Like any other type of investment, buying real estate properties comes with risks and returns. One of the driving forces behind making smart real estate investment decisions is estimating expected returns before buying. By doing so, you can determine how profitable an investment property is compared to the associated risks and whether or not it’s worth your time and money. If you’re just getting into real estate investing and don’t know what a good return on investment is and how to calculate it, you’ve come to the right place. Keep reading as we cover some basics that every investor should know about the ROI in real estate and how to calculate it.

Return on Investment: The Basics

So what is ROI? In simple words, it’s a standard metric that real estate investors use to analyze investment properties. It estimates the percentage of gain or loss in relation to the amount of capital invested in the rental property. The ROI formula is very comprehensive and straightforward:

This formula gives real estate investors a quick way to understand the financial rewards they’ll get from investing in a rental property. You can also compare the ROI of a property to that of others (of the same type and in the same location) to see how well it’s performing in the real estate market. This will further allow you to make sure you’re buying a property with a good expected rate of return. But this leads us to our main question – what is a good return on investment for real estate investors?

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The truth is, there isn’t a specific percentage that real estate investors consider to be “the best” on which they base their decisions. After all, the word “good” is subjective. You might think 10% is a good rate of return while another investor would consider it a bad one and would only buy rental properties that generate a 20% return on investment. It also depends on different factors like the investment property’s location, type, size, age, taxes, expenses, and more.

Related: How to Calculate the Rate of Return on a Rental Property

Furthermore, the above ROI formula is very general and includes broad numbers. So, it may not give an accurate measure for an investment property’s profitability. This is why real estate investors turn to two more specific metrics for analyzing investment properties. These are the cap rate and cash on cash return – you determine which one to use based on how you pay for the rental property.

Cap Rate Calculations

Real estate investors use the cap rate (short for capitalization rate) when they buy properties fully in cash. Basically, this metric tells you what the expected returns from a rental property are if you were to pay for it in cash (rather than financing it with a mortgage). Wondering how to calculate the return on investment using the cap rate metric? Simply divide the property’s net operating income (annual rental income – annual operating expenses) by its current market value.

For example, say you’re planning on buying an investment property with a purchase price of $200,000. Let’s also assume that after buying the property, you rent it out for $1,800 a month, which means you’ll gain an annual rental income of $21,600. After estimating your operating expenses (excluding mortgage payments and interest rate), they add up to $3,000. Thus, your NOI would be $18,600. In this example, you’ll get a 9.3% cap rate. Is this a good return on investment ratio?

As we said, there’s no right or wrong answer seeing that this is a subjective question. Yet, when it comes to what’s a good cap rate, experts in the real estate business recommend anything from 4% to 10%. Keep in mind, however, that cap rates of properties vary by city: rental properties in New York have different cap rates from properties in Nashville, for example. Typically, if the average cap rate for a rental property in a city is high, the location is considered to be profitable for real estate investing.

Wondering what the average cap rate for rental properties in your city is? Read 2019 Cap Rates by City: What Real Estate Investors Should Expect.

Cash on Cash Return Calculations

This real estate metric is more frequently used for calculating the return on an investment property. Investors use it to estimate the expected rate of return on a property which they plan to finance with a mortgage loan. So, to calculate the cash on cash return, you divide the NOI by the total amount of cash you actually invested (not the entire purchase price).

For example, say you want to buy the above investment rental property with a purchase price of $200,000. But, instead of paying the full price, you take a mortgage loan and put 20% of its price as a down payment ($40,000). Say that you’ve paid $2,000 for closing costs and invested another $10,000 for remodeling the property. In this case, your total cash invested is $52,000.

Don’t forget that you need to include the monthly payment associated with the mortgage (let’s assume the monthly mortgage payment amount is $500) in the calculation. If you rent out the investment property for the same $1,800 a month, you’ll have a monthly rental income of $1,300 ($1,800 – $500). Your annual rental income equals $15,600. Let’s take out the original $3,000 for rental expenses and your NOI equals $12,600. Finally, the cash on cash return for this investment property will be 24.2%.

As you can see, how you pay for an investment rental property changes what you consider to be a good return on investment. When it comes to good cash on cash return, experts believe anything from 8% to 12% is a good return on investment ratio.

Note: You can use Mashvisor’s Property Finder to find the best investments with high cash on cash return. Sign up for free to start looking for and analyzing investment properties in your city of choice!

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A Tool to Calculate Return on Investment

As a real estate investor, knowing how to calculate the ROI using different metrics is essential for success. But are you worried you’ll get inaccurate percentages and make the wrong investment decision? Thanks to advanced technology, an investment tool has been created so you don’t have anything to worry about! That tool is Mashvisor’s Investment Property Calculator.

Using our Investment Property Calculator, a real estate investor would simply enter necessary numbers like financing details, start-up costs, and operating expenses. Then, the tool will automatically calculate the numbers and give you an accurate expected rate of return in terms of cap rate and cash on cash return. Not only that, but Mashvisor’s tool also provides readily calculated data for investment properties in the US housing market. This way, you’ll have the ability to find the best properties for sale with high expected returns in a matter of minutes without having to do any calculations on your own!

Related: The Best Investment Property Calculator in 2019

The Bottom Line

For real estate investors, knowing what a good return on investment ratio is, is important for making wise decisions. After all, you should expect some rewards for investing your capital. All of the above real estate metrics are great for estimating the profitability of an investment property or for comparing properties to find the one with the most promising financial rewards.

Want to give our Investment Property Calculator a try to find the best investment properties? Click here to start your 14-day free trial with Mashvisor and subscribe to our services with a 20% discount after!

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