A rental property can be a great investment if managed properly. Many people find owning rental properties to be lucrative over the long term. Rental properties offer advantages of appreciation, debt paydown, and tax deferment that aren’t offered in other investment types.
Unlike other asset classes (stocks, bonds, etc), rental properties are investments in real, tangible assets that operate as a business. The calculation for the Return On Investment (ROI) of a rental property is much more complicated than for stocks and bonds.
Also, owning a rental property is a very active investment in contrast to passive investments in stocks or bonds. You will need to advertise, handle tenant requests, manage contractors, and much more. While this doesn’t affect the ROI, you should be sure you are ready to handle all there is in a rental property.
Let’s take a look at how to evaluate the return on investment of a rental property.
Rental Property Income and Expenses
Before we jump into the ROI calculation, let’s first walk through the different ways rental properties earn income and what expenses are incurred.
Rental Property Income Sources
Income from rental properties is collected in various forms. Some of these are collected monthly (rents, parking/storage, fees) while others are only realized on the sale of the rental property (appreciation, debt paydown).
The following list is the most common sources of income from a rental property.
- Rents Collected — This is the primary source of income in a rental property and is pretty self-explanatory. It is the money you collect from your tenants every month per the lease agreement.
- Parking/Storage — Some rental properties include additional charges for a tenant’s use of parking spaces, garages, storage units, or bike storage. These will be minimal compared to the rents collected and only applicable if the tenant chooses to make use of the space.
- Fees — You can collect various fees from tenants for things like rental applications, late fees, security deposits, and pet deposits.
- Asset Appreciation — Over time, the value of your rental property will change. On average, the price of a single-family home increases 3.8% per year. This isn’t a hard-and-fast rule (as evident in the 2008 housing market crash), but can be used to create reasonable expectations.
- Debt Paydown — As you make your mortgage payments, a portion of that goes to pay down your loan debt with the bank.
Rental Property Expenses
Rental properties incur certain expenses on a monthly or yearly basis. The following list describes the most common expenses for a rental property.
- Mortgage — Probably the single largest expense in a rental property is the mortgage. If you own your primary residence, you are already familiar with this. It includes the principal and interest payments to your bank.
- Property Taxes — Your state, county, or city impose local property taxes. According to WalletHub, this can range from 0.28% to 2.49% depending on your state. Also, the county or city may impose special tax assessments.
- Insurance — Your rental property needs to be covered in the case of damage. You will also want to carry an umbrella policy to protect your personal assets.
- Improvements/Repairs — Things break. Things also go out of style. You will need to maintain the state of the rental property and make improvements to attract tenants.
- Property Management — You may decide to have a property manager handle the advertising and tenant management for you. A property manager will charge 8-12% of your collected rents. They may have additional fees for advertising or new tenant placement.
- HOA Fees — If your rental property is part of a homeowner’s association, you will need to pay the HOA fees.
- Vacancy/Turnover — Every month you don’t rent your property costs you. While vacancy isn’t a direct expense, it does reduce your income. Turnover, however, is a direct cost to you. When a tenant moves out you will need to clean and repair the rental property before signing a lease with a new tenant.
How to Evaluate ROI of a Rental Property
Evaluating the ROI of a rental property is crucial to your success and an investor. Each rental property is different, but the formula for computing ROI is the same. We will walk through the formula and then look at an example of the ROI calculation.
What is ROI?
ROI is an expression of the rate of return of capital on the original investment. Simply put, ROI is the ending capital divided by the beginning investment.
ROI = Ending Capital / Initial Investment
This basic ROI formula doesn’t account for the timeframe. To make reasonable comparisons to other asset types, we will calculate the annualized rate return.
Annualized ROI = ( (Ending Capital / Initial Investment) 1 / Duration) – 1
Now that we know how to calculate the ROI, let’s look at each of the components.
The Initial Investment
This is the simple part of the equation.
The initial investment is simply the amount of money you paid out of your pocket for the rental property. This is typically the down payment for the property. It can also include any money used to improve or repair the property before renting.
Initial Investment = Down Payment + Initial Improvements
The Ending Capital
The ending capital is a bit more complex than the initial investment. It encompasses all of the incomes earned and expenses incurred over the duration of owning the property. It includes both realized (rents received, fees, taxes, insurance, mortgage payment, etc) and unrealized (asset appreciation, debt paydown) components.
The first step in calculating the ending capital is to calculate the Net Operating Income (NOI). NOI is all of the realized incomes minus all of the realized expenses. This includes all of the transactions over the time you owned the property. It will take some effort to go through all of your financial transactions to calculate the NOI.
NOI = Income – Expenses
Second, you need to account for the asset appreciation. This is simply the difference between the current value of the property and the purchase price of the property.
Appreciation = Current Property Value – Purchase Price
Next, you need to factor in debt paydown. This is the difference between the original loan and the current loan value.
Debt Paydown = Original Loan Amount – Current Loan Balance
Finally, the ending capital is the sum of the NOI, appreciation, and debt paydown.
Ending Capital = NOI + Appreciation + Debt Paydown
Duration
The duration can be any amount of time (6 months, 1 year, 10 years, etc), but must be expressed in terms of years. For example, 1 year 6 months is a duration of 1.5. This is done because the formula represents the annualized rate of return.
Example Rental Property ROI Calculation
Let’s walk through a simple example.
Let’s say you bought a rental property for $150,000 with a $30,000 down payment. You take out a mortgage for $120,000 with a monthly payment (P&I) of $550. You rent the house for $900 per month.
In addition to the mortgage, you have a yearly property tax payment of $1200 and insurance of $700 per year. You also pay $1000 per year for maintenance of the property.
You have owned this property for 5 years. The value of the property has risen to $160,000 and your remaining loan balance is $107,700. During the time you owned the property, it was vacant for 6 months.
Now let’s look at each component of the ROI calculation.
- Initial Investment: $30,000.
- Income: $900 x (60 – 6) = $48,600.
- Expenses: ($550 x 60) + ($1200 x 5) + ($700 x 5) + ($1000 x 5) = $47,500.
- NOI: $48,600 – $47,500 = $1,100.
- Appreciation: $160,000 – $150,000 = $10,000.
- Debt Paydown: $120,000 – $107,700 = $12,300.
- Ending Capital: $1,100 + $10,000 + $12,300 = $23,400.
- Annualized ROI: 12.22%.
What is a Good Rate of Return on a Rental Property
A well-established benchmark for investment returns is the S&P 500. Over the last almost 100 years, the average return for the S&P 500 is 10% before adjusting for inflation. Using the returns before inflation adjustment creates a fair comparison for our rental property example. If your real estate investment performs better than the stock market, you are better off in the long term.
This, however, isn’t a perfect comparison. Real Estate experts also have an opinion on this subject. On average, they believe 10-12% return is a good investment.
Conclusion
Owning a rental property can be a good investment. The right rental property can outpace the stock market over the long term. However, owning a rental property is an active investment rather than a passive investment like stocks or bonds. There is a trade-off of your time and energy for potentially larger returns.
Rental properties offer additional benefits beyond our ROI calculation. Taxes are deferred through depreciation and rents increase over time. Both of these factors will contribute to the returns from your rental properties.
Many people choose the path of real estate investment. Owning rental properties can be daunting at first. With experience, you will be better at finding and managing properties which will increase the ROI.
What rate of return do you seek on your investment properties?