How to calculate ROI on a rental property

What is Return on Investment (ROI)?

ROI, or return on investment, is one of the most important things to take into consideration when evaluating a rental property. Return on investment (ROI) is simply a measure of how much money you'll make on an investment, expressed as a percentage of the total cost of the investment. ROI can be used across a number of investments, including stocks, real estate, savings accounts, etc. However, calculating the ROI for a residential investment property can be a bit tricky given the number of variables that need to be included in the calculation.

There are several different metrics that are generally used to calculate ROI on a rental investment property:

We'll walk through each of these below, along with examples.

Formulas to calculate rental property ROI:

1) Net cash flow

Simply put, your cash flow is the sum of your gross rental income - expenses.

Here's an example of how this may play out with an actual rental property I've picked off Zillow. I'm also going to assume that I've purchased the property for $100,000 and taken out a loan, putting 20% (or $20k) down on the property.

Monthly Income:

Total monthly income: $1,400

Monthly Expenses:

Total monthly expenses: $996.03

So, our monthly net cash flow is simply:

Monthly net cash flow = $1,400 - $996.03 = $403.97

This means that, net of all expenses needed to run the property, we can expect to return a profit of $403.97/month.

2) Net operating income (NOI)

Net operating income, or NOI, is very similar to net cash flow, with the only difference being we assume no mortgage was taken out. So, if we were to purchase our home outright in the example above, the net operating income would simply be calculated as:

Monthly Income:

Total monthly income: $1,400

Monthly Expenses:

Total monthly expenses: $490.38

So, our net operating income (NOI) is simply:

NOI = $1,400 - $490.38 = $909.62

3) Cap rate

The capitalization rate, or cap rate, is the estimated rate of return on an investment property without factoring in loan expenses. It looks at the purchase price of the home rather than the actual cash you may have invested to buy it (e.g. a down payment + closing on a loan). Back to my example above, we can calculate cap rate as follows:

Cap rate = Annual NOI / purchase price of home*

*Where the purchase price includes any repairs / renovations necessary for occupancy

In my example above the purchase price was $100,000 -- so we can calculate the cap rate as:

($909.62 * 12) / ($100,000) = 10.9%

4) Cash-on-cash return

The cash-on-cash return is probably the most popular metric used to assess the performance of an investment property, especially in the residential real estate space. The metric shows the ratio of the annual net cash flow to the total amount of cash you invested up front. If you're not taking out a mortgage on the property, this should be the same as the cap rate. We can write the formula as follows:

Cash-on-cash return = annual net cash flow / total initial cost of out pocket

We typically will look for properties with >7% cash-on-cash return for long-term single family residential real estate investing, keeping in mind we like to use conservative assumptions around expenses and can likely expect some additional appreciation in property value over the long-term. This % should be high enough to compete with the typical 7% benchmark return generated by investing in equity indices.

Again going to our property example, we would calculate our cash-on-cash return as follows:

Cash-on-cash return = 12.7%

5) Appreciation

Another important thing to keep in mind when trying to assess the overall return of your rental property is the potential for appreciation. In general, homes across the U.S. appreciate ~3-4% per year, though this varies drastically by location.

So, when you're comparing rental properties for a potential investment, if you have one in a 'hot' market that you expect to appreciate more than maybe one in a small midwestern market, this is something that can be stacked upon the regular cash-on-cash return and may sway your decision one way or another. In other words, one may be willing to accept a slightly lower net cash flow (and therefore cash-on-cash return) in order to take a chance on a home expected to appreciate at an accelerated pace relative to the overall real estate market.