How to Evaluate the ROI of a Rental Property Investment
Owning rental properties can generate consistent cash flow and long-term income for savvy investors. This is an investment strategy that offers many benefits, but how do you determine if a property is viable as a rental? Estimating the return on investment, or ROI, for a property is key for evaluating rental properties and a tool that investors use before moving forward on a potential investment property. The ROI equation is used to understand the risk level on a particular investment opportunity.
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Before you attempt plugging figures into this equation, you should start by researching the real estate market in which you are planning to invest. Through your research you will learn more about the types of properties for rent in the area, make comparisons on the attributes of your prospective property against similar rental properties, understand the needs of tenants in the area, and drill down on the average rent based on those attributes. Once you have determined what rent range your property falls into, you can multiply the estimated monthly rent by 12 to find your Annual Rental Income.
Let’s use a duplex in Fayetteville North Carolina as an example. For this equation, we will assume this duplex has recently been renovated and each unit has 2 bedrooms and 1 bathroom. Based on the comparable properties in the area, each apartment in the duplex would receive $1,000 in monthly rent each. Taking $2,000 for the total duplex rent and multiplying by 12, you would receive an estimated $24,000 in annual rent.
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Now that you have estimated your Annual Rental Income, you next need to estimate the Annual Operating Expenses. This estimation includes any expense that investors are required to pay such as utilities, property taxes, and insurance, as well as some that may not always be applicable including homeowner’s association fees and third-party property management fees. If you need help determining these numbers, you can make phone calls to the local utility and insurance companies to get quotes, or even speak to other property managers in the area.
Taking the duplex in Fayetteville, annual property taxes on average are about $2,000 while insurance is estimated at $1,200 for the year. The utilities can vary depending on the frequency a tenant uses the electricity, as well as the kind of water and gas that the home operates on well water versus city water, and oil heat versus natural gas heat. For this example, let’s assume that it comes to $4,500 total for the year. Lastly, as the property owner you can decide to outsource your property management to a third party. Property management companies can be pricey; however, they alleviate the pressure on the owner of having to answer middle of the night phone calls to handle various emergencies. So, let’s include $10,300 in total for the year for property management. Tallying all those figures together, your total Annual Operating Expenses are $18,000.
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As for the Mortgage Value, this is something that you will determine with your lender when you are shopping around for properties. There are various factors that come into play when you are shopping for a mortgage or hard money loan. One piece of information that impacts your chances of getting your financing approved as well as the interest rates on the loan is your FICO score. If your FICO is good, a score of 700 or above, your lender will feel more comfortable extending a larger loan at a lower interest rate. Whereas if your score is below that point, the lender could drop the loan amount down and even raise your interest rate, requiring the borrower to put more money out of their pocket to fund the deal.
For our example let’s assume that you are refinancing the recently renovated duplex with Asset Based Lending’s DSCR loan, and we are extending you $80,000 for this rental property. That figure is now your Mortgage Value. The Mortgage Value, as it is used in this equation, does not include the total amount of interest owed over the life of the loan but rather just the total loan amount the lender is extending.
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Now to complete this equation, first subtract the Annual Operating Expenses from Annual Rental Income, which leaves you with $6,000. This figure is referred to as your Net Operating Income, or NOI.
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When you divide the NOI by the Mortgage Value, you are left with a decimal which represents the annual percentage of return you are seeing from your investment.
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Every real estate market is different, but the general rule of thumb that rental property investors use when analyzing deals is to earn between 5% and 10% a year for each rental property they own. This has become the accepted range because the typical retirement account will only earn about 3% annually, making your rental property investment a preferred stream of income.
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An ROI of 7.5% is a good starting point considering the Mortgage Value will decrease over time as you make payments towards the loan principal, improving your annual return. However, it is necessary to consider the variables that are inherent in the Operating Expenses. For example, as the property becomes older the more likely it will need renovations. So, while you are collecting 7.5% ROI most years, the Operating Expenses could change and affect that number.
The ROI calculation is an invaluable tool for real estate investors to use before taking the steps to commit to a rental property. Not only does it save investors from making risky investments, but it also saves them time. If you run this calculation on a potential rental property and determine if it is a worthwhile investment prior to contacting realtors or lenders, you will be able to move more quickly and with more confidence.
Final Thoughts
Understanding the money-making potential of a rental property is important, and the team at Asset Based Lending can finance your success. Whether you’re seeking your first rental property investment or looking to scale your existing rental portfolio, ABL is staffed with in-house experts that can analyze your deal and ensure you’re choosing the right property in the right market.
Once you evaluate the ROI of a rental property investment and decide you are ready to make the next move, visit ABL’s Loan Pre-Qualification page to start the rental loan process and discuss financing options with one of our qualified Loan Officers.