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How to Calculate Potential ROI Before Investing in a Rental Thumbnail

How to Calculate Potential ROI Before Investing in a Rental

5 Important Ratios & Calculations to Know.

Buying and owning rental property is a proven way to successfully invest in real estate. Rentals can provide passive income, long-term appreciation, and solid tax benefits. Like many real estate investments, a key challenge is choosing the right, or profitable, property.

Whether you’re considering single family, condos, or multifamily property, it’s important to review a property’s location for attributes that include areas with strong demand, flexible rental regulations, and reasonable property taxes.  

Besides location, analyzing several key ratios and calculations can help determine whether a rental property has the potential to generate a profitable return. It’s important to keep in mind that real estate investors may use these and other metrics depending on their investment goals.  

Cash Flow
Cash flow is an easy way to evaluate how well a rental is performing. It shows how much net cash is left after rents are received minus expenses including mortgage payments.  
-Formula: Cash Flow = Monthly Pre-Tax Rents minus Monthly Mortgage and Operating Expenses (utilities, maintenance, property taxes, and insurance).

Monthly Rents, $2,500
Monthly Mortgage and Operating Expenses, $2,100
 = $400 Monthly Net Cash Flow

Net Operating Income
NOI measures the profitability of a rental not just its cash flow. It looks at rental income and operating expenses, except mortgage payments and income taxes, to evaluate how well a property performs as a stand-alone business.

-Formula: Gross Rents minus Operating Expenses (utilities, maintenance, property taxes, and insurance):

Gross Rents (Annual), $30,000
Operating Expenses, $6,000 ($500 X 12 months)
= $24,000 NOI

Gross Rent Multiplier
GRM is the ratio of a property’s price compared to its annual rents. It determines how many years it would take to earn back what you invested using rental income. A lower GRM means it will take less time to pay off your rental, increasing profitability.

-Formula: Gross Rent Multiplier = Property Price / Annual Gross Rents

Property Price, $300,000
Divided by
Annual Gross Rents, $30,000
In this example, it would take about 10 years in rents to pay off the property. GRM can range between 4 to 10, varying based on rentals in a specific market.

Cash-on-Cash Return
Measures cash income earned compared to the cash invested in a property. In general, the higher the percentage of cash-on-cash return, the better the investment.

-Formula: Cash-on-Cash Return = Annual Pre-Tax Rents / Total Cash Invested

Annual Pre-Tax Rents, $30,000
Divided by
Cash Invested in Property, $60,000 (20% down on a $300,000 condo)
= 0.50 or 50% cash-on-cash return
The investment generated a 50% return on the cash invested during the year.

Capitalization Rate
The cap rate determines the returns on the property without financing costs. This allows you to compare the estimated ROI on multiple properties, avoiding variations in down payment and financing scenarios. The higher the cap rate, the better the investment.

-Formula: Cap Rate = Net Operating Income / Property Purchase Price (not including financing costs)  

Determine Net Operating Income:
Annual Rents, $30,000 ($2,500 a month X 12)
Operating Expenses (utilities, maintenance, property taxes, and insurance), $6,000 ($500 a month X 12)
= $24,000 in NOI

NOI ($24,000)
Divided by
Property Cost ($300,000)
= 0.08 or 8% cap rate
The cap rate for rentals can range from 4% to 12%, but can vary depending on an area’s market factors.

Choosing a rental property is more than just comparing its purchase price and potential rents. Running these calculations is a critical part of a rental assessment, helping to maximize profit and reduce risk. A good rental can help generate healthy returns while a poor choice can drain your earnings and time. If you’re looking to invest in a rental, we can help calculate these ratios and explain financing options to help you achieve your investment goals. Contact us for details.