Real estate has been proven to be a lucrative investment. But before buying a South Florida rental property, you should calculate the return on investment (ROI) to be sure that it’s the best way to spend your hard-earned savings. Since it can be challenging to calculate the ROI, in this article, we will cover some of the most simple calculations. These will — hopefully — help you invest wisely.
And remember, if you lack the accounting chops, you can always count on a property management company like Luxury Property Care.
The Return on Investment (ROI)
The Return on Investment (ROI) or rate of return measures the amount of money that remains after subtracting the associated costs. In real estate, it measures the profitability of a property as a percentage of its original cost (i.e. how much money you put into the property). Calculating the ROI is critical, as it tells you whether or not you’re putting your money in the right property. It also assesses the performance of your property, so you can decide if you should alter your property management tactics.
It’s worth mentioning that calculating the return can be complicated. It contemplates the type of property (e.g single-family home, short-term rental, condominium, etc.), the cash flow, and so on. With this said, not all real estate will yield the same returns. Hence, it would be worth your while to hire a South Florida property management company to help you calculate the ROI. They know the local real estate market well, so they can calculate the ROI as accurately as possible.
What You Should Consider When Calculating the ROI
When calculating the ROI, you shouldn’t assume that the cost of the investment is the purchase price. Let us assume that you purchase a single-family home for $200,000 and spend $3,000 on repairs. The amount you spent on repairs should also be considered in your total costs. So, the total cost of the investment wouldn’t be $200,000, but instead, $203,000.
Another factor that affects the ROI is the financing term. If you purchased the property with cash, the calculations are straightforward. Now, let’s say you took out a loan to buy the property. You’ll need to take that into consideration, too. You need to deduct the down payment, monthly mortgage payments, as well as closing fees from the annual return.
Keep reading for a closer look at the formulas for determining the ROI.
How to Calculate the ROI on Your Rental Property
As we mentioned, there are several ways to calculate the ROI on your South Florida property investment.
Method #1: Cap Rate
Real estate investors calculate the capitalization rate for properties that they purchased in cash. This formula is also used to determine the profitability of one property compared to similar properties in the same area. The formula is:
Cap Rate = NOI / Purchase Price x 100
This formula is fairly simple. Let’s say you purchased a rental property for $200,000 in cash. If your tenants pay you $2,000 per month, that means you earned $24,000 in rental income for the year. In addition, you spent $5,000 to cover other costs such as property taxes, property management, property insurance, etc. Hence, your net operating income or NOI (i.e. income minus the expenses) would be $19,000.
To calculate the ROI, divide the NOI by the purchase price:
Cap Rate = ($19,000/$200,000) x 100% = 0.095 = 9.5%
The rate of return of the rental property would be 9.5%.
Method #2: Cash on Cash Return
Calculating the ROI on a property that you bought by taking out a mortgage can be complicated. The cash-on-cash return contemplates the percentage of a particular property’s NOI to the total amount that was put into the property. The formula is as follows:
Cash on Cash Return = (Pre-Tax Cash Flow / Total Cash Invested) x 100%
Let’s say you bought a $200,000 home in Hialeah. Rather than paying in cash, you decided to put a 20% downpayment on a loan, paying $2,500 for closing costs in the process. You also spent $8,000 for repairs and remodeling. That means that you put a total of $50,500 ($40,000 + $2,500 + $8,000) into the property.
Remember, you still need to deduct the monthly mortgage payments. For this example, let’s assume that you pay $600 per month. If your tenant pays you $1,000 per month on rent, your cash flow would come to $400 per month ($1,000 – $600). Multiply that by twelve months, and your net annual income would be $4,800.
Using the formula above, put all of the figures together, and it will look like this:
Cash on Cash Return = ($4,800 / $50,500) x 100% = 0.095 = 9.5%
Your rate of return would be 9.5%.
Ideal Rate of Return on a Rental Property
The “ideal” rate of return depends on the size of the property, the location of the property, the associated risk, and so on. In general, a good number is 10% or more, but anything between 5% to 10% is also acceptable. This is because, ultimately, the “best” return on a rental property depends on you. If you’re willing to take more risks, you can anticipate a higher rate of return. Conversely, cautious investors can settle for lower ROIs for the sake of certainty.
The Bottom Line
It can be valuable for real estate investors such as yourself to learn how to calculate the rate of return on a particular rental property. Whether you pay in cash or by monthly mortgage payments, you can determine the rate of return by following the two formulas discussed in this article.
However, be aware that these formulas provide a basic overview of your investment. To be certain that you’re putting your money in the right South Florida property, you should consider hiring a South Florida property management company. At Luxury Property Care, we advise investors to save them from the wrong investments.