Calculating the ROI on your Rental
Many rental property owners buy a property, rent it out, collect a net profit and sit back while they continue to collect that income year after year, doing little to evaluate if their investment is a very good one.
If their money was in a stock or mutual fund, these same people would likely look up the prices periodically to see how well their investment is doing. If the price started to go down, they may sell or buy more shares. The same concept should hold true for real estate investments. The trouble is that most people don't know how to compare investments or they don't know the true value of their property. Considering your real estate equity is likely to be a large part of your financial portfolio, it is a good idea to do a regular analysis of your properties to make sure they are still as profitable as when you first began renting.
For example, let's assume you invested $20,000 in a single-family rental near a local college with a market value of $120,000 and a $100,000 mortgage. You manage to collect $415 a month after expenses (mortgage, taxes, insurance etc...). That equates to a 25% return on your investment computed as follows:
Net profit x 12 / your equity investment = ($415 x 12) / $20,000 = 24.90%
5 years later, the property is now worth $145,000 based on similar properties that have sold in the area. You raised the rent a few times and now collect $475 a month profit. You have also paid down $10,000 on the mortgage. Let's calculate the return on your investment now.
Net profit x 12 / your equity investment = ($475 x 12) / $55,000 = 10.36%
Amazingly, the same property that was giving you a 25% return 5 years ago is now only reaping a little over 10%! This happens because your equity in the property has increased to $55,000 but the income you earn has not increased relative to your investment. If you were to sell the house today, you would collect $145,000 and have to pay $90,000 on your mortgage leaving you with $55,000. This is money you could use to purchase another property or other investment at a higher rate of return. In this situation you should consider either raising the rents, or selling the property and using the money for a more profitable investment.
While understanding the accurate value of your rental property may take a little effort to determine, the value typically won't change often enough to warrant an evaluation like this more than once per year. But as you can see, it is great way to check if your rents are in-line with the market or if your investment is returning a good enough profit.
Here is a format that you can use to complete this exercise for your own properties.