People invest for various reasons, one of which is to increase their wealth. However, investors' objectives may differ—some may want money for retirement, while others may want to save for other life events like having a baby or a wedding—the goal of all investments is usually to make money. And it does not matter where you invest your money, whether in real estate, the stock market, or the bond market.

Real estate is tangible property made up of land and typically includes any structures or resources found there. Many people view real estate as an investment option because they believe it will increase in value over time. When you buy an investment property to rent, you're not just expecting the property's value to rise over time; you're also trying to make a profit by renting it out.

Whatever the aims, investors that diversify their investment portfolio with real estate should assess return on investment (ROI) to determine the profitability of a property. Here's a quick rundown of return on investment (ROI), how to calculate it for your rental property, and why knowing a property's ROI is critical before making a real estate acquisition.

What is the Return On Investment (ROI)?

Return on investment (ROI) is a metric that estimates how much money, or profit, is made on a given investment as a proportion of its cost. It demonstrates how profit-generating investment expenditures are spent effectively and efficiently. Knowing the return on investment (ROI) assists investors in determining whether or not investing in a particular asset is a good idea.

Return on investment (ROI) can be calculated for any investment, including stocks, bonds, savings accounts, and real estate. Because calculations can be easily manipulated—certain variables can be added or deleted in the calculation—it can be challenging to calculate a realistic ROI for a residential property. It can be very tough when investors have the option of paying cash or taking out a mortgage on the property.

The formula to calculate ROI

To calculate the profit or gain on any investment, subtract the original cost of the investment from the total return on the investment.

To calculate the percentage ROI, we take the net profit and divide it by the original cost of the investment.

ROI = (Gain of investment - Cost of investment)/ (Cost of Investment)

For instance, if you invested $500,000 in a house and sold it two years later for $600,000, you'd calculate your ROI this way.

ROI = (600,000 - 500,000 = 100,000) / (500,000) = 0.2%

This means your return on investment is 0.2%.

What to Consider While Calculating ROI

More than merely the buying and selling prices have an impact on ROI. The cost of your investment, for example, is not only the purchase price. Let's say you pay $250,000 for a cute little house that needs some work. You spend $8,600 on repairs and remodeling. This sum is added to your total costs, giving you a total of $250,000 + $8,600 = $258,600.

Let's say you decide to rent out your home and hire a property manager. The gains would be added to your rental revenue, while the property management costs would be added to the cost.

Some property owners factor in their home equity, defined as the market worth of a home minus the amount owed on the mortgage. Every time you pay your mortgage, you build your equity. You can include the equity in your annual return, which is the cash flow provided by the property after expenses like maintenance and mortgage payments are deducted.

Calculating ROI on Rental Properties

The above equation is easy enough, but remember that several variables might alter ROI numbers when it comes to real estate. Repair and maintenance costs, as well as methods for calculating leverage (the amount of money borrowed with interest to make the initial investment), are among them. The financing terms might significantly impact the ultimate cost of the investment.

ROI for cash transactions

If you buy a property with cash, then the calculation of ROI is pretty straightforward. You'll divide your annual return—the revenue from the property minus expenses—by the amount you paid for the residence in cash.

• You paid $250,000 for the rental property in cash
• You spent $4000 on remodeling, bringing your total investment to $254,000.
• You then rented it out for $2000 per month for 12 months.

A year later

• You earned $24,000 in rental income
• Expenses, including utilities, property taxes, and insurance, totaled $84,00 for the year
• Your annual return is $15,600 ($24,000 - $ 84,00)

To calculate the ROI of the property

• Divide the annual return ($15,600) by the amount of the total investment, $250,000
• ROI = $15,600 ➗ $254,000 = .061
• Your ROI is 6.1%

ROI for Financed Transactions

The ROI on financed transactions is more difficult to calculate. Take, for example, the same $100,000 rental property described above, but instead of paying cash, you took out a mortgage.

• The mortgage required a 20% downpayment of the purchase price, or $20,000 ($100,000 sales price x 20% downpayment).
• Closing costs were greater than usual for a mortgage, totaling $2,500 in the beginning.
• You paid $9,000 for remodeling.
• The total amount you paid out of pocket was $31,500 ($20,000 + $2,500 + $9,000).

With a mortgage, there are also ongoing costs:

• Assume you had a 30-year loan with a set 4% interest rate. The monthly principal and interest payment on the $80,000 loan would be $381.93.
• To cover expenses including water, taxes, and insurance, we'll add the same $200 every month, bringing your total monthly payment to $581.93.
• A year's worth of $1,000 in rental revenue equals $12,000.
• The monthly cash flow is $418.07 (rent of $1,000 minus mortgage payment of $581.93).

After a year:

• At $1,000 per month, you received $12,000 in rental income for the year.
• Your yearly profit was $5,016.84 ($418.07 divided by 12 months).
• To determine the property's return on investment, use the following formula:

To calculate ROI,

• Divide the annual return by your initial out-of-pocket spending (the $20,000 down payment, $2,500 closing costs, and $9,000 for remodeling).
• Return on investment (ROI) = $5,016.84 / $31,500 = 0.159.
• Your ROI is 15.9%.

Bottom line

A rental property's return on investment differs from other investments in that it varies substantially depending on whether the property is financed with a mortgage or purchased outright. When calculating the ROI for several properties, it's critical to have a consistent approach. When calculating the ROI for several properties, it's crucial to have a consistent approach. This can provide you with the most realistic picture of your portfolio.