How To Calculate Return On Investment in Real Estate
So you’re thinking about becoming a real estate investor? Great! It’s a fabulous place to put some of your wealth. Just like any investment vehicle, there are associated costs that chip away at your total bottom line, which we refer to as Return On Investment, (ROI.)
ROI can be measured many different ways but two of the most familiar ways are by measuring the annual percentage returned of your total investment, and another is the number of years that you will recoup your entire investment, which all boil down to your “capitalization rate.”
A simple example. You purchase a home for $100,000 and you intend to rent it to prospective tenants. You pay for the property in cash and it’s all yours. Your total cost of ownership at closing is somewhere around $101,500.00. Cash buyers do not bear the burden of expensive closing costs due to loans and mortgage insurance, and the inspection(s) and appraisal is optional.
You determine that you can rent your house for $1,200 per month. So how do you determine your GROSS return on investment? The reason I say GROSS is because the number you calculate here will be reduced ever so slightly by the cost of ownership. Those costs can add up. We’ll get to that.
If you can rent your house for $1,200 per year, then your GROSS annual lease would be valued at $14,400. That’s $1,200 X 12 months. Make sense? Good. Now, what you do is you take the entire sum of money that it cost you to purchase the home, and divide it INTO your gross annual lease. In this case, our fictional estimate was $101,500 and our gross lease is $14,400. So, $14,400 ÷ $101,500 = 14.18%.
Not bad, right? We could also say that with $101,500 invested, before costs, we could expect the annual income to pay for this house in 7.05 years.
Well, we aren’t done yet. We now have to subtract the costs, some of which you won’t be able to pinpoint, and may need to be estimated, and I haven’t included initial rehabilitation costs to make the property ready to rent.
1. Marketing, Tenant Acquisition
You have to get a renter into the property. There are a few popular ways to achieve this goal, but the most effective and time conscious method is to hire a REALTOR to list the property, offering a small commission to other agents to attract potential renters. Let’s say for argument’s sake, that you strike an agreement with your REALTOR to list your rental for $1,200 per month at a 10% commission rate. A portion of that will go to the renter’s agent, and a portion will go to your agent for representing you. Your cost, upon securing a tenant, would be 10% of the gross annual lease, or $14,400 × 10% which is $1,440.
Subtract that from $14,400 and you’re left with $12,960.00, thereby reducing your Cap Rate from 14.18% to 12.76%.
There’s no guarantee that you’ll have a tenant in your property. As a result, you’ll need to figure out, for your area, what the vacancy rate it, give it a percentage value, and apply it to your overall costs. Start with 5% of the gross annual lease. It may be higher or lower, but that depends on location, supply, and demand. If it’s 5% then we have to subtract that from your gross annual income. 5% of $14,400 is $720.00, which reduces your overall income to $12,240 and your Cap Rate from 12.76% to 12.06%.
You can see how your return is slowly being whittled away.
3. Property Taxes
You paid cash for your property which means you don’t have a loan, nor do you have an escrow account with your lender to handle annual property taxes. In Arizona, your tax rate will be somewhere around 1% of the assessed value of your home, give or take. In our example, that would mean your annual taxes could ring in at $1,015.00. Subtract this from $12,240 and you end up with $11,225 coming in every year. Your Cap Rate has just been reduced again from 12.06% to 11.05%.
Depending upon the amount of risk assessed by your insurance company, your annual property insurance rate might land somewhere between $300 to $1000 per year. We’ll go with $800 for this example. Insurance at $800 reduces your annual income to $10,425 which yields a final cap rate of 10.27%.
Notice that we’ve dropped from 14.18% to 10.27%? Welcome to investing.
5. Reconditioning and Repairs
Every time you have a tenant, you need to make sure that the property is rehabilitated to the original condition you need it to be in for the next tenant. Each tenancy produces a different result, so it’s wise to over-estimate for this. You never know what’s going to happen that won’t be covered by insurance, or an annual warranty (which I don’t recommend.) You also don’t know what’s going to go wrong DURING the tenancy that could end up costing a few thousand dollars.
Let’s buffer ourselves by 10% of the gross annual lease, which as we saw before, was $1,440. Costs to get the property ready for a new tenant may exceed, or may be under this amount. It will be a measure of trial and error. This will drop your annual income on the property to $8985 which is a Cap Rate of 8.85%. Your best course of action for years where you don’t incur this cost out of pocket would be to set aside this amount in your “property savings account” so you have it when it’s needed.
This is a respectable rate of return for a long term rental, but it’s not spectacular, as you have competing investment vehicles that consistently out-perform real estate rentals. But, keep in mind, we have not factored in annual appreciation, which we could say might fall in the 4% – 7% range for Scottsdale, provided we have a balanced market operating under familiar historical conditions.
6. Property Management
Property management is a negotiable service offered by many different real estate professionals. Market rate for this service is around 8% – 10% of the gross annual lease. That’s another $1,440.00 off the top, reducing the overall Cap Rate from 8.85% to 7.43%. Depending on the service, some of the above costs may be included as a part of their offering, which would greatly change the actual rate of return on the rental.
As you can see, being a landlord not as simple as buying a property to rent it out to someone. There are REAL costs to consider when you get into this business. We didn’t even cover the potential legal battles you might be facing in the future, and the hassle you might face dealing with the property if you choose to forego professional property management, or the obligations to the State that you may have when it comes to collecting taxes from tenants. Many ambitious landlords quickly learn that it’s not a game for the weak at heart, and they bail out learning valuable lessons.
The scenario that I’ve laid out above was developed from a cash perspective, whereby the landlord owns the house out-right, which is the most financially secure way to go about being a landlord. Yes, it’s possible to dramatically improve your rate of return by leveraging. Imagine that you only put 20% down on the property. Since you’re taking a loan, your initial costs will go up, but your total cash out of pocket is $20,000+/- on a $100,000 property. Instead of dividing $14,400 by the total cost of the property, you divide it by the total CASH invested. The yield is much different. In fact, it jumps from 14.18% to a whopping 78%. But, like any investment, big risk equals big reward, and big risk doesn’t always mean smart risk. While property management was the sixth cost to consider, we would now need a 7th, which would be the annual cost of carrying the mortgage payment.
How you invest in property determines how much of a return you earn, but owning free and clear is the most reliable way to secure a long-term real estate rental. In this example, if you add annual appreciation to the ROI in step 6, you end up with a potential annual return of 11.43% – 14.43%. That is a solid return, sure to secure your finances throughout your lifetime…especially if you repeat the process.