Understanding Return on Rentals: A Comprehensive Guide

Rental properties offer investors an attractive way to diversify beyond traditional assets like stocks and bonds while providing access to a passive income stream. A well-located property in a growing market can generate steady cash flow and appreciate in value over time. Add debt to
the mix and the returns to an investor’s equity get even more attractive through the power of leverage.

However, while the prospect of owning a portfolio of income-producing properties may seem like the perfect early retirement plan, investors must be aware that rental property investing comes with its own set of challenges. Fortunately, real estate has a long-established track record, and numerous performance metrics can help guide investors in making informed decisions. One of the most valuable of these metrics is the return on investment (ROI).

Understanding Return on Investment (ROI)

ROI is a fundamental metric for real estate investors evaluating the profitability of rental properties. It measures how efficiently an investment generates returns relative to its cost. A strong ROI indicates a potentially lucrative investment, while a weak ROI suggests financial drawbacks.

Along with the internal rate of return (IRR) and cash-on-cash return, the ROI is one of the best ways to assess the attractiveness of an investment property.

The ROI for rental properties can be used to help assess how effectively an investor’s capital is generating returns through rental income, property appreciation, and tax benefits.

Understanding ROI allows investors to do the following:

• Evaluate different properties based on expected profitability.
• Determine whether a rental property meets an investor’s hurdle rate (the cost of capital plus a risk premium to compensate for market and property-specific risks)
• Identify areas to reduce expenses or increase revenue.
• Guide decisions such as whether to hold, sell, or refinance.

Below, we'll review two examples for calculating ROI on residential rental property—a cash purchase and one that's financed with a mortgage.

ROI Formula

To calculate the ROI, take the current value of the investment minus the cost of the investment. Then divide that number by the cost of the investment.

$\begin{aligned}\text{ROI}=\frac{\text{Current Value of Investment}-\text{Cost of Investment}}{\text{Cost of Investment}}\end{aligned}$ROI=Cost of InvestmentCurrent Value of Investment−Cost of Investment​​
For example, if you bought shares of a stock for $10,000, and a year later the shares rose to $16,000, you had an ROI of 60%, calculated as ($16,000 - $10,000)/$10,000.

Calculating ROI on Rental Properties

For real estate, ROI is a bit more complicated than with stocks because you must consider debt, interest rates, property taxes, insurance and maintenance, as well as your initial equity and rental income.

Real estate ROI compares the net income a property generates divided by the initial
cost, as opposed to just the net gains of the investment. For example, if a property costs $100,000 to acquire, and it generates net profits of $10,000 every year, the ROI for the property is 10%.

ROI for Cash Transactions

Calculating the ROI on properties purchased with cash is simpler than calculating the ROI on properties financed with debt.

• Assume an investor purchases a property for $100,000.
• Closing costs are 5% of the purchase price, or $5,000.
• The real estate agent’s commission is also 5%, or $5,000.
• That means the total initial cost of the property is $110,000.
• The investor then collects $1,000 monthly, or $12,000 per year in rental income.
• Expenses such as insurance and property taxes total $300 monthly, or $3,600 annually.

A year later, the investor would have earned $12,000 a year in rental income. After subtracting the expenses, the net income is $8,400.

Next, divide $8,400 by the initial cost of $110,000. That gives you an ROI of 7.6%.

ROI for Financed Transactions

Calculating the ROI for properties financed with debt is a bit more complicated.

• Assume the investor bought the $100,000 property with a 20% down payment, or $20,000.
• The closing costs are still $10,000.
• The initial investment in this example is $30,000 ($20,000 down payment plus $10,000 in closing costs).
• The mortgage is a 30-year mortgage at 5% interest rate, compounded monthly. Using the PMT function on a finance calculator or in Excel, the monthly payments can be calculated as $429.46 or $5,153.52 per year.
• P = 80,000 (loan amount = purchase price - down payment)
• r = 5% ÷ 12 or 0.004167 (monthly interest rate)
• n (the number of payments) = 30 × 12 or 360
• Property income remains at $1,000 per month or $12,000 per year
• Expenses remain $300 per month or $3,600 per year

One year later, the investor would have earned the following:

$12,000 - $3,600 - $5,153.52 = $3,246.48 (net income).

Dividing this by the initial cost of $30,000 yields an ROI of 10.8%.

This example illustrates that although the net income earned in the second example is lower because of the mortgage payments, the ROI is higher because of the lower upfront cost, thanks to the power of leverage.

Home Equity 

To further highlight the power of leverage, we need to take equity into account. After all, as the principal on the mortgage gets paid down, the investor accumulates equity in the property. Looking at the second example, after a year the mortgage principal has been paid down by $1,180.29.

Adding this into the annual net income results in a new figure of $4,426.77, or a ROI of 14.8%.

An example of an amortization table can be seen below:

Factors Affecting ROI in Rental Properties

Expenses and Maintenance

While an ROI of more than 10% may seem attractive, investors must account for common budgeting principles regarding expenses and maintenance. Unexpected costs, such as a leaking roof or a boiler repair, can quickly erode profits accumulated over months or even years.

A good rule of thumb is to budget 50% of the monthly rent toward total expenses. For example, if your monthly rent is $1,000, set aside $500 monthly for operating expenses before mortgage payments to account for contingencies.  

Vacancy Rates

In addition, for enormous one-time costs such as a boiler repair, another rule of thumb is to set aside 1% to 2% of the purchase price annually for a financial cushion for significant expenditures, which can also include HVAC replacements, roof repairs, or structural improvements. That's above a reserve fund of about two to six months of operating costs to prevent cash flow shortages when large capital projects arise.

High vacancy rates reduce rental income, as every month a unit sits empty leads to direct revenue loss while fixed expenses like property taxes, insurance, and mortgage payments continue to accumulate. Looking back to our mortgaged property scenario, the investor needs at least six months a year of rental income to break even just on the mortgage payments.

Furthermore, frequent vacancies often mean higher turnover costs, such as advertising for new tenants, screening applications, and making necessary repairs or renovations to attract renters. Leasing commissions or finder’s fees paid to real estate agents further reduce net income.

These steps can help mitigate high vacancy rates:

1. Screen tenants carefully. Investors should carefully vet prospective tenants, performing or obtaining background checks, credit reports, and references from previous landlords.
2. Offer competitive rental rates. Pricing your rental competitively ensures steady occupancy. While overpricing can cause vacancies, underpricing limits profitability.
3. Maintain the property. Regular inspections, prompt repairs, and aesthetic improvements increase a property's appeal and tenant retention.

Cash vs. Financed Purchases

Based on our previous example, financing the initial purchase with a mortgage appears to generate significantly higher ROIs than a cash transaction because of the power of leverage. However, as with most financial decisions, there’s no such thing as a free lunch.

Investors should be mindful that financing comes with its own set of challenges, including the following:

• Debt obligations: Monthly mortgage payments can strain cash flow, especially during vacancies or unexpected expenses.
• Interest costs: Over time, interest payments increase the total cost of the investment.
• Risk of market fluctuations: If rental income drops or property values decline, investors may struggle to cover mortgage payments or face negative equity.

To mitigate these pitfalls, experts commonly recommend that a monthly mortgage payment should not exceed 28% of your gross monthly income. In addition, your total debt payments, including your mortgage, should not be more than 36% of your gross income—this is called the "28/36 rule."

The Bottom Line

ROI in rental properties is a key metric for assessing profitability, considering rental income, operating expenses, financing costs, and tax benefits. While leverage can amplify returns, investors must carefully manage risks such as vacancies, maintenance costs, and market fluctuations.

A well-researched approach, incorporating financial prudence and strategic property management, ensures a more stable and profitable real estate investment.