What is Considered a Good Rate of Return for an Investment?
Many businesses generate a profit of between eight and twelve percent annually. Of course, if the business is earning a high amount of gross revenue, the net income is greatly affected. Some businesses earn more than twelve percent, to be sure, but the average amount of net profit after taxes and other costs is around ten percent. According to NerdWallet.com, the average rate of return for a stock investor is ten percent. With that number in mind, many real estate investors feel a ten percent return on an investment property is good while other investors won’t look at a property with less than double that amount.
Good Rates of Return on Rental Property
Real Estate rental property investors have one thing in common. They all search for the best rate of return on a property. Like any other investment, real estate investments have a variety of ways to calculate the rate of return based on different factors and also based on an investor’s perspective. Smart investors know due diligence, a mind for numbers, and proven formulas help guide them to the best decisions when it comes to investing in rental real estate property.
What’s Perspective Got to do With it?
Some real estate investors are looking for a long-term return and others seek shorter-term results. For a long-term investor, the calculations include equity gains and overall cash return. A short-term investor may be more focused on property value increases and a larger cash return in exchange for risks taken. It all depends on what the overall financial objectives are and how to best accommodate the facts and figures to get an accurate result to make a decision.
Rate of Return and Return on Investment (ROI)
The Rate of Return on an investment employs a different formula than the calculation formula for the Return on Investment. The Return on Investment (ROI) is used to calculate the Rate of Return. The first step is to use a simple formula:
Return on Investment (ROI) = (Investment earnings – Investment cost) / Investment cost
For example, If an investor puts $100,000 into a property and generates $25,000 in income the formula is:
($125,000 – $100,000) = $25,000 / $100,000 = .25 or 25% Return on Investment
This is the simplest and most general formula to use for calculating a Return of Return on a rental property. It incorporates many other numbers and assumes some basic costs for its use, so it isn’t the most accurate method of measurement.
Better Rate of Return Formulas
Two other formulas can be employed by rental property real estate investors. There is the Capitalization Rate or Cap Rate formula and the Cash on Cash or CoC rate formula. Again, each formula depends on certain conditions for the investor’s capitalization method. The Capitalization rate method includes all values including property value or total property price. The Cash on Cash calculation allows for financing or mortgaging the real estate. Depending upon the type of investment made, the rates of return can vary widely.
Capitalization Rate of Return
The overall capital required to purchase the property is included in this formula. This formula is particularly useful for property investors who pay cash for a rental property and don’t finance or mortgage any portion of the purchase. The Capitalization rate is the ratio established between the Net Income, rental revenues minus expenses, and the property’s purchase price. The Capitalization rate is determined by adding up all the acquisition costs of property including closing costs, remodeling, and other expenses associated with the purchase. The formula to determine the Cap Rate is:
Capitalization Rate = Net Income / Purchase Price x 100%
Capitalization Rate Formula Results
For example, an investor purchases a rental property for $100,000 and also pays $2,000 in closing costs along with another $23,000 in remodeling costs. The total expenses for determining the Cap Rate is $125,000. Next is the amount of the rental property’s Net Income. Net Income is determined by adding up all the rent payments for a year and deducting the overhead costs from the rent payments like maintenance costs, HOA fees, property taxes, and insurance, For the example, the rent revenue is $1,500 per month less $300 per month in overhead expenses, resulting in Net Income of $1,200 per month or $14,400 per year. The formula for Cap Rate would be:
$14,400 / $125,000 = 0.1152 x 100% = 11.52%
Cash on Cash Rate of Return
The Cash on Cash method of calculating the rate of return requires more steps to determine than the Cap rate formula. This is a method of calculation that includes allowance for an investor financing a portion of the rental property investment. This is also a ration calculation that uses a rental property’s annual Net Income and the total cash paid to acquire the property. The Cash on Cash rate of return is calculated as:
Cash on Cash Rate of Return =
(Annual Revenue / Total Cash Invested) x 100%
Different Cash Flow, Different Results
Buying the same rental property as in the above example, the investor pays a 20% down payment on the property and finances the remaining $80,000. The cash outlay is $20,000 plus the closing costs of $2,000 and an additional $1,000 for the cost of getting a mortgage. There is still a remodeling cost of $23,000 and the total cash paid out equals $46,000. In addition to these costs are the monthly mortgage payments that are deducted from the rent payments of $500 per month. A tenant paying $1,500 per month less overhead of $300 and a $500 mortgage payment leaves a net income of $700 per month or $8,400 per year.
Cash on Cash Rate Formula Results
Using the example rental property purchase of $100,000 with a $20,000 down payment and incorporating the rental revenue value of $8,400 per year, the Cash on Cash (CoC) Rate of Return is determined as:
($8,400 / $46,000) = 0.183 x 100% = 18.3%
Same Property Has Three Different Return Rates
The same investment rental property has produced three different rates of return. Depending upon the type and size of investment in a rental property, a real estate investor can determine whether or not a potential property is a good investment or not. There are other considerations to take into mind when formulating a return rate for any given property. Land values fluctuate as well as interest rates on mortgages and costs to maintain the property. Rental revenues go up and down as well as vacancies that can occur, both of which affect the result of the calculations. The perspective a rental property real estate investor brings to the table greatly affects the outcome and performance of the investment.
Time, Space, and Other Factors
When it comes to investing in rental real estate property some conditions can affect values and numbers that can’t be calculated accurately but that can make the difference between a successful investment and a write-off. Local, regional, and national economic conditions beyond the control of the investor as well as changes in zoning laws or other governmental actions can elevate or reduce a property’s value. Changes in tax laws, interest rates, and other costs that directly impact an investor’s return can also become issues. Sometimes an investor gains and sometimes an investor loses, just like being a shareholder in the stock market, rental property investors need the ability to weather any potential storms if they want to experience the benefits associated with investing.
Good Rate of Return on Rental Property
Every investment has a unique method of calculating its value over time and an investment in a rental property is no different. Some investors want to hold onto their investment properties for the long-term, bequeathing their holdings to future generations. Other investors are in the game for the short-term, looking to fix and flip properties to gain a fast return on their cash. There are many different formulas to use when calculating the Rate of Return on real estate investments with a variety of results. What’s important to remember is that no matter which formula is used or what result is determined, the variables and considerations can be few or many. Savvy investors always calculate the good factors in with the not-so-good factors before deciding to invest or not.
Only One Consideration for the Calculation of Rate of Return
The only thing a real estate investor has to decide, regardless of the method or formulation of a rate of return, is the profitability of the investment measured against the investor’s financial goals. Many investors spread their money across a variety of investments thinking that each investment is a hedge against losses with other investments. Some investors put their funds into only one market feeling a greater level of comfort due to experience and personal knowledge. Whether an investor is spread out across many opportunities or decides to invest in only rental real estate property, the ability to calculate and then achieve the desired rate of return is always the goal.