What is a Good Return on Real Estate Investment?
This is a question that real estate investors usually wrestle with as they search for an investment property in the hopes of landing the most profitable real estate investment.
In the search for a good Return of Investment (ROI), many beginner real estate investors expect someone to give them a specific number.
For the purposes of clarification, rental property ROI cannot be labeled by a single number. Investing in real estate isn’t that simple.
However, this doesn’t this mean that estimating income properties’ ROI is complicated. It’s simple when you understand the factors that go into determining the ROI of an investment property.
3 Methods of Measuring Return on Real Estate Investment
1. Cash on Cash Return
Cash on Cash (CoC) return is often used to evaluate the cash flow of an income-generating property. It is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage.
To calculate CoC, divide the net operating income by the down payment (total cash actually invested).
Suppose you buy a rental property valued at $200,000 via a mortgage, with a $40,000 down payment. You collect a monthly income of $1,200, and your annual expenses sum up to a total of $2,500.
In this case, the CoC would be calculated as follows:
Cash on Cash Return = (12 x $1,200 – $2,500)/$40,000 = 29.75%
2. Capitalization Rate
The second widely used metric for determining the profitability of a real estate investment property is the capitalization rate. The capitalization rate is the ratio of Net Operating Income to property asset value.
For example, suppose you buy an investment property for a total of $350,000, you rent it out for $1,700 per month, and, all operational expenses of the real estate investment is a total of $4,000.
In this example, the capitalization rate would be calculated as follows:
Capitalization Rate = (12 x $1,700 – $4,000)/$350,000 = 4.69%
3. Rate of Return
This is the simplest and most basic way to calculate the Rate of Return of an income property. When it comes to the rate of return on investment, successful real estate investors consider ROI to be the most important number.
To calculate the Rate of Return, you need to divide the annual rental income by the total cash investment.
For instance, suppose you buy a rental property valued at $250,000 and paid another $9,000 in maintenance costs, closing fees, and so on. In addition to this, you charge tenants a monthly rent of $1,500. Therefore, the Rate of Return for your rental property would be:
Rate of Return = 12 X $1,500/($250,000 + $9,000) = 6.95%
Considering these, what is a good ROI for a rental property?
· Cash on Cash Return
A good rate of return in terms of the cash on cash return depends on various metrics. For example, location and the investment property type.
However, only by knowing what is a good CoC return can real estate investors find positive cash flow rental properties and begin earning profits. Some experts say that a good rate of return is anything in the range of 8% to 12%.
Others, though, don’t advise investing in a rental property that provides an ROI of less than 20%.
· Capitalization Rate
A good rate of return in relation to the cap rate is not straightforward. The investment property’s characteristics influences the ROI.
Generally speaking, 4% to 10% is a reasonable range to earn for your investment property. Low cap rates imply lower risk, higher cap rates imply higher risk.
Multifamily properties, for instance, have the lowest cap rate because these are considered to be low risk. The reason is rather simple: such properties are able to generate rental income from a number of tenants each month. Therefore, even with a few vacant units, the impact on cash flow is relatively insignificant.
Single-family homes, conversely, have higher cap rates – which is very risky. Without a tenant, it means zero cash flow.
Aside from the investment property’s characteristics, another factor that influences cap rate is location. In real estate investing, as you’ve heard many times, location is everything.
Neighborhoods, cities, and states all have differing capitalization rates. This is because, acquisition costs, operating costs, and rental fees change from place to place and from time to time.
· Rate of Return
Just like the previous real estate metrics, a number of factors determine a good Rate of Return. For example, the risks associated with the real estate investment, the size of the property, and the location.
On average, a Rate of Return of 15% and above is considered good. However, if the investment is riskier, then don’t settle for anything less than 40%.
Hopefully, this article has answered your question – “What is a good return on real estate investment?”
While subjective, these are some general guidelines about the minimum ROI, cap rate, and CoC returns you should expect from a real estate investment prior to purchasing it.
Article written by:
David Weber, the owner of State Property Management,
a professional property management company in the
State of Florida specializing in the management of investment properties
throughout Central Florida and the greater Orlando area.
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