What constitutes a good return on investment (ROI) for a rental property?
While a quick and easy reply might be, “It depends,” there are ways to get more specific answers. Generally, many investors aim for an ROI of around 5%–10%. However, the true definition of a “good” ROI can vary widely based on your investment goals, risk tolerance, and local market conditions.
In this article, we discuss rental property ROI. We explore why a seemingly attractive 15% ROI might be considered subpar in some markets while a modest 5% could be a home run in others. We also examine the factors influencing ROI calculations, review complementary financial metrics, and offer strategies to improve your returns.
Whether you’re eyeing your first investment property or fine-tuning your existing portfolio, we can help you understand and optimize the ROI of your real estate investments.
How to calculate ROI for rental properties
Return on investment (ROI) is a financial metric that measures the profitability of an investment relative to its cost. For rental properties, ROI helps investors evaluate a property’s potential return against other investment opportunities.
Basic annual ROI formula
Here’s the simplest way to calculate ROI on a rental property over a single year:
- ROI = (Net profit / Total investment)
Where:
- Net profit = Total income – Total expenses
- Total investment = Purchase price + Closing costs + Renovation costs
Total holding period ROI
This calculation considers the entire period you’ve held the property, including appreciation:
- ROI = [(Final value – Initial value) + Net income] / Initial investment
Annualized ROI (CAGR method)
To compare investments held for different periods, use the compound annual growth rate (CAGR) with “n” being the number of years you held the investment:
- CAGR = (Ending value / Beginning value)^(1/n) – 1
This equation differs from the single-year ROI as it accounts for the compounding effect of returns over multiple years.
Example: Single-family rental (SFR) ROI calculation
As an example, consider a single-family rental purchased without financing that has the following financial details:
- Purchase price: $200,000
- Closing costs: $5,000
- Renovation costs: $15,000
- Annual rental income: $24,000
- Annual expenses: $10,000 (including property management, taxes, insurance, and maintenance)
- Holding period: 5 years
- Net proceeds from sale after 5 years, net of closing costs: $250,000
Basic annual ROI calculation:
- Total investment = $200,000 + $5,000 + $15,000 = $220,000
- One year net profit = $24,000 – $10,000 = $14,000
- One year ROI = ($14,000 / $220,000) = 6.36%
Total holding period ROI:
- Net income over 5 years = $14,000 × 5 = $70,000
- Appreciation = $250,000 – $220,000 = $30,000
- Total ROI = [($70,000 + $30,000) / $220,000] × 100 = 45.45%
Annualized ROI (CAGR):
- Beginning value = $220,000
- Ending value = $250,000 + $70,000 = $320,000
- CAGR = ($320,000 / $220,000)^(1/5) – 1 = 7.79%
In this example, while the basic annual ROI is 6.36%, the total holding period ROI is 45.45% over five years. The 7.79% CAGR represents the smoothed annualized return, including both rental income and appreciation.
What is a “good” ROI?
The definition of a “good” ROI can be somewhat subjective. However, understanding industry benchmarks and typical ranges can provide a valuable starting point for evaluating your investments.
Industry benchmarks and typical ROI ranges
Depending on the market and investment strategy, some real estate investors might consider an ROI between 5% and 10% good for rental properties, while others aim for a higher ROI of 12% or more.
Why “good” ROI varies among investors
What constitutes a good ROI for one investor could be unsatisfactory for another. Several factors contribute to this variation.
1. Investment strategy
Short-term vs. long-term: Investors focusing on quick flips might require higher ROIs to offset the risks and costs associated with rapid turnover. Long-term investors may accept lower initial ROIs if they anticipate strong appreciation or increasing cash flow over time.
Cash flow vs. appreciation: Some investors prioritize immediate cash flow and seek properties with high cap rates. Others might accept lower cash flow if they believe the property will significantly appreciate in value.
2. Risk tolerance
Conservative investors might be satisfied with lower, stable returns, while more aggressive investors might seek higher ROIs to compensate for increased risk.
3. Market expectations
ROI expectations can vary based on local market conditions. A 5% ROI might be considered excellent in a stable, low-growth market but poor in a rapidly appreciating area.
4. Investment goals
An investor nearing retirement might prioritize stable cash flow over appreciation potential, affecting their ROI expectations.
5. Financing costs
Investors with access to low-cost financing might accept lower unleveraged ROIs, while those with higher borrowing costs need higher returns to offset the cost of their debt service.
The potential pitfall of low-value properties
It’s important to remember that ROI percentages don’t tell the whole story, especially for low-value properties. While a cheap property with low rent might show an attractive percentage ROI on paper, the actual dollar amount of return could be minimal. In these cases, one significant expense, such as a major repair or extended vacancy, could wipe out an entire year’s profit.
For example, consider two properties:
- Property A: $50,000 purchase price, $500/month rent, 12% ROI
- Property B: $200,000 purchase price, $1,800/month rent, 10% ROI
While Property A has a higher ROI percentage, its annual profit is only $6,000. A roof repair that costs $5,000 would nearly eliminate the year’s gains. Property B, with its lower ROI, generates $21,600 annually, providing more cushion for unexpected expenses and potentially offering better long-term stability.
So, what is a good ROI?
Ultimately, a good ROI aligns with your investment goals, risk tolerance, and overall strategy. While industry benchmarks provide useful guidelines, considering the broader context of each investment opportunity is essential.
As you evaluate potential properties or assess your current portfolio, remember to look beyond the ROI percentage. Evaluate the actual dollar amounts, potential for appreciation, market stability, and how each property fits into your overall investment strategy.
Need help measuring the financial performance of your rental properties? Check out Stessa. Stessa’s real-time dashboards and advanced reports help you see exactly how your properties are performing.
Common pitfalls in ROI calculations
If you’re looking at buying a property and running the numbers to estimate your potential ROI, be conscious of the following mistakes newer investors often make:
1. Overlooking expenses
- Property management fees
- Regular maintenance costs
- Property tax and insurance increases
- Capital expenses
- Homeowners association (HOA) fees and special assessments
- Utilities (if not paid by tenants)
- Licensing and inspection fees
- Unexpected tenant turnover and eviction expenses
2. Unrealistic income projections
Be conservative with your income projections and base them on current market rates, not what you hope to charge at some point in the future.
3. Overly optimistic vacancy rates
Failing to account for periods when your property might be vacant can significantly skew ROI calculations. Even in hot markets, consider factoring in at least a 5% vacancy rate.
4. Underestimating repair and renovation costs
Initial repairs and ongoing renovations often cost more than expected. Adding a 10%–20% buffer into your estimated repair costs is wise.
5. Neglecting long-term capital expenditures (CapEx)
Major expenses like roof replacements, HVAC systems, or kitchen remodels are often overlooked. Set aside a portion of your rental income for these future costs.
6. Ignoring the time value of money (TVM)
Simple ROI calculations don’t account for the fact that a dollar today is worth more than a dollar in the future. More sophisticated metrics like internal rate of return (IRR) can provide a more accurate picture.
7. Assuming linear appreciation
Many investors mistakenly assume property values will steadily increase year over year. Real estate markets can be cyclical, and appreciation rates can vary widely.
Additional financial metrics to consider
While measuring ROI is crucial for rental property performance, several other financial metrics can provide a more comprehensive view of your investment. Next, we explore these metrics and how they complement ROI calculations.
1. Net operating income (NOI)
NOI represents the property’s annual income generated after deducting all operating expenses but before considering debt service, capital expenditures, depreciation, and taxes:
- Formula: NOI = Gross operating income – Operating expenses
Example:
- Gross operating income: $50,000
- Operating expenses: $20,000
- NOI = $50,000 – $20,000 = $30,000
Why use it: NOI offers a clear picture of a property’s ability to generate income regardless of its financing structure. It’s a key component in calculating other metrics like cap rate and is crucial for comparing similar properties in the same area.
How it complements ROI: While ROI considers the total return, including appreciation, NOI focuses solely on operational performance, helping investors assess the property’s income-generating potential.
2. Capitalization rate (Cap rate)
Cap rate is the rate of return on a real estate investment property based on the income the property is expected to generate:
- Formula: Cap rate = NOI / Property value
Example:
- NOI: $30,000
- Property value: $500,000
- Cap rate = $30,000 / $500,000 = 0.06 or 6%
Why use it: Cap rate allows for quick comparison between properties and markets, indicating the potential return on an all-cash purchase.
How it complements ROI: While ROI includes financing and appreciation, cap rate focuses on the property’s intrinsic ability to generate income relative to its value, providing insight into market conditions and property performance.
3. Cash-on-cash return
This metric measures the annual cash flow of a property relative to the actual cash invested:
- Formula: Cash-on-cash return = Annual pre-tax cash flow / Total cash invested
Example:
- Annual pre-tax cash flow: $15,000
- Total cash invested: $100,000
- Cash-on-cash return = $15,000 / $100,000 = 0.15 or 15%
Why use it: Cash-on-cash return provides a view of an investment’s performance, especially when using leverage.
How it complements ROI: While ROI looks at total return, including appreciation, cash-on-cash focuses on actual cash yield, which is particularly useful for investors prioritizing regular income.
4. Internal rate of return (IRR)
IRR is the discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis:
- Formula: 0 = NPV = Σ [CFt / (1+IRR)^t] – Initial investment
Where:
- CFt = Cash flow in period t
- IRR = Internal rate of return
- t = Number of time periods
Example:
Calculating IRR typically requires financial software or a calculator. For instance, an investment of $200,000 that returns $50,000 annually for 5 years and is then sold for $250,000 might have an IRR of around 28%.
Why use it: IRR accounts for the time value of money and provides a single number to compare investments with different cash flow patterns over varying lengths of time.
How it complements ROI: While ROI gives a straightforward total return, IRR provides a more sophisticated analysis of returns over time, accounting for both the size and timing of cash flows.
The easiest way to track your rental property performance
Understanding various performance calculations and financial metrics is crucial. However, manually tracking all these elements can be time-consuming and prone to errors. That’s where Stessa comes in, offering a comprehensive solution for real estate investors to monitor their rental property performance effortlessly.
Real-time performance insights at your fingertips
Stessa’s user-friendly dashboards provide instant access to key performance indicators, including net cash flow, equity value, and cash-on-cash, for each of your properties. With Stessa, you can:
- View up-to-date financial metrics for your entire portfolio or individual properties.
- Track income, expenses, and cash flow in real time.
- Monitor key ratios like cap rate, cash-on-cash return, and more.
- Visualize your property’s performance trends over time.
Automated data collection and reporting
Say goodbye to manual data entry and spreadsheet management. Stessa automates the process by:
- Syncing with your bank accounts and credit cards to categorize transactions automatically.
- Generating real-time financial reports, including profit and loss statements and balance sheets.
- Providing customizable dashboards that update as new data flows in.
Streamline tenant management
Stessa goes beyond financial tracking to help you manage your tenants more efficiently:
- Vacancy marketing: List your vacant properties easily on popular rental websites directly from the Stessa platform, maximizing your exposure to potential tenants.
- Tenant screening: Access comprehensive tenant screening tools to help you make informed decisions about applicants, including credit checks, background checks, and eviction history.
- Rental applications: Utilize customizable online rental applications that make it easy for prospective tenants to apply and for you to review their information.
- Rent collection: Simplify your rent collection process with online payment options, automatic reminders, and real-time tracking of incoming payments.
These features can save you time while helping minimize vacancies, reduce risk, and lead to a steady cash flow — all crucial factors in maximizing your ROI.
Simplified tax preparation
Come tax season, Stessa makes your life easier by:
- Organizing all your income and expenses in one place.
- Providing easy-to-use tax reports for you or your accountant, including Schedule E.
- Offering smart recommendations for potential tax deductions.
Make strategic investment decisions
With Stessa’s comprehensive performance tracking, you can:
- Identify underperforming properties that may need attention.
- Recognize top-performing assets for future investment strategies.
- Make data-driven decisions about property improvements, refinancing, or selling.
Getting started is easy and free
Stessa offers these powerful tools at no cost to you. Start tracking your rental property performance today:
- Visit Stessa and create your free account.
- Add your properties and connect your financial accounts.
- Watch as your personalized dashboard populates with real-time data.
Don’t let complex calculations and time-consuming tracking hold you back from maximizing your rental property ROI. Let Stessa do the heavy lifting so you can focus on growing your real estate investment portfolio.
Get started with Stessa today and take control of your rental property investments!
