Financial Planning, Millennials

How To Know If A Rental Property Is A Good Investment

Almost every millennial I talk to wants to get started investing in real estate. It’s a great goal and a great way to build wealth when done right. However, you cannot just go and buy any rental and think it’ll work out numbers wise. You have to do the math both on new and existing rentals to ensure they are a good investment.

So how do you do that? Let me show you.

How To Know If a Specific Rental Is a Good Investment?

Let’s be real with ourselves for a second, it’s not worth it to have a rental and do all the work if it’s a bad property with really low returns. At that point you might as well own something more passive that has higher expected returns.

Anyways, let’s dive into how you can calculate your return on your rental property.

Note: many do this wrong and do not include savings. You have to factor in saving for an emergency fund, repairs, vacancies, etc. It’s not just revenue – expenses = returns.

What is ROI?

ROI stands for return on investment. It is the metric to determine the property’s profitability. To calculate the ROI, you have to first know if you have a mortgage or paid outright in cash (very few do this).

To calculate your ROI you need to account for your downpayment, repairs, maintenance, etc. to get the true ROI. And if you have a mortgage, you need to add in the mortgage payment and interest.

The calculation is below:

How TO Calculate ROI If You Paid In Cash

If you paid in cash here’s how you would get your ROI using an example.

  • Bought a property for $250,000
  • Closing Costs were $7,500
  • Remodeling cost $7,000
  • You collect $2,500 in rent every month

In this first year:

  • You earned $30,000 in rental income
  • Had expenses of $10,000 (utilities, property taxes, etc)
  • Your annual return was $30,000 – $10,000 = $20,000
  • However you want to also save for emergencies and build a CAPEX fund. Let’s say you want to do 10% of revenue for this (taylor this based on how old the house is and how much work may be needed) = $3,000
  • Total annual return = $20,000 – $3,000 = $17,000

Now to calculate the ROI:

  • Divide that annual return of $17,000 by how much you invested in the property ($250,000 + $7,500 + $7,000).
  • ROI = $17,000 / $264,500 = 6.43%

How TO Calculate ROI If You Financed

This one is a little bit trickier.

Let’s assume you bought the same rental as above for $250,000, but chose to finance 80% and put down 20%.

  • The downpayment is $50,000
  • Closing costs are $7,500 (typically more for mortgage but we will just keep it simple)
  • Paid $7,000 for remodeling
  • Collect $2,500 a month in rent
  • Mortgage with the interest at 5% costs about $1,073
  • Cash flow = $1,427 a month
  • Annual expenses still around $10,000 or $833 a month
  • Total cash flow = $594 a month x 12 = $7,128
  • Emergency/CAPEX savings of 10% = $3,000 = $4,128

To calculate the ROI:

  • Divide the annual return of $4,128 by all your costs (down payment of $50,000, closing costs of $7,500, and remodeling of $7,000 to get your ROI
  • ROI so far = $4,128 / ($50,000 + $7,500 + $7,000) = 6.4%

One thing missing here is appreciation and equity built. Some choose to not add this in, I definitely add it in.

To add appreciation and equity built into ROI, you would simply add in the equity you have. After year 1 of the mortgage above, you will have built $1,849.99 of equity in year 1 (I know, not a lot. Mortgages are front loaded). And we will assume no appreciation to make it simple.

  • ROI = annual return + equity built then divide by all the costs.
  • ROI = $4,128 + $1,850 / ($50,000 + $7,500 + $7,000) = 9.27%

I personally do like accounting for equity in the return. You can build equity from paying down the mortgage as well as home appreciation. But as we are seeing now, you also have times where homes decrease and would hurt the return. So in years it does well, add the appreciation in. When it does not do well, you have subtract it out.

Now after seeing the numbers, you may be wondering, what is a good return on a rental property? Generally, people like to look for around 10% ROI or higher for it to be a solid investment.

Cash on Cash Returns

Another metric real estate investors like to use is cash on cash return. To figure this out, you do annual cash flow / initial cash out of pocket. Generally, people look for 7%ish or more cash on cash return.

Here’s how you figure yours out (using example above):

  • Annual take home cash flow = $4,128 (for the one with the mortgage)
  • Initial out of pocket costs = $50,000 down, $7,500 closing costs, $7,000 repairs = $64,500
  • Cash on cash return = $4,128 / $64,500 = 6.4%

A little lower than we would like, but not horrible. Cash on cash return can be another great way to evaluate a rental property.

The key point here is that you need to make sure you are evaluating your rentals and adding in all the costs and revenues to ensure you are making good investments.

Hopefully this was helpful and can allow you to do this with your own! But I urge you to do it. I have had way too many people not do this, and then realize they have a rental getting 4-5% a year pre any savings for emergencies, vacancies, etc.

Disclaimer: None of this should be seen as advice. This is all for informational purposes. Consult your legal, tax , and financial team before making any changes to your financial plan.

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