When thinking about investing in a rental property, one of the most important questions you're probably thinking is "is this a good deal?"
There are many ways to assess whether a property is a good investment but it's generally a good idea to know what the Return on Investment (ROI) is on a potential property?
Now, for property investing, the Return on Investment is essentially the annual profit or cash flow divided by the total amount invested.
The ROI is probably one of the most reliable things to calculate when considering to purchase a rental property and it's not very difficult to calculate.
In this article I will show you a very simple way of how to calculate the ROI on a rental property so that you can make better property investing decisions.
This property investment ROI quadrant approach that I'll go through below was inspired by BiggerPockets, and what it is is simply working out 4 key numbers on a property.
Once you know these four numbers. The ROI will fall in your lap.
Below is an example ROI quadrant, on a fictitious property, with these 4 key numbers.
Using the ROI quadrant method, you first estimate the rental income, adding any other additional income you think you could generate from the property (for example, a garage space).
Then you calculate all the expected expenses. Vacancy and repairs are simply earmarked amounts at approx. 6% and 5% respectively. It's up to you how much you reserve for these items.
After you have the total income and expenses you can then calculate the cash flow, which is simply the cash left over at the end of the month (assuming vacancy and repairs are out of the equation even if not spent).
Once you have the property's expected cash flow you need to calculate the total investment.
Now you need to annualised (x12) your monthly cash flow amount on the 3rd box. Once you have this, in order to calculate the property ROI you divide the annual cash flow by the total investment.
As you can see this property rental example looks to be providing a ROI of 7.22%.
Well, it depends. It depends on your opportunity cost. It depends on your goals. If you have the money in the bank, you'll probably be looking at a return less than 1%. That's a quick math that most could probably figure out!
That said, if you have another business and are confident you can produce 20% ROI then perhaps that could be a better deployment of your cash.
Stocks, particularly US stocks have average around 7% annual return over the pass 50+ years. That is substantial and the stock market has created many wealthy people with this level of return. But property has also done well. Many properties in the north of England can provide ROIs between 8-15%, feasibly. That said, there are of course risks. Property prices are said to move in line with inflation at a minimum, but that depends hugely on the area. Many industries have moved from cities which has caused a detrimental effect to long-term property price appreciation.
However, if you do your research and pick a prosperous stable area for your next rental property and set a minimum property ROI that you are willing to take then you could be on the way to building a very healthy property portfolio.
I have spoke a lot about analysing rental yields and ROI on property investments but these is one key thing that is missing... Capital appreciation.
The above ROI only takes into account the rental income, however, when you include the property price increase over time. This ROI starts looking even more appealing. Another calculation method people use to find this out is the Internal Rate of Return (IRR). But I'll leave that for another blog post.
Don't forget to check out our Property ROI calculator to find calculate the ROI on your next rental property.