Calculating the True Return on Investment for Rental Properties

Real estate is one of the best long-term investments for building wealth and generating passive income. Rental properties can provide steady cash flow while the property appreciates in value over time. 

Forbes stated, “Appreciation, or the rising of home prices over time, is how the majority of wealth is built in real estate. This is the “home run” you hear of when people make a large windfall of money. While prices fluctuate, over the long run real estate values have always gone up, always, and there is no reason to think that is going to change.

However, to accurately assess the profitability and return on a rental property investment, it’s important to look beyond just the purchase price and rental income. Calculating the true return on investment (ROI) requires a thorough analysis of all the costs and benefits.

Determine All Expenses

The first step is identifying and adding up all of the expenses associated with acquiring and operating the rental property. These include:

• Purchase price and closing costs
• Renovation and repair costs to make the property rent-ready
• Ongoing maintenance, repairs and capital expenditures
• Property management fees
• Vacancy costs during tenant turnover
• Property taxes, insurance, HOA dues
• Mortgage interest if financing the purchase
• Project Total Rental Income

Next, estimate the total annual rental income the property will generate. Look at market rent rates for comparable properties in the area. Factor in realistic vacancy periods between tenants. Consider if rents are likely to rise over time with inflation.

Calculate Net Operating Income

Subtract the operating expenses from the total rental income to determine the property’s annual net operating income (NOI). This is the annual profit generated by the property before accounting for mortgage payments.

Consider Financing Costs

If using a mortgage to purchase the rental property, the loan payments need to be factored into the overall return. While the principal portion of the payment goes toward building equity, the interest is an expense that reduces the cash flow and ROI. However, also consider the power of leverage in magnifying returns.

“Using prudent leverage to buy rental properties can significantly enhance the cash-on-cash return for investors,” explains Kent Clothier Sr., CEO of REINation, a national turnkey real estate investment company. “We advise our clients to analyze deals based on the cash flow and appreciation potential relative to the actual cash they’re putting into the deal.”

Evaluate Appreciation

In addition to the cash flow, the other major financial benefit of rental property investing is appreciation in the property value over the long-term. While predicting future appreciation is not an exact science, look at historical trends and economic fundamentals in the market, like population and job growth. Appreciation can supercharge the overall ROI, especially when using leverage.

Calculate Cash-on-Cash Return

A good way to evaluate and compare rental investments is using the cash-on-cash return metric. This looks at the annual pre-tax net cash flow relative to the actual cash invested to acquire the property. To calculate, divide the annual NOI by the total acquisition costs (down payment, closing costs and renovation costs). This shows the annual return on the upfront investment. Most investors look for deals with at least an 8-10% cash-on-cash return.

“Rental properties in affordable markets with strong rent-to-value ratios, like many markets in the Midwest and South, can often generate cash-on-cash returns in the 10-15% range or sometimes even higher,” notes Clothier. “That’s very attractive compared to other asset classes, especially given the relatively low risk and stability of rental properties.”

Consider Tax Benefits

Real estate also offers significant tax advantages that can further boost the overall ROI. Owners can deduct operating expenses, mortgage interest and depreciation. This depreciation deduction can often shelter most or all of the cash flow from income taxes. When the property is sold, owners can often defer or avoid capital gains taxes by reinvesting the proceeds into another property via a 1031 exchange. Always consult a tax advisor for guidance on maximizing the tax benefits.

Think Long-Term

Analyze deals with a long-term mindset. Rental properties are not a get-rich-quick scheme but rather a stable way to gradually build wealth over time as tenants essentially pay down the mortgage while the property appreciates. The longer the property is held, the greater the ROI will likely be as the income increases, the mortgage is paid down and the property value grows.

The True Return on Investment Properties

Evaluating a rental property requires looking at the total acquisition costs, operating expenses, rental income, financing costs, and potential appreciation. While real estate investing always entails some risk, a properly vetted rental property in a solid market purchased at a fair price can be one of the most reliable and lucrative ways to achieve financial security and independence.

However, the true return on an investment has to be viewed through the lens of what happens if I don’t make the investment.  Too often, investors calculate all of the financials and weigh their options without considering the cost of doing nothing.  Lost opportunity can be a huge financial drain while investors search and search for the perfect investment without realizing the lost opportunity.  I’ve never advocated rushing into an investment, but at some point, a real estate investor makes their move and puts capital to work. Investors that calculate their returns, weigh their opportunities and understand that stagnant money is losing value daily are the investors who enjoy the biggest success.