A year later:

• You earned $12,000 in rental income for those 12 months.
• Expenses including the water bill, property taxes, and insurance, totaled $2,400 for the year. or $200 per month.
• Your annual return was $9,600 ($12,000 – $2,400).

To calculate the property’s ROI:

• Divide the annual return ($9,600) by the amount of the total investment, or $110,000.
• ROI = $9,600 ÷ $110,000 = 0.087 or 8.7%.
• Your ROI was 8.7%.

ROI for Financed Transactions

Calculating the ROI on financed transactions is more involved.

For example, assume you bought the same $100,000 rental property as above, but instead of paying cash, you took out a mortgage.

• The downpayment needed for the mortgage was 20% of the purchase price, or $20,000 ($100,000 sales price x 20%).
• Closing costs were higher, which is typical for a mortgage, totaling $2,500 up front.
• You paid $9,000 for remodeling.
• Your total out-of-pocket expenses were $31,500 ($20,000 + $2,500 + $9,000).

There are also ongoing costs with a mortgage:

• Let’s assume you took out a 30-year loan with a fixed 4% interest rate. On the borrowed $80,000, the monthly principal and interest payment would be $381.93.
• We’ll add the same $200 per month to cover water, taxes, and insurance, making your total monthly payment $581.93.
• Rental income of $1,000 per month totals $12,000 for the year.
• Monthly cash flow is $418.07 ($1,000 rent – $581.93 mortgage payment).

One year later:

• You earned $12,000 in total rental income for the year at $1,000 per month.
• Your annual return was $5,016.84 ($418.07 x 12 months).

To calculate the property’s ROI:

• Divide the annual return by your original out-of-pocket expenses (the downpayment of $20,000, closing costs of $2,500, and remodeling for $9,000) to determine ROI.
• ROI = $5,016.84 ÷ $31,500 = 0.159.
• Your ROI is 15.9%.

Some investors add the home’s equity into the equation. Equity is the market value of the property minus the total loan amount outstanding. Keep in mind that home equity is not cash-in-hand. You would need to sell the property to access it.

To calculate the amount of equity in your home, review your mortgage amortization schedule to find out how much of your mortgage payments went toward paying down the principal of the loan. This builds up the equity in your home.

The equity amount can be added to the annual return. In our example, the amortization schedule for the loan showed that a total of $1,408.84 of principal was paid down during the first 12 months.

• The new annual return, including the equity portion, equals $6,425.68 ($5,016.84 annual income + $1,408.84 equity).
• ROI = $6,425.68 ÷ $31,500 = 0.20.
• Your ROI is 20%.

The Importance of ROI for Real Estate

Knowing the ROI for any investment allows you to be a more informed investor. Before you buy, estimate your costs and expenses, as well as your rental income. This gives you a chance to compare it to other, similar properties.

Once you’ve narrowed it down, you can then determine how much you’ll make. If, at any point, you realize that your costs and expenses will exceed your ROI, you may need to decide whether you want to ride it out and hope you’ll make a profit again—or sell so you don’t lose out.

Other Considerations

Of course, there may be additional expenses involved in owning a rental property, such as repairs or maintenance costs, which would need to be included in the calculations, ultimately affecting the ROI.

Also, we assumed that the property was rented out for all 12 months. In many cases, vacancies occur, particularly in between tenants, and you must account for the lack of income for those months in your calculations.

The ROI for a rental property is different because it depends on whether the property is financed via a mortgage or paid for in cash. As a general rule of thumb, the less cash paid up front as a downpayment on the property, the larger the mortgage loan balance will be, but the greater your ROI.

Conversely, the more cash paid upfront and the less you borrow, the lower your ROI, since your initial cost would be higher. In other words, financing allows you to boost your ROI in the short term, as your initial costs are lower.

It’s important to use a consistent approach when measuring the ROI for multiple properties. For example, if you include the home’s equity in evaluating one property, you should include the equity of the other properties when calculating the ROI for your real estate portfolio. This can provide the most accurate view of your investment portfolio.