Key Takeaways:
A passive income property’s return on investment, otherwise known as ROI, represents an income-producing asset’s potential. More specifically, however, a rental property’s ROI suggests how much of a profit an investor stands to make on a given asset. As a result, ROI has become synonymous with today’s best indicators for determining whether a deal is viable or not. Therefore, it is of the utmost importance for an investor in today’s market to evaluate rental property ROI.
How To Calculate ROI On Rental Property
The ability to calculate ROI on a rental property is second to none; every passive income investor needs to know how to do it. Those that can accurately predict what they expect to make on an investment may actually be able to increase their likelihood of success. And what is success to a passive income investor, if not for mitigating risk to realize returns?
If that sounds like something you could get behind, here are some of the simple steps you should consider if you want to learn how to calculate an asset’s potential ROI:
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Add Up The Likely Income Potential: The first thing you are going to need to do is calculate your annual rental income. Add up how much you expect to make over the course of a year on rent.
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Subtract Expenses: Take that same annual rental income you just calculated and subtract any expenses you expect to incur. Be sure to remove everything from taxes, maintenance costs, and anything else that’ll deduct from your bottom line. The number you end up with will be known as your cash flow (the amount you have left in your possession after expenses have been accounted for).
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Add The Equity: Don’t forget to account for the equity you stand to make in the property. Every payment towards the mortgage principal will increase your equity in a property. The number you are left with (once you account for income, equity, and expenses) will be your net income.
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Divide The Net Income By The Total Investment: Finally, proceed to divide the net income by the total investment to calculate your ROI on rental property.
I want to make it abundantly clear: these steps are not representative of everything involved in calculating ROI on a rental property but are a brief synopsis. There are more components to calculating ROI, and no two deals are the same. You may encounter additional variables in your own transactions that need to be accounted for, so be sure to mind due diligence.
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Rental Property ROI For Cash Transaction
It should go without saying, but calculating the rental property ROI for a cash transaction is a little simpler than one with financing. As you would assume, cash transactions are a bit more straightforward, as the middleman (the bank) tends to complicate things with underwriting and interest rates. Perhaps even more importantly, there aren’t any ongoing costs associated with an all-cash transaction. When calculating ROI on rental property acquired in cash, there’s no need to include monthly interest payments, as there are none. Therefore, the expenses you would need to subtract to register the cash flow number are a bit easier to calculate.
ROI On Financed Transactions
Calculating the ROI on financed transactions is a different story. While the process isn’t all that different, it is a bit more involved and requires a little more due diligence. Whereas calculating rental property ROI for a cash transaction doesn’t require the buyer to think about monthly interest rates, buyers financing their purchase with a loan will need to account for the interest they pay each month in their expenses. Interest is nothing, if not an expense buyers need to be aware of and account for when calculating their ROI.
The Best ROI On Rental Property By Market
We have all heard of real estate’s cardinal rule: location location, location. There is perhaps nothing more important to a property’s potential to make a profit for investors than its location. After all, where the house is situated is just about the only thing you can’t change. That said, where you buy a rental property will have a drastic impact on its potential return on investment.
The differences in rental markets are already as abundant as they are obvious. More specifically, rents will vary dramatically between markets, even those that are just a few cities over. Take California, for example: The average one-bedroom apartment in Danville, Ca rents for $4,280 a month, whereas single-bedroom apartments in Huntington Beach, CA rent for an average of $1,850 a month. Of course, Danville represents the most expensive end of the spectrum, but the point is clear: rents are typically correlated to the location in which the rental property is located, and not solely the property itself. Therefore, if you are hoping to get into the rental property game, you had better study the location you intend to rent in because strategies will change drastically from city to city and even neighborhood to neighborhood.
Summary
Today’s most prolific investors already know it, and it’s about time you did, too: To realize success in this industry, you need to be able to mitigate risk. The best investors are, after all, those that reduce their exposure to risky situations. To the best of my knowledge, the best way to mitigate risk on a rental property is to calculate its potential return on investment. Rental property ROI is, after all, one of the single greatest indicators for determining whether or not a property is worth pursuing. What’s more, it doesn’t take a seasoned investor to calculate ROI on rental property portfolios. Follow the steps listed above, and you’ll be able to calculate rental property ROI in no time. Before you know it, you’ll be able to determine the viability of an investment property all on your own.
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