Discussing the Average Return on rental property: A guide for landlords

Rental property owners, are you wondering what the average rental property return is and if your investments fall in line?

Calculating ROI can be a game changer when determining if your money is invested in the right place and your real estate endeavors are profitable.

Imagine knowing exactly where you are in terms of profitability and having the confidence that your decisions are the right ones.

This article will discuss a return on investment, how it's calculated, and what factors impact the results. We will also discuss the average return on investment so you can see where your property fits in and discuss alternative ways to calculate profitability; let's get started.

What is return on investment? 

Return on investment, otherwise known as ROI, is a calculation that can be used to determine the profitability of an investment.

In terms of rental property, it is the net profit earned from rental income along with the appreciation the property has received over time. This metric is very helpful as property owners can use it to assess how well an investment has performed relative to its cost.

Net operating income

Before diving into the ROI calculation for rental properties, it's important to understand the concept of Net Operating Income (NOI). NOI is the property's total income (primarily through rent) minus the operating expenses incurred in maintaining it.

These expenses do not include mortgage payments or interest, as NOI aims to measure the property's profitability regardless of financing methods.

Key components affecting NOI and ROI

1. Property management fees: Hiring a property management service can significantly influence your ROI by optimizing rental operations, ensuring steady income through efficient rent collection, and maintaining tenant satisfaction. While an expense, effective property management can enhance property value and operational efficiency.
2. Property taxes: This fixed cost varies depending on the property's location. Property taxes directly impact NOI, as they are a significant operating expense.
3. Mortgage payments and mortgage interest: While not part of NOI, mortgage payments and interest are key for calculating ROI, especially if the property was purchased with financing. The mortgage payment's interest portion is considered when calculating the overall investment cost.
4. Maintenance costs: Regular maintenance and repairs are essential to keep the property attractive to current and potential tenants. These costs reduce NOI but are necessary for preserving the property's value and ensuring it continues to generate income.
5. Closing costs: The initial costs of acquiring a property, including closing costs, are integral to calculating the total investment cost, which is necessary for determining ROI. These one-time expenses should be factored into the ROI calculation to understand the true cost of the investment.

How is investment return calculated?

Calculating rental properties' return on investment (ROI) involves a straightforward formula. However, the inputs can vary significantly based on individual circumstances, particularly in financing methods and the amount of cash initially invested. To understand how ROI is computed, let's break it down:

ROI formula

The formula for ROI in the context of rental property investments is: ROI=Annual Returns

Cost of Investment×100%ROI=Cost of InvestmentAnnual Returns​×100%

Components of the formula

• Annual returns: This is your property's net income annually after deducting all operating expenses. As mentioned previously, operating expenses include property management fees, property taxes, mortgage payments (excluding principal), interest, maintenance costs, and any other expenses related to the property.
• Cost of investment: This encompasses the total cost incurred to make the investment. For rental properties, this includes the purchase price, closing costs, and any renovation expenses incurred to make the property rentable.

Example calculation

Suppose you purchased a rental property for $200,000. The annual rental income is $12,000. Let's calculate the operating expenses:

• Property management fees: $1,200
• Property taxes: $2,500
• Mortgage interest: $7,500 (assuming interest only for simplicity)
• Maintenance costs: $1,000
• Closing costs: $5,000 (incurred during the purchase)

Annual returns

Annual Rental Income−Total Operating Expenses=$12,000−($1,200+$2,500+$7,500+$1,000)=$12,000−$12,200=−$200

In this example, it appears there's a slight annual loss, indicating the property isn't generating a positive cash flow. However, this simple calculation doesn't account for property appreciation or the benefits of paying down the mortgage principal over time, which can significantly affect the overall ROI.

Cost of investment:

Purchase Price+Closing Costs=$200,000+$5,000=$205,000

ROI calculation

Given the initial calculation shows a loss, let's adjust by considering a scenario where the property appreciates, or additional income sources are identified, flipping the annual returns to a positive number. For instance, if after a year, the net gain (considering property appreciation and any adjustments in rental income or expenses) is $10,000:

ROI=$10,000$205,000×100%=4.88%

Tailoring ROI to individual situations

It's important to remember that financing methods (e.g., the down payment size, and loan terms) significantly affect the ROI. A larger down payment reduces mortgage expenses, potentially increasing ROI.

What impacts ROI in real estate?

ROI encompasses the net profit earned from rental income and considers the property's appreciation over time. However, several factors can significantly impact the ROI of a real estate investment. Let's dive into some of these aspects:

Property value growth

• Appreciation: One of the primary factors influencing ROI is the appreciation in the property's value over time. Properties in high-demand areas tend to appreciate more, enhancing the overall ROI when the property is sold.
• Market conditions: Economic factors, supply and demand dynamics, and local market trends can all affect property value growth. Investors should research and understand the market trends in their investment area.

Rental income

• Occupancy rates: High occupancy rates ensure a steady stream of rental income, directly contributing to ROI. Utilizing platforms like Azibo can assist property owners in efficiently managing their properties, potentially increasing occupancy rates through better tenant screening and lease management.
• Rental rates: Setting competitive yet profitable rental rates is essential. Rental rates should reflect the property's value, amenities, and the local market conditions.

Financing terms

• Interest rates: The terms of any mortgage or loan used to purchase the property can significantly impact ROI. Lower interest rates reduce the cost of borrowing, thereby improving ROI.
• Down payment: A larger down payment might reduce mortgage payments and interest costs, potentially increasing the ROI by lowering the overall investment cost.

Location

• Desirability: The property's location significantly affects both the potential for value appreciation and the ability to attract tenants. Properties in desirable locations, with access to amenities, good schools, and public transport, often command higher rents and appreciate more over time.
• Economic stability: Locations with stable or growing economies tend to offer better opportunities for real estate investment ROI. Economic stability can lead to higher demand for housing and, consequently, higher property values and rental rates.

Additional factors

• Operating expenses: Expenses such as property management fees, taxes, maintenance costs, and insurance directly reduce ROI. Efficient management of these expenses, possibly through services like Azibo, can help maximize ROI.
• Capital expenditures: Investments in property improvements and major repairs can affect ROI. While they may increase the property's value and rental income potential, they also increase the investment cost.

Understanding and managing these factors effectively can help real estate investors maximize their ROI.

Average return on investment on a rental property

When exploring real estate investments, particularly residential properties, understanding the average return on investment (ROI) is pivotal for investors aiming to make informed decisions. The landscape of real estate investment is diverse, and consequently, as mentioned, the ROI can vary significantly based on numerous factors, including location, property type, market conditions, and the use of financial leverage.

Historical perspective

The real estate sector has demonstrated a blend of volatility and growth in the last two decades. Historical data reveals that the broader real estate market, particularly when focusing on residential properties like single-family homes, has generally offered attractive returns.

While specific figures vary, according to Investopedia, investments in real estate have been known to yield average annual returns in the range of 4-8%, with certain investment strategies and periods showing even higher profitability.

The influence of leverage on investment returns cannot be overstated, especially in the real estate market context. Utilizing borrowed funds to invest, known as leverage, can potentially elevate the returns on residential real estate investments. Yet, this financial strategy brings with it a heightened level of risk.

This risk primarily stems from the possibility of magnified losses should the market experience a downturn, underscoring the importance for investors to carefully balance the lure of higher returns against the increased vulnerability associated with using leverage.

Understanding the role of leverage in Real Estate

Leverage is a double-edged sword. By borrowing capital to invest, investors can significantly boost their profit potential, often achieving greater returns than would be possible with solely their own funds.

Nevertheless, the application of leverage demands a cautious strategy. The flip side of its potential to amplify profits is its equal potential to escalate losses, particularly in volatile markets.

Alternative ways to calculate ROI for your investment property

Real estate investors employ various metrics to evaluate the potential and actual returns on rental properties. These include:

• Gross rent multiplier (GRM): This metric offers a quick way to compare the value of rental properties by dividing the property price by its gross rental income. It's a useful preliminary assessment tool, though it doesn't account for operating expenses.
• Cash-on-cash return: This measures the annual return the investor makes on the property in relation to the amount of mortgage paid during the same year. A 10% cash-on-cash return is often considered good for long-term rentals, indicating a strong performance relative to the initial investment.
• Net operating income (NOI): NOI calculates the property’s annual income minus operating expenses, providing insight into the property's profitability before financing and taxes.
• Capitalization rate (Cap Rate): This ratio, calculated by dividing NOI by the property's current market value, offers investors a snapshot of their potential return on an unleveraged investment, helping to assess the risk and return profile.

Rental property rate of return-- More than just a percentage

Return on investment is an important measure for real estate investors, encapsulating the profitability of rental properties through rental income and property appreciation. Understanding and calculating ROI, along with considering net operating income (NOI) and the impact of various expenses, equips investors with the insights needed to evaluate the effectiveness of their investments against their initial costs.

While leveraging can offer the potential for heightened returns, it also introduces an increased level of risk, necessitating a careful balance between opportunity and caution. Ultimately, deciding between investing in real estate or other avenues depends on individual investment goals, risk tolerance, and the strategic management of property-related expenses and financing options.

Through meticulous analysis and informed decision-making, investors can navigate the complexities of the real estate market to achieve sustainable growth and long-term profitability.