Your return on investment is basically your total income (gross income) minus expenses and divide by your total investment (represented by the equation below).

gross income – expenses

total investment

As an example, let’s say the property you own is worth \$350K and your rental income is \$2,000 per month.  If you had no expenses for your property, your return on investment would look like this.

\$2,000 x 12 months = \$24,000  = .08

\$300,000

Now, all we need to do is turn the result into a percentage by multiplying by 100.  This leaves us with a return on investment percentage of 8.0%. Not bad, but unfortunately that is the simple math and we have not yet factored in the expenses.  This is where it starts to get a little tricky, and there are many factors in play, so let’s analyze a bit further. This is when using a real estate investment calculator can help because it will help factor multiple variables into the equation.

## We will dig deeper here by looking at the top and bottom line of the equation:

Let’s start with the bottom line as there is only one variable: the price of the property.  When analyzing the cost of the property there are two ways to look at the price of the home.  The first way to look at it is as we have been, the total cost or value of the asset. If your home is worth \$300K, it makes sense to use this number to divide the income by, but there are a few variables to consider.  By placing \$300K on the bottom line, this assumes there is this much invested in the property. This is the most common way to value return on investment (ROI) in real estate, also known as Cap Rate. But this number is only correct if you own the property with no mortgage on the home.

It is more likely that you have a mortgage on the home, so this will need to be factored into the equation. By subtracting the mortgage balance on the home from the value of the home you can get to a rough number of the equity you have on a home. On a new home purchase, you can do this very easily as you know exactly what the home is worth (you just purchased it) and you know exactly what you put down on the home (your down payment).  Let’s use the same property above and factor \$300K (Purchase price) and a \$75K down payment (a 25% down payment is common for investment properties). In this example, instead of factoring the full value of the home in the equation, we will only use the \$75K number, which is the total cash invested in the home.

This is a rough approximation as there may be factors like repairs to the home and mortgage costs that can be factored in, and will vary widely on each potential investment.  But let’s take a look at this new equation that will determine your return on investment based on actual cash invested.

\$2,000 x 12 months = \$24,000  = .32 or 32%

\$75K (actual cash invested)

#### Ok, so this is a much larger number—what happened here?

This is a great example of the power of the leverage of capital, one of the greatest benefits of investing in real estate.  This is also an example of risk vs. reward. With a home you own outright, there is a very little risk (outside of market volatility) as you own the property in full.  As soon as you leverage your capital through mortgage lending, your risk goes up as you now owe someone money (the mortgage company). Your overall risk tolerance will be determined by your own personal beliefs and financial strategy.  The more risk you take (mortgages) the more open you are to risks in a recession, but also you can realize more on your investment.

We are not done here, however, as we have yet to factor in expenses.  If it was that easy to make money in real estate, everyone would be doing it.

#### Let’s take a look at top-line expenses now

We now need to start factoring in their impact on the return here and also look at other expenses that may factor into the equation.  As a rental owner, your expenses will typically fall into the categories below:

• Mortgage payment
• Taxes
• Insurance
• HOA payments
• Property management
• Landlord paid utilities
• Maintenance
• Vacancy

If you own your home and have a current mortgage in place, your interest rate and monthly payments are easy to find on your most current mortgage statement.  If you are looking to purchase a new investment, your lender will be a big help in determining current mortgage rates and mortgage associated expenses. Your Top Properties agent will have great recommendations if you don’t already have a lender in place.  Another good way to look at mortgage cost is using a mortgage calculator, one we like is Bankrate.com.

#### Ok, let’s take this example to the next step and associate real numbers to our equation above

For this example, we will use a mortgage balance of \$225K (\$300K purchase price – \$75K down payment).  We will use an interest rate of 4.5% (your interest rate as an investor will be slightly higher on an investment property than on your primary residence).  Below we will associate realistic figures to the expenses listed above on a monthly basis.

\$834.74 Mortgage interest

\$142.00 Taxes

\$118.00 Insurance

\$0.00 HOA payments (we like to stay away from HOA’s if possible)

\$206.00 Property management (averaged over the year)

\$0.00 Landlord paid utilities (we like to have tenants responsible for all utilities)

\$150.00 Maintenance (7.5% long term average of home)

\$80.00 Vacancy (factoring 2 weeks per year)

\$1,530.74   Total Expenses

Now we have a comprehensive list of the monthly cost of running your rental property (business). Below we will look at how these expenses have affected your return.  We will go through both examples from above (cash investment and property with a mortgage) to compare.

#### Cash Investment Return

The great part of a cash investment is lower risk and lack of interest payment on the loan.

\$2,000 Income – \$696 expenses (no interest cost) = \$1,304 x 12 months = \$15,648 = 5.216%

\$300,000 purchase price

#### Mortgaged Property with 25% Down

\$2,000 monthly income – \$1,530.74 expenses = \$469.26 x 12 months = \$5,631.12 = 7.508%

\$75,000 cash down on property

Another factor to think about with a leveraged investment is that your monthly principal payment continues to increase with the life of the loan and the interest payment continues to shrink.  The interest payment above was taken from the 12th payment of the loan.  One great feature on Bankrate.com’s mortgage calculator is that you are able to see the full amortization schedule (there’s a tab for it).

This has been a fairly comprehensive breakdown on how to calculate your ROI on an investment property.  It is best to use an investment calculator like the one on our site to make the process simple and to best understand your return.  You Top Properties agent is a great resource for this as well.

Calculating your cash flow on an investment property is similar, yet a bit different.  This is where your risk vs. reward can really show. Your cash flow can help determine your risk tolerance as well.  Finding your balance of how much cash (immediate return) you want to see vs. your overall return on investment is important to consider.  Our ROI calculator on our site also factors cash flow into your specific situation.

#### Using the examples above, let’s compare cash flow:

In the cash purchase example, cash flow is easy to easy to establish because all you have is cash flow after expenses.  100% of your return comes to you in cash.

\$2,000 Income – \$696 expenses (no interest cost) = \$1304 x 12 months = \$15,648 cash flow

For the leveraged (mortgaged investment) this is not the case.  In this example, your return is much higher, but it mainly comes in the form of mortgage paydown vs cash flow.

\$407.40 monthly mortgage paydown

\$407.40 x 12 months = \$4,888.80 yearly mortgage paydown

\$2,000 monthly income – \$1,530.74 expenses =
\$469.26 x 12 months = \$5,631.12 – \$4,888.80 = \$742.32 cashflow

Once again, developing a strategy that fits your risk profile as well as cash flow requirements is very important to your overall strategy.

In both of our examples above, we have avoided factoring in any price appreciation to the equations, as appreciation can be very hard to approximate.  Of course, factoring appreciation can be a very important factor in investing in real estate. We don’t like factoring it into the numbers proposed above though, as even factoring a conservative 3% rate of appreciation can change the number to look almost too rosy.

This conservative rate of appreciation can be historically tracked by resources like Zillow’s research page.  Appreciation is a big reason for homeownership, so let’s take a brief look at how factoring appreciation can alter your return numbers. For simplicity, we will not be taking into account the cost of the sale of the property.

#### Cash Investment

All yearly return estimates are taken from our examples above:

\$15,648 rental income + \$9,000 (3% of 300K) = \$24,648 = 8.216%

\$300,000

#### Mortgaged Property

All yearly return estimates are taken from our examples above:

\$5,631.12 rental income + \$9,000 (3% of 300K) = \$14,631.12 = 19.508%

\$75,000 cash down

The return on investment obviously looks a lot better here, but remember this is factoring in appreciation, which is hard to approximate and even harder to guarantee.  However, historic numbers have shown real estate to appreciate consistently over long periods of time.