Calculating ROI is essential for making smart investment decisions in rental properties. Understanding potential returns helps landlords assess whether a property will provide enough profit relative to the money and effort invested.
However, accurately calculating ROI can be tricky, as there are various methods like cap rate and cash-on-cash return, each offering different insights into profitability.
At Brentwood Square Management Services, Inc., we’ve created this guide to help landlords confidently evaluate the financial performance of their rental properties.
Whether you’re managing long-term rentals or short-term vacation properties, this article will walk you through the basics of ROI calculation, the different methods to measure it, and what qualifies as a good ROI for rental properties. Keep reading to learn more!
Types of Rental Properties
Rental properties generally fall into two main categories, each with its own financial dynamics. Recognizing the differences between these methods allows landlords to perform more precise ROI assessments.
Properties with Long-Term Leases
Long-term rentals are typically leased for six months or more, with many tenants staying a year or longer. These types of rentals provide stable income, as rent collection happens consistently over an extended period.
Long-term rentals require fewer operational tasks, such as tenant turnover management or frequent cleaning, which helps reduce operating expenses. This stability makes them attractive to landlords who prefer predictable cash flow.
Short-Term Vacation or Temporary Rentals
Short-term rentals, such as vacation homes or temporary furnished apartments, are typically rented out on a daily, weekly, or monthly basis. Platforms like Airbnb or Vrbo have made these properties increasingly popular.
While short-term rentals can offer higher rent per night compared to long-term leases, they come with increased operational costs, including cleaning fees, utilities, and marketing efforts.
Since seasonal demand can affect occupancy rates, calculating ROI for short-term rentals may be more complicated and requires continuous tracking.
How to Calculate Rental Property Returns
Knowing how to calculate returns on rental properties is crucial for landlords to make sound investment choices. Below are the primary methods used to determine ROI.
Basic ROI Formula
The easiest way to compute ROI is by dividing the property’s annual profit by the total amount invested.
Formula: ROI = (Annual profit/Total Investment) x 100
Start by calculating your annual profit, which is the total rental income minus all operating expenses (such as mortgage payments, taxes, insurance, maintenance, and property management fees).
Then, divide that annual profit by the total amount you’ve invested, which includes the down payment, closing costs, and any upgrades or repairs made.
Example: If your property generates $10,000 in profit annually and you invested $100,000, your ROI would be:
ROI = (10,000/100,000) X 100 = 10%
Understanding Cap Rate
The capitalization rate (cap rate) is another popular metric to assess a property’s profitability, especially when comparing different investments. Cap rate focuses on the net operating income (NOI) in relation to the property’s current market value.
Formula: Cap Rate = (Net Operating Income/Property Value) x 100
NOI is calculated by subtracting operating expenses from the total rental income, without including mortgage payments. This method is particularly useful for analyzing a property’s performance without considering financing details, which vary between landlords.
For example, if a property’s NOI is $14,000 and its market value is $200,000, the cap rate would be:
Cap Rate = (14,000/200,000) x 100 = 7%
A higher cap rate generally indicates a better return, though it might also imply greater risk, particularly in areas with less stable rental demand.
Identifying a Strong ROI
Once you understand how to calculate ROI, the next step is knowing what constitutes a good return.
What Is Considered a Good ROI?
A “good” ROI depends on several factors, such as market conditions, the type of property, and the landlord’s financial goals. Generally, an ROI of 8% to 12% is considered healthy for most rental properties.
However, long-term properties in stable markets might offer lower ROIs with less risk, while short-term rentals could provide higher returns but with increased volatility.
It’s also essential to consider the time and effort required to maintain the property. Even if a property offers a high ROI, landlords must assess whether the operational workload aligns with their expectations.
Explaining the 1% Rule for Rentals
The 1% rule serves as a fast method to evaluate possible rental properties. It suggests that the monthly rent should be at least 1% of the total property purchase price to ensure the investment is worthwhile.
Example: If you purchase a property for $200,000, the 1% rule suggests you should charge at least $2,000 in rent per month.
While the 1% rule isn't a precise ROI calculation, it helps landlords quickly identify whether a property is likely to generate sufficient rental income.
If a property doesn’t meet the 1% rule, it could indicate that the rental income may not cover expenses or yield a strong return. However, this rule varies by market, and in some high-demand areas, properties may still be profitable even if they fall slightly below 1%.
Bottom Line
Calculating ROI is a crucial step for any landlord looking to maximize profits. By understanding the basic ROI formula, cap rate, and cash-on-cash return method, landlords can make well-informed investment decisions.
Each method provides different insights—basic ROI gives a broad overview, cap rate evaluates performance relative to property value, and cash-on-cash return focuses on the cash flow generated from the initial cash investment.
Brentwood Square Management Services, Inc. offers expert property management solutions to help landlords optimize their rental income and maximize ROI.
Our experienced team can assist with tenant screening, market analysis, and day-to-day management, ensuring your property performs at its best. Contact us today to schedule a consultation and learn how we can help you achieve your investment goals.