Ultimately, the goal of investing in real estate is to make money! And this is where return on investment (ROI) comes in.
ROI is a metric that property investors use to determine the profitability of an investment or to compare returns across a diverse range of investments. Generally, there are two categories of property investments in real estate. That is, long-term- and short-term lease properties.
In this article, we’ll focus on these two types of property investments and their expected ROI.
Short-Term Rentals
These property investors only rent out for short durations. Typically, the rental duration doesn’t go beyond 30 days. Often, landlords list these types of rentals on platforms such as Airbnb and VRBO.
The ideal ROI of a short-term rental is about 10 percent. It can, however, change significantly depending on the season. In the off-peak seasons, it can dip to as low as 5% and go as high as 20% during the peak seasons.
Aside from the seasons, other factors that can affect the ROI of a short-term rental include location and management efficiency.
Long-Term Rentals
Landlords rent out this type of rental for an extended period, usually between a few months to multiple years. Examples of long-term lease rentals include residential properties, apartments, and commercial buildings.
In these rentals, tenants pay rent consistently over the lease period. This can ensure you get a stable, consistent income over several months.
Ideally, expect an ROI of between 8- and 10 percent. This not only includes the monthly rental yield, but also the potential capital gains from the investment’s value.
How to Calculate the ROI of a Rental Investment
As a potential landlord, it’s important to calculate the ROI of an investment before diving in. Now, there are generally three formulas you can use for the calculation.
Simple ROI Calculation
This is the most basic of the three formulas. For the calculation, you’ll only need to factor in two things. That is, the rental income, and the cost of the investment.
Suppose, for instance, that you are looking to invest $120,000 to buy a rental property. And after deducting your expenses at the end of the year, you realize a profit of, say, $150,000.
ROI = Profit (Rental Income – Expenses)/Cost of Investment
$30,000/$150,000 X 100 = 20%.
On the downside, though, this formula may not be able to give you a specific ROI to expect from an investment. Why? The numbers are fairly general and may fail to account for certain variables.
For more granular figures, consider basing your ROI calculations on either cap rate of cash on cash return.
Capitalization Rate
The other formula you can use to calculate your expected ROI is known as capitalization rate (cap rate). The cap rate formula can help you determine the potential return on investment or payback of capital.
Ideally, the formula works well for commercial properties rather than short-term rentals. This is because the value of short-term investments is usually based on comparable residential properties in the area.
To calculate the ROI of an investment using cap rate, you’ll need to factor in the following metrics.
Net Operating Income (NOI). The net operating income is the difference between the operating expenses and the rental income.
Rental Income. This is the income you receive from tenants.
Operating Expenses. These are the recurring costs you’ll incur in the maintenance and management of the investment property. They include things like property taxes, insurance, utilities, property management fees, vacancy costs, and marketing and advertising expenses. These can have a huge impact on your rental’s profitability.
Then finally, to calculate the ROI, you’ll need to divide the NOI by the Purchase Price.
Assume that the total purchasing costs of an investment total $200,000. This includes the property’s price, closing costs, and remodeling costs. If you’ll be charging tenants $1,000 every month, then this will mean getting an annual rental income of $12,000. Please note that this assumption is based on full occupancy.
Now, let’s say that the running costs sum up to $1,500 in a year. This will bring the expected annual return to $10,500. To calculate the investment’s expected ROI, you’ll need to divide the annual rental income by the total purchase costs.
ROI = $10,500/$200,000 X 100 = 5.25%.
Cash on Cash Return (CoC)
Are you looking to finance the property’s purchase through a mortgage? If so, the cash-on-cash formula is ideal.
Let’s assume, for instance, that you are looking to buy an investment valued at $210,000. To qualify for the mortgage, you put down a deposit of 20%, which comes to $42,000. In addition to the deposit, you also incur closing costs and remodeling costs of $3,000 and $15,000, bringing the total cash invested to $60,000.
Remember, though, with mortgage financing comes monthly interest payments. Let’s say this cost is $1,000. If you charge a monthly rent of $1,700, this would leave you with a cash flow of $700 every month. Per year, this would amount to $8,400.
With the formula, your CoC would become $8,400/$60,000 X 100 = 14%. This would be your expected annual ROI.
What should a Good ROI be?
It depends! The figure is subjective depending on the investor’s goal and other circumstances, such as location and prevailing rental prices.
But generally speaking, with the simple ROI calculation, go for at least 15%. With capitalization rate calculation, aim for an ROI of at least 10%. And with the Cash on Cash return formula, an ROI of around 10% is normally regarded as good.
Conclusion
Just like with other investment types, due diligence is key before making the leap. Real estate investments are usually capital intensive and mistakes can cause a serious dent in your bottom line.
Ideally, if starting out or are an out-of-state investor, hiring a professional expert would be ideal. JTS Property Management would be more than happy to walk this journey with you. We can help you buy the right property and manage it as well for minimum stress and maximum ROI.
We offer professional property management services to property owners in the Greater Sacramento area. Get in touch to learn more!
