Ramonelle Zaragoza

Jan 10, 2022

·

9 min read

Return on investment is one of the most important metrics in the world of real estate investing. Knowing the ROI for a property you want to buy lets you make better-informed decisions. But in order to calculate this, you need to consider a lot of variables such as your rental income, costs and expenses, and the property’s market value.

In this article, you will learn what return on investment is and the different ways you can calculate it to determine an investment’s profitability. If you are a beginner investor who is not sure how to calculate this, keep reading. And if you need to know what other formulas you should know when assessing an investment property, watch this video:

Return on Investment, or ROI for short, is **a metric used to evaluate the profitability of a real estate investment** and sometimes to compare it against the profitability of other properties. The basic formula in calculating this is by dividing the investment’s current value by the cost. The result is usually expressed as a percentage.

Investors like to find the return on investment because it is versatile and simple to calculate and understand. If the result is positive, it indicates that the investment is probably worthwhile. And when comparing the ROI among two or more properties, you consider the one with the highest number to be the best. Meanwhile, a negative ROI implies a net loss.

There is no fixed number of a “good” return on investment. It usually depends on a number of factors such as your risk tolerance and the time required for your property to generate a return. Investors who are more risk-averse would accept lower ROIs as long as profit is guaranteed. A good example of this is traditional rentals, which provide stable but lower income.

There are also investments that give higher returns but take longer to pay off. These can be buy-and-hold and BRRRR properties, which you keep in your portfolio (and sometimes rent it out) for several years before selling it at a higher price than you paid for. Whichever approach you choose depends on your goals.

While the return on investment metric is simple to understand, it has its limitations. One, it does not take into account the holding period of an investment. This can be problematic when comparing multiple properties against one another. It also does not adjust for risk, and the figures can be exaggerated if you do not include your expected costs in the calculation. Finally, your financing terms can affect the overall cost of the investment and thus may reduce or increase your ROI.

To resolve these limitations, you can use more specific methods to measure profitability.

Because ROI’s basic formula tends to overlook several important factors, real estate investors use other formulas or look at different metrics to determine if a property is worth investing in. Here are five of them:

Short for capitalization rate, the cap rate is used to indicate the rate of return on investment in real estate. You compute it based on the net income that you expect to generate by dividing the net operating income (NOI) by the property’s current market value.

Another way to calculate this metric is to divide the NOI over the acquisition cost of the property. However, this is not often used because it gives unrealistic results for old properties that were purchased a long time ago at lower prices. It also cannot be applied to inherited property as the purchase price is zero. But if you are considering buying an investment property and need a quick calculation, this version is the one to use.

## Cap Rate Example

- You want to purchase a property for $215,000.
- You estimate the closing costs to be $2,000 and remodeling at $19,000, bringing your total cost of acquisition to $236,000.
- You also estimate your monthly rental income to be $1,100, and your operating costs like insurance, maintenance, and property tax would run up to $400.

You then estimate your cash flow after 12 months to be as follows:

- Your total rental income would have been $13,200.
- Your total operating costs would have amounted to $4,800.
- Your annual net operating income would have been ($13,200 — $4,800) = $8,500.

To calculate the property’s cap rate based on your acquisition cost:

- Divide your annual return ($8,500) by your total acquisition cost ($236,000).
- Cap rate = $8,500 / $236,000 = 0.0360 or 3.60%.
- Your cap rate for the property would be 3.60%.

If you base it on the property’s value:

- For this example, you predicted that with remodeling and external factors, your property’s value would increase to $285,000 after 12 months.
- Divide your annual return ($8,500) by its new market value ($285,000).
- Cap rate = $8,500 / $285,000 = 0.0298 or 2.98%.

Cash on cash return calculates the cash income you earned on the cash you invested in a property. It is sometimes called “cash yield”. This metric is important for investors who want to measure the annual return they made on the property in relation to the amount of mortgage they paid during the same year. Because it only calculates the return on the actual cash invested, this metric provides a more accurate analysis of the property’s performance.

To get the cash on cash return, divide your annual pre-tax cash flow by the total cash you invested. The annual pre-tax cash flow is your gross income minus vacancy, operating expenses, and mortgage payments. Meanwhile, the total cash invested includes down payment, closing costs, remodeling costs, and mortgage payments.

## Cash on Cash Return Example

- You want to purchase a property for $215,000.
- You plan to make a 20% down payment ($43,000) and borrow $172,000.
- You estimate the closing costs to be $2,000 and remodeling at $19,000, which you will pay out of pocket.
- You also estimate your monthly rental income to be $1,100, and your operating costs like insurance, maintenance, and property tax to run up to $400.

You then estimate your cash flow after 12 months to be as follows:

- You paid a total of $10,000 towards your mortgage.
- Your total rental income would have been $13,200.
- Your total operating costs would have amounted to $4,800.
- Your annual pre-tax cash flow would have been [$13,200-($4,800 + $10,000)] = -$1,600.
- Your total cash invested would have been ($43,000 + $2,000 + $19,000 + $10,000) = $74,000.

To calculate your property’s cash on cash returns:

- Divide your annual pre-tax cash flow (-$1,600) by the total cash invested ($74,000).
- Cash on cash returns = -$1,600 / $74,000 = -0.0216 or -2.16%.
- Your cash on cash return for your property would be -2.16%. Because the is in the negative, it means that you are likely to lose money if you buy this house with financing.

Some investors want to add the property’s equity into their ROI calculations. Investopedia defines equity as “the market value of the property minus the outstanding total loan amount”. Equity is not cash-in-hand; you must first sell your investment to access this amount.

To include this in your ROI calculations, you have to get the amount of equity in your property by reviewing your mortgage amortization schedule. This will help you find out how much of your mortgage payments went toward paying down the principal of the loan. You can then add the equity amount to your annual return (NOI + equity).

## ROI With Home Equity Example

- You want to purchase a property in Park Falls, WI for $215,000.
- You plan to make a 20% down payment ($43,000) and borrow $172,000.
- You estimate the closing costs to be $2,000 and remodeling at $19,000, which you will pay out of pocket.
- You also estimate your monthly rental income to be $1,100, and your operating costs like insurance, maintenance, and property tax to run up to $400.

You then estimate your cash flow after 12 months to look like this:

- You paid a total of $10,000 towards your mortgage, $6,000 of which would go toward your principal repayment.
- Your total rental income would have been $13,200.
- Your total operating costs would have amounted to $4,800.
- Your annual return plus equity would have been [($13,200 — $4,800) + $6,000] = $14,400.
- Your total cash invested would have been ($43,000 + $2,000 + $19,000) = $64,000.

To calculate your ROI with equity:

- Divide your annual return with equity ($14,400) by the total cash invested ($64,000).
- $14,400 / $64,000 = 0.225 or 22.50%.
- Your ROI with equity is 22.50%.

It is worth noting that including your property’s equity would balloon your ROI. Using this formula is only useful if you are planning to access the amount of equity by selling the house or refinancing it.

If you are planning to do house flipping or buy-and-hold, then this method will help you calculate your ROI by dividing the equity in your property by its costs.

## Cost Method ROI Example

- You want to purchase a property for $215,000.
- You estimate the closing costs to be $2,000 and remodeling at $19,000, and you think that the house’s value post-remodeling would increase to $253,000.
- You also predict that with remodeling and external factors, its value would increase to $285,000 after 12 months.

If you resell the property after remodeling:

- Get your equity position in the property by subtracting your property costs ($215,000 + $2,000 + $19,000 = $236,000) from the post-remodeling market value ($253,000).
- Equity = $253,000 — ($236,000) = $17,000.
- Divide your equity position ($17,000) by the property costs ($236,000).
- ROI = $17,000 / $236,000 = 0.0720 or 7.20%.
- Your ROI for house flipping would be 7.20%.

If you hold onto the property for 12 months:

- Get your equity position in the property by subtracting your property costs ($236,000) from your predicted market value ($285,000).
- Equity = $285,000 — ($236,000) = $49,000.
- Divide your equity position ($49,000) by the property costs ($236,000).
- ROI = $49,000 / $236,000 = 0.2076 or 20.76%.
- Your ROI for holding onto the property would be 20.76%.

Using this formula can help you decide whether to sell your investment right after you remodel or wait for its value to appreciate first.

This is similar to the cost method, except you are only including the amounts you paid with cash in your calculations. The out-of-pocket method is perfect for house flippers and buy-and-hold investors who buy properties with financing. Many investors also prefer this because it provides higher results.

## Out-of-Pocket ROI Example

- You want to purchase a property for $215,000.
- You plan to make a 20% down payment ($43,000) and borrow $172,000.
- You estimate the closing costs to be $2,000 and remodeling at $19,000, which you will pay for out-of-pocket.
- You think that the house’s value post-remodeling would increase to $253,000.
- You also predict that with remodeling and external factors, its value would increase to $285,000 after 12 months.

If you resell the property after remodeling:

- Get your equity position in the property by subtracting your cash expenses ($43,000 + $2,000 + $19,000 = $64,000) from its post-remodeling market value ($253,000).
- Equity = $253,000 — $64,000 = $189,000.
- Divide your equity position ($189,000) by the new market value ($253,000).
- ROI = $189,000 / $253,000 = 0.7470 or 74.70%.

If you hold onto the property for 12 months:

- Get your equity position in the property by subtracting your cash expenses ($64,000) from its new market value ($285,000).
- Equity = $285,000 — $64,000 = $221,000.
- Divide your equity position ($221,000) by the new market value ($285,000).
- ROI = $221,000 / $285,000 = 0.7754 or 77.54%.

To summarize, return on investment is a ratio or percentage of your returns on an investment property in relation to its cost. While it helps you determine a property’s profitability, its basic formula (investment value divided by investment cost) has its limitations. To resolve this issue, we found five formulas that calculate ROI depending on your specific strategy or payment method, which were listed in this article.

We hope our explanation and examples for each ROI formula will help you decide if a property you are looking at is worth investing in. But if you find these formulas too complicated for you, an investment property calculator can help you in your analysis. This tool is especially helpful for more complex calculations that include Airbnb demand, occupancy rate, accumulated cash flow, and more.