Buying an investment property can be one of the best decisions you can make!
If you go about the process the right way, you can set yourself on the journey to financial freedom. You can use this potential income to pay down debt or save up for your retirement.
But buying a real estate is a journey. You’ll need to do your proper due diligence in order to avoid potentially costly mistakes. A key part of this process is calculating the return on investment (ROI) of a property in order to ascertain whether it’s going to be worthwhile or not.
After all, the goal of any investor is to make money. No one invests their money intending to lose it. In this blog, we at Taylor Street Property Management will walk you through everything you need to know when it comes to calculating one of the most important real estate terms - ROI.
Types of Property Investments
There are many different types of property investments that you can make. Common examples include single-family homes, condominiums, townhouses, apartments, duplexes, and multi-family apartment buildings.
If you make the right investment move, there is great potential for return on investment. Also, many real estate experts are of the consensus that property investments are one of the safest investments you can make.
What’s more, you have the option to choose whether to rent on long-term- or short-term basis. Of course, both of these options have their pros and cons depending on the investing goals you have.
But whatever property you choose to invest in, it’s important that you know how to calculate the ROI.
What You Need to Calculate ROI
Suppose you have found a property that you think can help meet your goals. How would you know whether or not it’s going to be a good rental investment?
This is where knowing how to calculate the ROI on a property investment is useful. ROI is a metric that will be able to tell you how profitable the property is going to be. The following are some of the basics that you’ll need, in order to calculate the ROI of a property investment.
- Property Details: You’ll need to know details such as the property’s value, the cost estimate of annual repairs, and the square footage of the home.
- Rental Income Details: You’ll want to know the prevailing rental rate for a similar property in the area. In addition to this, you’ll also want to know the vacancy rates, as that will have a direct impact on the ROI.
- Mortgage Details: If taking a mortgage, you’ll want to know things like the loan terms, interest rate, down payment, and closing costs.
- Rental Expenses: There are operational expenses that come with owning a rental property. Examples include tenant screening costs, rental marketing expenses, property management fees, repair and maintenance costs, keeping in line with safety codes, as well as materials and supplies.
With these details, calculating the ROI on the potential property investment should be relatively easy.
Calculating the ROI on a Property Investment
After gathering all of the aforementioned details and are ready to calculate the ROI of a potential investment, the following are crucial figures you’ll need to calculate. There are also a couple of useful tools online that can help you.
Net Operating Income (NOI)
Calculating the NOI of a property investment can help you determine whether the investment is going to be worthwhile or not. To calculate it, you’ll need to subtract the operational expenses from the gross rental income.
Should the result be a positive value, it means that the investment is likely to be profitable.
Cap Rate is also known as capitalization rate. Just like the NOI, you can use the cap rate to estimate the ROI of an investment property. The following are some of the things that you’ll need to have in order to calculate the cap rate.
- Gross rental income
- Operating expenses
- Cost of buying the property
Once you have these, start by determining the annual net operating income. Next, divide that value by the cost of buying the property. Finally, express the value into a percentage.
For an illustration, let’s work with the following figures.
- Annual rental income: $9,500.
- Annual operating expenses: $2,500.
- Cost of buying the investment property: $50,000.
Cap Rate = NOI/Purchase Price. ($9,500-$2,200)/$85,000X100=8.5%.
Annual Gross Multiplier (AGM)
The AGM is an easy calculation that you can use to compare rental property opportunities in a given market. AGM is a ratio of the subject property’s price and its gross rental income.
To calculate the AGM of a property, you’ll need the following details: what the property is selling for, and the potential rental income.
Next, you’ll simply need to divide the purchase price by the annual gross rental income. The value that you get will tell you the approximate number of years it’ll take for the property to pay itself.
Cash on Cash Return
This is another metric you can use to determine whether an investment is going to be worthwhile or not. It looks at the after-tax annual cash flow versus a property’s purchase price.
Let’s suppose the property rents out for $2,500 per month. Let’s also assume that the repair and maintenance costs add up to $800. This would put the annual pre-tax cash flow at ($2,500-$800) X 12 = $20,400.
Next, to determine the CoC Return, you’ll need to divide the annual pre-tax cash flow with the cost of purchasing the property. Supposing the purchase price is $90,000, then the CoC Return of the property would be 0.2222 (22.22%).
Conducting your due diligence is key to making the right investment. Calculating the ROI on a property investment should be part of that diligence process. That said, if you’re just starting, hiring an expert can make all the difference.
Taylor Street Property Management has decades of experience in acquiring, owning, managing tenants and resolving their complaints, and even the financing of investment properties and 1031 exchanges in Phoenix, AZ. Get in touch to learn how we can be of help!