With few exceptions, the goal of having an investment rental property is to make a profit. Investors may have other reasons for purchasing a second home, such as their love for beaches in South Carolina or their desire to own property in a community with a full-service equestrian center, but whether or not they make the purchase often comes down to return on investment, or ROI. Calculating ROI on rental properties allows investors to estimate the profitability of their investment before they commit to the purchase. If you’re thinking about investing in rental property on Seabrook Island or anywhere else, be sure you know how to calculate ROI.
What Is ROI?
ROI is a profitability metric that estimates your profit on a property as a percentage of your initial investment. This is a key indicator of how efficiently your investment dollars are being used to bring in profits for you; many investors say that they won’t purchase a property if the ROI is less than 4%.
Knowing your estimated ROI will allow you to compare several properties against each other for their expected profitability. Again, you may have other reasons for deciding on one property over another besides profitability, but this is a useful metric to keep in mind.
You can find the potential ROI of a rental property by subtracting all of your expenses from your gross earnings, then dividing the difference by your initial investment. This formula can be simplified by dividing net profit by original cost.
ROI Formula: ROI = (Earnings – Total Cost)Initial Investment
Example 1: General ROI Formula
Say you purchase a second home for $300,000 in 2019 and sell it for $325,000 in 2020. Your net profit (the numerator of the ROI equation) would be $25,000. Divide $25,000 by your initial investment of $300,000 and you get an ROI of 8.33%.
This is an extremely simplified example of calculating ROI, because it does not take into account other expenses that you may have incurred over the course of the year in regular household maintenance or HOA membership fees, interest payments, vacant months, or your down payment.
Example 2: ROI with Cash Transactions
This example is similar to the first one, but with a few more details that make it slightly more realistic.
- You bought a new rental property in 2019 for $200,000 entirely with cash
- Closing costs totaled $2,500
- You did some remodeling work that amounted to $23,000
- You found a rental tenant for the full year and charged them $3,000 each month, not including water and utilities
- Your monthly expenses for insurance and property taxes were $350
To calculate ROI for that one year, you need to total up all yearly expenses, income, and also determine your full initial investment.
Yearly Expenses: $350 insurance and property taxes per month * 12 months = $4,200 yearly expenses
Yearly Income: $3,000 rental income per month * 12 months = $36,000 yearly rental income
Total Initial Investment: Your full initial investment includes the purchase of the home, the closing costs, and the remodeling: $200,000 home price + $2,500 closing costs + $23,000 remodeling costs = $225,500 total initial investment
ROI: ( $36,000 – $4,200 ) / $225,500 = 14.10% ROI
Example 3: ROI with Financed Transactions
This final example is probably the most realistic of the three. Not many people can pay entirely in cash for a second home, let alone the first one. Instead, they turn to financing from a bank and pay a mortgage each month. To try to keep things simple, we’ll use some of the same numbers from the previous example problem.
- You are buying a new rental property for $200,000, but it requires a 20% down payment
- Closing costs were $2,500
- Your remodeling work amounted to $23,000
- You took out a 30-year loan with a fixed annual interest rate of 3%
- Your monthly cost for insurance and taxes are $350
- Your rental income is $3,000 each month
Down Payment: 20% * $200,000 = $40,000 down payment
Out-of-pocket expenses: $40,000 down payment + $2,500 closing costs + $23,000 remodeling expenses = $65,500 out-of-pocket
Monthly principal and interest payments: Using an online time value of money (TVM) calculator (we’re using this one), you can determine your monthly principal and interest payments on your 30-year 3% loan. TVM calculators contain five main variables: the present value of the loan, periodic payments, the future value of the loan, the annual rate, and the number of periods. On the calculator we’re using, we must also select the compounding periods and whether payments are made at the beginning or end of the period (mode).
Present Value (of the loan): $200,000 cost – down payment of $40,000 = $160,000
Payments: unknown (what we’re solving for; leave empty)
Future Value: $0 (because it will be entirely paid off)
Annual Rate: 3%
Periods: 30 years * 12 compounding periods per year (we’re figuring out monthly payments) = 360 compounding periods
Click on the PMT button and hit the return/enter key. The calculator will solve for the missing payment value. In our case, the monthly payments will be $674.57.
Monthly Return: $3,000 rent – $674.57 monthly principal and interest payments – $350 rental insurance and taxes costs = $1,975.43 monthly return
Annual Return: $1,975.43 monthly return * 12 months = $23,705.16 annual return
ROI: $23,705.16 / $65,500 out-of-pocket expenses = 36.19% ROI
There are more formulas and examples that can become even more complex, but these should provide a basic understanding of calculating ROI on rental properties. If you’re interested in buying a rental property on Seabrook Island, take a look at our available listings and reach out to one of our experienced real estate agents.