This video will answer the questions "How do you calculate return on investment for a rental property?" This question may not be as easy as it seems among all the different metrics people may use to calculate rates of return for real estate investments.
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How do you calculate return on investment for a rental property?
The right way, will allow you to take your calculated return on investment on your rental property, and compare it to any other investments so that you can have an accurate apples to apples comparison.
So to begin the conversation, I want you to understand what I mean when I say return on investment or ROI. The reason I want to make this absolutely clear is that real estate professionals and investors like to throw around different terminology. First, it may work better to explain what I DON’T mean. When I say return on investment, here’s what I DON’T mean. I DON’T mean cash on cash return, I DON’T mean your Rental Yield, I DON’T mean your Capitalization Rate, and I DON’T mean your equity build up rate.
That’s what I don’t mean, but what I DO mean is your return on investment on an annualized basis on your rental property. One other way you may hear this term phrased is your “Internal Rate of Return” on your real estate investment. Both of these things mean the same thing.
So what do these two ways of saying the same thing mean? What this means is that you are factoring in ALL income and ALL your expenses and just to be clear, the emphasis is on ALL. I emphasize all because some expenses such as depreciation and taxes tend to get left out...and if they get left out, the calculation won’t be accurate. Based on your calculation of all income and all expenses, this should be used to calculate your annual net cash flow from the real estate. (See our other video on how to calculate net cash flow)
Once you have your net cash flow, and this is projected into the future annually, you must use the IRR or Internal Rate of Return methodology to calculate your IRR. Again, IRR or your internal rate of return can be used interchangeably with your annualized return on investment.
The goal of the internal rate of return calculation is to consider all cash flows and use the time value of money principle in order to come to a rate of return calculation that factors in the time value of money. Something people forget to think about is that this calculation must factor in ALL cash flows. There are two in particular that people overlook. First, your cash invested in the property in year 0. And second, it must also factor in the cash flow from selling the property in the last year because these two cash flows are very important, maybe the most important cash flows that come during your property ownership.
Now that I’ve described the IRR calculation, next I have to let you know that this calculation should not be done on paper. It would take a person several days to make this calculation on the back of a notepad. It can be done much faster using excel, or we recommend using IQ Calculators' real estate investment calculator. You just enter your projections and the calculator automatically does the rest.
I’ve already touched on the many wrong ways to calculate your ROI or return on investment, but if I could add a general statement that any calculation that you do in real estate, that does not factor in your time value of money, WILL NOT get you to your true return on investment in a given year and as such, those calculations should NOT be useful to compare to competing investments outside of real estate such as the stock market.
I’m not saying you won’t find these calculations such as cash on cash return and rental yield useful when comparing competing real estate investments.
In summary, internal rate of return and annualized return on investment should be considered the same thing when it comes to calculating your return on investment. This must be a time value of money IRR calculation in order to be considered comparable to investments outside of real estate. Cash on cash return, equity build up rate, and rental yield can all be excellent quick calculations to compare rental properties but cannot be used to compare competing investments outside of real estate.
Annualized return on investment is an IRR calculation and shouldn’t calculated on paper. Use a real estate investment calculator for this calculation.