How to Calculate the Return on Investment Rental Property
There are a number of different ways to calculate a return on investment real estate property, and although they may look like simple, or complicated, mathematical accounting calculations, they are, in fact, much more amorphous. However, by calculating a return that is based on standardised assumptions, you can better understand how your investment is performing relative to other investments as well as your goals.
Compute your property's effective gross income--it's typically equal to your actual rent collections over the past year plus any additional income that you can count on continuing to receive. For instance, if you have an apartment building, you can usually count on receiving income from a laundry room on a year-by-year basis. With an office building, you may receive annual reimbursements from tenants for maintenance costs for common areas. Both of these should be included as additional income. If your building is experiencing better-than-market occupancy, you should subtract a vacancy factor. One good rule of thumb is to reduce the gross income of a 100 per cent-occupied building by 5 per cent. For instance, if your building generates £120,250 in annual rent and £9,750 in other income, you would then subtract a £6,500 vacancy factor to come up with an effective gross income of £123,500.
Calculate your annual recurring non-capital expenses--these include property taxes, insurance, utilities, non-capital repairs and maintenance, and a reasonable management fee. If you self-manage your property, add a reasonable market-level management fee to your expenses. Remove any "personal" expenditures such as mileage and travel. In addition, take out any capital expenditures--money that you spend on non-recurring items with a useful life longer than one year, such as a new roof or tenant improvements for a new tenant. A good rule of thumb is that if you would need to depreciate it instead of expensing it on your taxes, you should subtract it. Add in a reasonable reserve amount as determined by your market and property type's norms. Finally, take out any expenses tied to your financing. Once you have all of your expenses for the year tabulated, add them up.
Subtract your total expenses from your effective gross income to find your net operating income, usually referred to by its initials. This represents your yearly net income from the property relative to its income and performance.
Find the cap rate of the property based on what you paid for it by dividing your NOI by your original purchase price. That represents your yearly unleveraged return as a percentage. To see how your returns are today, divide the NOI by today's value.
Calculate your leveraged return, referred to as a cash-on-cash return, by dividing what is left of your NOI after you make one year's worth of loan payments, also referred to as a net cash flow, by your down payment. This shows you how much money you get out relative to how much money you put in. To really understand your property's performance, divide your net cash flow by your equity. Calculate your equity by subtracting your current loan balance from your property's current market value. That rate of return is your return on equity, which truly indicates just how hard your money is working for you.