What is a Good Return on Real Estate Investment?
An increasing number of people without prior experience in real estate investing are choosing to diversify their investments through real estate. This shift is being driven by factors such as:
- Record-low interest rates and housing prices are causing many people to take a keen interest at rental property investing.
- Many people want to diversify their investments, which means moving away from solely investing in the stock market.
- Several years of record-low interest rates make people wary of future inflation, which drives them away from the bond market.
- Many people are dissatisfied with the meager returns provided by their savings accounts and investments such as Certificates of Deposit.
But like any other type of investment, real estate investing has associated risks and a return on investment.
The chief – if not the only – reason for real estate investing is making money. In the property market, you can only make money if the investment is giving you a good return. So this begs the question – what’s a good ROI in real estate?
Sadly, the answer isn’t straightforward. Not having a direct answer surely sucks. Luckily, the experts from OnsiteProperty.com will help you get some clarity as to what a good return on real estate investment is.
Ways to Determine the Profitability of a Rental Property
Generally, there are four ways to determine whether a real estate investment is worthwhile or not. Read on to know more.
1. The One Percent Rule
This is a great tool to quickly screen potential rental properties. According to the rule, your rental property will only be profitable if the rent before expenses (gross monthly rent) equals to at least 1% of the buying price.
Using this general rule of thumb, a $200,000 house, for example, would need to be rented for $2,000 each month. In other words, if you had to pay $250,000 for a property that rents for $2,000, it wouldn’t meet the rule.
Or, if the rent is only $1,500/month, the $200,000 price would not meet the rule either.
The one percent rule helps save time. With it, you can quickly filter 20 listed properties that your real estate agent sends you. Besides time, the rule also helps investors remain disciplined thus minimizing potentially costly investment mistakes.
2. Capitalization Rate
Capitalization rate also helps measure the return on investment. It’s usually arrived at through a process involving market research and in-depth knowledge of the property industry.
Also called cap rate, the capitalization rate is calculated by dividing the net operating income of the property by its current market value.
Let’s assume a property makes $300,000 over a year and costs $200,000 in operational expenses. Its annual net operating income then becomes $100,000.
Now that we have the NOI, the next step is to divide it with the current market value of the property. Let’s assume a property with an NOI of $100,000 has a market value of $800,000.
In such a case, the capitalization rate of the property will be equal to 0.125, or 12.5%. 12.5/100($100,000/$800,000).
3. Return of Investment (ROI)
Usually expressed as a percentage, the ROI is typically used to compare the efficiency of different investments.
So, how do you calculate the return on your real estate investment using ROI? You’ll need to do four things:
- Determine your annual rental income.
- Calculate your cash flow. This is your rental income minus your expenses.
- Determine your net income. This is your equity plus your cash flow.
- Divide your net income by your total investment to get your ROI.
Here is an example to better illustrate this. Suppose you buy a house worth $400,000 and pay $15,000 in additional fees like closing fees, rehabilitation costs, and so on. Then you can compute to charge $2,500 as a monthly rent.
Your ROI for that property then becomes 7.2%. 12x$2,500/ ($400,000 +$15,000).
4. Cash on Cash Return (CoC)
Cash on Cash return is probably the most popular tool when it comes to calculating an investment property’s profitability. Usually expressed as a percentage, it’s the ratio of the annual before-tax cash flow to the total amount of cash invested.
So, how do you calculate CoC? For this purpose, you’ll need the NOI and the total cash invested. To make things a bit simpler, let’s look at an example.
Let’s suppose you bought a rental property worth $350,000 through a mortgage. You paid $70,000, or 20% as down payment and rent it for $1,800. And, your total annual expenses sum up to $4,000.
In this case, your CoC becomes 25.1%. That is, (12x$1,800 – $4,000)/$70,000.
There you have it. Four ways to measure return on a real estate investment. Done right, they can help you better your chances of having a successful career in the real estate business.