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Real estate investing can be a lucrative investment strategy. Most of the world’s richest people acquired their wealth through real estate investments and converting homes into rental properties.
If you do it right, a real estate investment has the potential to generate significant wealth for you. You could benefit from a recurring passive income, rising property appreciation rates, and a myriad of tax benefits.
That said, real estate investing isn’t without its list of challenges. That’s why it’s always important to work with professionals. A property manager, for instance, can help you invest in the right property and help you maximize your ROI.
If you’re planning to invest in an investment property, the following is what you should know when it comes to calculating ROI.
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Types of Investment Properties
As a budding rental investor, there are different investment options you could consider. Including, single-family homes, apartments, vacation homes, condos, duplexes, and multi-family units.
However, if you’re just starting out, you should consider investing in a single-family home. Why? Managing a single-family home is relatively easier and less complex than a multi-unit property.
With only one tenant to handle, tasks such as repairs, maintenance, and lease enforcement, become simpler and more manageable. Managing multiple tenants, on the other hand, especially when just starting out, can be a daunting and stressful experience.
How to Calculate the ROI on a Property Investment
Most property investors go for cash flow when looking to invest in a rental property. But here is the tricky part – calculating the ROI on a property investment is not always straightforward.
As a property investor, you’ll need to weigh different aspects to determine the potential ROI of a property investment. You see, the ROI of an investment property is what determines whether a rental investment will be worthwhile or not.
The following are some of the things that you’ll need to factor in when calculating the ROI of an investment property.
- Property Details: This includes things like the number of bedrooms and square footage.
- Mortgage Details: Find out about the mortgage details should you get pre-approved. For example, the cost of the down payment, loan terms, and the monthly interest rate.
- Vacancy Rates: High vacancy rates are a definite red flag. This will mean less income for you, resulting in suboptimal ROI. Your goal should be to find units with high occupancy rates.
- Rental Rate: Rent is going to be the bread and butter of your investment property. As such, it’ll be in your best interest to know how much rent you can charge. You can do this by conducting a comparative market analysis.
This may include interviewing landlords renting out comparative units, or doing research on some of the top rental listing sites. The goal should be to find out what comparative units are charging for rent. - Rental Expenses: This is another important factor you’ll want to consider when looking to see whether an investment property will be profitable or not. Find out what expenses will impact your cash flow. Ideally, the lower the expenses, the higher the rental income you can expect.
With that in mind, the following are proven methods on how to calculate the ROI on property investment.
LEARN HOW TO CALCULATE YOUR ROI
Cash Flow
Cash flow is king when it comes to rental investments. Cash flow can take either of two forms: positive or negative. When cash flow is positive, it means that the gross monthly income exceeds the operational expenses. This is the ultimate dream of every smart landlord.
Negative cash flow, on the other hand, is when the operational expenses exceed the gross monthly income. With negative cash flow, it means that you’re losing money from your property investment.
A good example of this is when you have a vacancy. With every passing month without a tenant, your property investment will be losing money.
Before investing in a property, first find out the prevailing vacancy rates in the area. Additionally, find out the cost of running the investment. Such as, property taxes, insurance rates, repairs and maintenance costs, and the property management costs.
Ideally, you’ll want to keep your operational expenses between 35% and 45% of the gross operating income (GOI) and know how to read a cash flow statement.
Cash on Cash Return
This metric compares the annual cash flow to the initial investment amount. The ratio you get can tell you whether the real estate investment is going to be worthwhile or not.
To calculate Cash on Cash Return (CoC), you’ll need to divide the cash flow from the property with the actual investment you put upfront.
Now, suppose that you rent out your property for $1,200 a month. And, the monthly operating expenses add up to $850. In this case, your monthly cash flow would amount to $350. But since CoC takes into account the annual cash flow, then we’d need to multiply the value by 12. $350 x 12 = $4,200.
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Let’s assume that the initial cash you invested in the property is $50,000. And, this includes the down payment, closing costs, and renovation costs. In this case, the CoC would be $4,200 / $50,000 = 8.4%.
This would be a good CoC, as the average ranges between 7 and 10%.
Capitalization Rate
Capitalization rate also measures the rate of return of an investment property. To calculate the cap rate of a property, you’ll need to divide the Net Operating Income by the property’s value.
To calculate NOI, you’ll first need to sum the rental income and other income sources and then subtract the operational expenses. Supposing the rental income from the property is $1,200 and the operational expenses amount to $500, then the NOI would be $700.
If the value of the property is, say, $100,000, then the cap rate would be $700X12=$8,400. Then, $8,400/$100,000X100=8.4%. This would be considered a “good” investment, as the average cap rate usually varies between 8- and 12%.
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Bottom Line
Now you know what calculations to consider when looking to invest in a property investment. The exterior aesthetics may not always tell the truth, it’s the calculations that ultimately matter.
Sand Dollar PM is one of the best property management companies in Central Florida. With over 65 years of combined property management experience, you can count on us for sound property investment advice. Get in touch to learn more!
