Transactions
- The down payment needed for the mortgage is 20 percent of the purchase price, or $50,000.
- Closing costs were $12,500 and remodeling cost $25,000.
- Your total out-of-pocket expenses were $87,500.
- The mortgage was a 30-year fixed rate at 3 percent. On the borrowed $200,000, the monthly principal and interest payment is roughly $843.
- We’ll add the same $208.33 a month to cover taxes and insurance, making your total monthly payment $1,051.33
- Rental income of $1,500 per month totals $18,000 for the year.
- The monthly cash flow for the property is $448.67 ($1,500 rent - $843 mortgage payment - $208.33 for taxes/insurance).
- Your annual return was $5,384.04 ($448.67 x 12 months).
- ROI is calculated by dividing your annual return by your original out-of-pocket expenses, or $5,384.04 divided by $87,500.
- The financed property’s ROI is 6.2%.
Depreciation and ROI
For example, consider the ROI of a rental property without depreciation. You have $30,000 in taxable income for your rental, for which you owe 25 percent in federal taxes, or $7,500.
However, accounting for depreciation means you owe less in taxes. If you have the same $30,000 in rental income, you can deduct your deprecation from this—say, $17,500. Thus, your new taxable rental income is $12,500. At a 25 percent tax rate, you now only owe $3,125.
Taxes aren’t generally included in ROI calculations, but for real estate investors, the depreciation expense can be a useful tool that makes rental property investing more advantageous than different investments.
Negative Return on Investment
For example, assume you invested in a $200,000 rental property and after a series of unfortunate events had to sell it for $150,000. Your capital gain (or in this case capital loss) is $50,000. The ROI for the property would be negative 25 percent.
Negative ROI can happen for a variety of reasons, including having a high turnover rate or long vacancy periods.
Maximizing ROI for Real Estate Investors
Meanwhile, making sure you have your property rented consistently is the biggest driver for income. Having a high turnover rate means you're missing out on income and having to spend more on expenses to find and vet tenants.
The other key to increasing rental ROI is increasing rent when possible. Increasing rental rates will help investors better manage rising expenses, which can include taxes, insurance and repairs.