What is a good ROI on a rental property?
Real estate investing is a popular way for many people to diversify their investment portfolios. Investment properties can bring additional and ongoing revenue streams via monthly rental income or can help fund other financial goals, such as education costs, or retirement. As with all investments, the Return on Investment (ROI) is very important, and today we will explore the benefits of using the property as an asset class to maximise ROI. In particular, we will focus on and calculate what is a good ROI on a rental property?
Rental Yield vs Rental ROI: What’s the difference?
Sometimes our clients ask us what is the difference between Rental Yield and Rental ROI. It’s easy to see how it may be confusing. After all, both indicators refer to the income earned on an investment, and most property consultants discuss rental yields with their clients when presenting them with a new property investment opportunity. Here’s how to differentiate between the two:
Rental Yield
Rental yield is a measure of how much income your property will generate for you annually as a percentage of the property’s value. Rental yield does not factor in how much the property might appreciate in value over time.
Return on Investment
ROI, on the other hand, looks at the bigger picture and can take into account not only the annual rental income but also capital gains that the property might produce in the future. It is a more wholesome indicator of investment success than the rental yields alone.
The higher the ROI, the higher the net gains compared to the costs invested. Knowing the ROI gives investors the information they need to make an informed decision as to whether investing money in the said investment or property will give them the returns they were looking for.
How to calculate ROI on a rental property?
In real estate, the ROI is the profit you make from the net income generated by the rental property over time. In this example, we will show how you can calculate a yearly ROI on your rental property, including the capital appreciation factor in the 2nd calculation.
ROI for Rental Property Acquired with a Mortgage
In most cases, people purchase rental property and use rental income to pay the mortgages off. Therefore, to calculate the ROI on investment property, you would have to factor in the down payment and mortgage payments to correctly calculate your ROI, as well as predicted capital appreciation of the asset.
- You buy a rental property worth GBP 200,000.
- Your down payment for it equals 30%, which is GBP 60,000.
- You rent it monthly for GBP 1,000.
- Your monthly expenses, such as taxes, maintenance and insurance average out to GBP 300 per month.
- Your mortgage repayments on an (assumed) 30-year loan for GBP 140,000 with a fixed 4% interest rate would be GBP 467 a month on an interest-only basis.
- Your property’s net income (income minus your expenses) is GBP 233 per month or GBP 2,796 per year.
To calculate the property’s ROI in the 1st year, not including capital appreciation:
Divide the annual net income (GBP 2,796) by your original out-of-pocket expenses (the downpayment of GBP 60,000)
ROI for this rental property is GBP 2,796/ GBP 60000 = 0.046, or 4.6%.
However, these calculations only take into account net rental income. One of the primary drivers for purchasing an investment property is capital appreciation and this is where the benefit of having a mortgage in place is high.
To calculate the rental property ROI including capital appreciation
Using the same GBP 200,000 example above, and assuming a 5% capital appreciation, the ROI, if there were no mortgage, would be 5% (gain of GBP 10,000/capital investment of GBP 200,000).
If you had taken a mortgage, then the ROI would be 16.6% (gain of GBP 10,000/capital investment of GBP 60,000). This is the reason many people utilise mortgages to make significant ROI with the property.
Note: In the above calculations, we assumed that the property was rented out for all 12 months. In reality, vacancies occur, and you must account for the lack of income for those months in your calculations.
Answer: What is a good ROI on a rental property?
A good ROI on a property depends largely on the current market conditions, property location and associated rentability. Moreover, if we are looking for a good long-term ROI, capital appreciation rates are a good indication of your return on rental property investment.
The answer to the question in terms of what makes a good ROI depends also on your own circumstances, such as is income or capital appreciation a priority? As much as both can be combined, you typically find that one is greater than the other depending on the investment chosen and for this reason, it is important to work with a professional who can highlight the ROI in terms of both yields, and also capital appreciation and ensure that you find an investment which best suits your needs.
Rental Property Investment Made Simple
If you’re not sure how to diversify your investment portfolio, a financial advisor, who might be a property consultant, may be able to help. Having a strong knowledge of how to choose the right property investment and the details about the property market you want to enter, as well as ways to calculate return on your property investment are all crucial to your investment success.
There are different financing options available for rental properties purchases, and the financing can have an impact on your ROI, too. There are projects we currently have on the stock that only require an initial investment of 5% of the property value, making it more accessible to people with lower cash capital. There are also projects which offer initial purchase price discounts, and projects which predict exceptionally high rental yields.
Talk to us if you are interested in knowing more about these opportunities, or if you simply want to discuss all things property investment related with us.
