Are you thinking of buying a rental property? In this blog, we are going to teach you how to calculate the Return on Investment (ROI), which is the rate of return, on a potential rental property. The term ROI might sound complicated, but it’s actually pretty straightforward. If you’re putting in tens of thousands of dollars towards your real estate investment, you might want to know first if your rental property is a good investment.
How do you calculate annual ROI on rental property?
If you’re thinking about putting tens of thousands of dollars towards a real estate investment, you might want to know first whether or not this rental property is a good investment to begin with. To start the calculator, go to this Rental Property Calculator. From there we will input various numbers to compute the ROI, or rate of return. Don’t worry, we will explain every single detail.
Now, before we move forward, we need to come up with a rental property example. Let’s assume we find a 3 bedroom condominium in Virginia listed for $385,000. So in the calculator, input the purchase price of $385,000. Usually for a rental property, you will want to have a 20% down payment, so you are not paying private mortgage insurance (PMI). So a 20% down payment on this property is around $77,000. Keep 20% in the down payment field of the calculator.
For the interest rate on the calculator, in order to estimate the current interest rate at the time you’re buying, you can go to Freddie Mac. This site will show you the rate that you can get if you buy a residential property. Investment properties will usually be about .5% or .75% more than the rates that show for primary home purchases. At the time this is written, 30-year rates are going at 2.78%. So we will assume 3.25% here over 30 years, which can be inputted into the Interest Rate and Loan Term sections of the calculator.
Now we move down to closing costs. These costs are usually 3% of the purchase price. So if our purchase price is $385K times 3%, we can assume closing costs will be around $11,500. We will assume no repairs are needed on this property. If you want to buy a property for cheap and then you’re going to fix it up, then you just input how much you’ll end up needing to repair it and then what you think the value of the house might be after you repair it. In this example, we’re not assuming any repairs.
Don’t forget about rental property expenses
Now, the second section of this rental property calculator are rental property expenses.
- Property Taxes: Property taxes are a big one. Usually, property taxes are around 1% of the value of your property, depending on your county and state. If you live in Washington, D.C., it’s .85%. In this example, we will use 1% in the calculator, so $3,850.
- Insurance: Insurance will range from $200 to maybe $1,200 a year. We’ll just assume $800 for this example.
- HOA Fees: HOA fees can be a big consideration. A single family detached home may not have HOA fees, and if they do, depending on the community amenities, they may be low. Since we are looking at a condo, there will likely be larger HOA fees. In the condo example we are using, the HOA fees are $708 per month. So $708 per month times 12 is around $8,500, so add that into the HOA portion of the calculator. Be very careful, you might be tempted to just type in the monthly HOA dues, but remember, it’s asking for annual.
- Maintenance: For the maintenance section, some people forget this when you’re making calculations. But things do break down when you own a rental property. HVAC, water heater, garbage disposal, etc. If you’re buying a single family detached, consider the roof and surrounding property. Usually they recommend 1% of the value of your home when you’re estimating maintenance costs. For our purposes, it’s a condo, so it’s gonna be less than that. We will assume $2,500 per year. To be conservative, we will assume it will all increase around 3% a year.
So, how do you calculate if rental property is really worth it?
Now let’s go to how much money we’re going to bring in in order to calculate the ROI for this rental property. In order to do this, we need to make some assumptions.
- Monthly rental rent: Monthly rent is the main driver of ROI for rental properties. So we want to estimate it smartly. To begin with, let’s go to this Rentometer website. First you will input the property address into the search. The website will then give us the rental income prices in the area. Let’s assume, for our example, the average rental income is around $2,500. So under monthly rent, type $2,500.
- Rent increase: For rent increase, I’m gonna assume here 2%, which is what tenants are usually expecting each year.
- Vacancy rate: For vacancy rate, input 5%, which is what we can typically assume. That’s around two to two and a half weeks of vacancy over a year. This is the amount of time that you might need to look for another tenant if your tenant leaves.
- Management fee: For the management fee this is something that you need to think about. Are you wanting a rental property manager to help you find tenants and collect rent, amongst other things? If not, you will need to be prepared to take the time to do all of the things a rental property manager does. To hire one usually costs around 8%. It could be as high as 10%. That’s actually the price that one of our clients currently pay their property manager. At District Capital, we actually have connections with good property managers that we recommend to our clients.
- Selling price of the rental property: The last set of assumptions is the selling price. Usually, I am a little bit conservative on this. So I assume 2% per year, which historically speaking, housing prices have increased by the rate of inflation. The Federal Reserve is assuming right now a rate of inflation of around 2%. So we will assume 2% or 2.5%. You might be tempted to assume more than that because you might look to Google and see housing prices have increased 5% over the last 10 years. That can be a very dangerous assumption. It might not match reality. Maybe you’ll be lucky and it’ll increase by 5% a year, but I tend to follow what the studies say, which is the inflation rate.
Let’s assume you will hold the property for 20 years. The cost to sell is typically 6%. You’ll have to pay commission to both your realtor and buyers when it’s time for you to sell. So now we have input all of the assumptions. Next we will click ‘Calculate’. This will calculate the ROI for this rental property.
In this example, it’s telling us the ROI for this rental property is 5.69% per year. IRR is the same as ROI. It stands for internal rate of return. I want you to focus mainly on this number, and just forget about the rest. So, what does 5.69% mean? Well, ask yourself what is the alternative? If you had $77,000 in cash (the equivalent of your down payment) and you invested it in the stock market, how much would you make? When we assume retirement projections for our clients, assuming a 100% stock portfolio, we’re actually assuming around 6% per year on the average for stocks right now. You might ask yourself if it’s worth all of the trouble to make the same amount of money when you buy this rental property when you can just ask your financial advisor what to buy in stocks? Stocks are only a few clicks away and then it’s done.
One last thing to keep in mind about the ROI on rental properties
I want to point out the cash flow in the results of our rental property ROI. You can see in the calculations we just used that you actually have negative cash flow. A lot of YouTube videos that you might watch on rental property will show that you will have passive income, but you really only get passive income once your mortgage is paid off. In this example, we’re assuming that you got a mortgage and you’re paying principal, interest, taxes and insurance. So in this example, you’re actually down $5,500 per year. So that’s just something to keep in mind. If you’d like to learn more about how to calculate ROI for rental property, schedule a free discovery call today!
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help 30s and 40s professionals achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.