There are many different ways rental owners measure profit, but most look to earn about 10% to 15% on their investment. Find out the different ways to calculate a good return based on the owner’s goals for the property.
What is Included in Rental Property Profit?
The simplest measure of rental profit is to take your monthly cash flow and subtract all of your expenses. In other words, whatever money you have left over at the end of the month is your profit.
However, it’s more complicated than that, because there are plenty of factors to include that may not enter or leave your bank account each month. For example:
- Planning for future expenses
- Appreciation of the overall value of the property
- Tax deductions, such as depreciation
How to Calculate Rental Property Profit
There are a few different ways to calculate profit based on your goals.
Monthly Cash Flow
This is the simplest way to calculate your profit, and many investors like to do a variation of this one. It’s simply how much cash you get to keep each month.
Generally, your expenses each month will include:
- Mortgage payment (including principal, interest, and taxes)
- Property management costs
- Utilities (vary slightly, but generally similar)
- Landscaping (same)
Those are the easy things to calculate and predict every month. However, there are plenty of costs that are less predictable but still need to be taken into account, such as:
- Vacancies
- Maintenance
- Emergencies
Cash-on-Cash Return
Many investors also prefer to measure their investments simply by comparing the return they’re making on the cash they spend.
This is popular because it helps an investor compare their rental investment to other types of investments. Real estate profit can be complicated, but by comparing cash in versus cash out, you can compare the return to what stocks, bonds, or REITs would have returned.
To calculate cash-on-cash return, first figure how much net cash you earned from the rental property throughout the year. Then divide that by the amount of cash you spent on the property.
For example, let’s say you spent $100k cash on the property and profited $6k throughout the year on rental income.
$6,000 / $100,000 = .06, or 6%.
In other words, you would have earned a 6% return on your cash during the year. Of course, this doesn’t fully tell the story because it doesn’t include tax deductions and appreciation. However, many investors still like to use this to compare how the returns look to other investments in their portfolio.
Cap Rate
Capitalization rate is an extremely simple measure of net operating income (NOI) against the total cost of the property. It’s often used as a quick metric for investors to use when deciding to purchase a property. They may first use cap rate, and if the number falls within an appropriate range, they’ll continue to do their due diligence.
For example, let’s say the property would rent out for $2k per month. You expect to have $300 per month in operating expenses (not counting the mortgage). This would give you $1,700 per month x 12 months for an annual NOI of $20,400.
If the property will cost $300,000, then you divide $20,400 by $300,000 for a cap rate of 6.8%.
Whether this is a good number or not depends on other factors, such as the quality of the neighborhood. Cap rate is best used to measure similar properties in similar areas.
Total ROI
Calculating your total return on investment is the most complicated method, but also the most accurate. We’ll take everything into account, including appreciation and tax deductions.
This method works best when looking back over a longer period of time, as appreciation can be harder to figure out each year.
Essentially, you’re going to figure out how much total you’ve spent on your investment over a period of time (let’s say 5 years). You can include the deductions you’ve made over that time as well. Then, you can also figure out how much you’ve earned over that time, including appreciation.
So, your calculation is going to look like this:
(Net income + appreciation) / down payment
So, if you have cash flow of $300 per month for 5 years, that comes to $18,000. Let’s say the property appreciated $50,000 during those 5 years.
Overall, you invested $100k up front and spent another $10k remodeling the property, for a total initial investment of $110k.
Now you have this equation:
($18,000 + $50,000) / $110,000 = 61.8%.
Then you divide by 5 to give you annualized returns of 12.46%.
How to Evaluate Good Rental Property
When evaluating an investment, there are plenty of factors that you’ll need to take into account, such as:
- Return – Perhaps the most important factor. If the raw numbers don’t look favorable, then nothing else may matter. If your initial cap rate and cash-on-cash calculations look favorable, perhaps only then do you consider the following factors.
- Age – Older houses require much more maintenance than brand-new ones. If new houses aren’t much more expensive in the area, that may be the way to go. It also may be the right choice if you’re willing to forego some profit for decreased maintenance headaches.
- Price trends – Have properties in that area decreased while nearby neighborhoods increased? Perhaps the neighborhood is going downhill.
- Current quality of neighborhood – Drive around. Are there homes with graffiti or boarded-up windows within a few blocks? Are there too many unkempt yards? These could all be signs of decreased value for the neighborhood as a whole in the future.
- Condition of the unit – The sweet spot for an investor is to spend only a little on getting the property rental ready. If the property needs a brand new roof, how long will it take for you to earn that money back through rental income?
How Much Profit Should You Make?
There’s no “one size fits all” number here, although many investors will often say that you should be earning at least 10% on your money. This would generally include appreciation, as earning 10% without including the property’s increased value would be nearly impossible in most markets.
There are also other considerations that go into the profit that you earn.
How Do You Want to Run Your Business?
Some investors consider profit to be king and the only thing that matters. Others value flexibility and time freedom while still earning some money.
Here are a few things that can change in your rental business based on your priorities:
- DIY vs property manager – Hiring a property manager can be expensive, but can also save you time and headaches.
- How quickly you find new tenants – If you only care about profit, then avoiding vacancies can be huge. However, you’re also more likely to bring in bad tenants who later need an eviction.
- Better service – Someone focused on profit may turn down non-essential repairs, while someone who wants to give people a better experience may eat the cost to have happier tenants.
How Conservative Do You Want to Be?
Deciding how much money to set aside for emergencies in your business can make or break you. Someone intensely focused on profit may set aside too little, but then be hit by a major repair they can’t afford.
However, someone may be too conservative, setting aside much more than is needed. Having money that’s doing nothing for you is also not a great investment tactic.
What’s Your Goal With the Property?
Again, not everyone is in it to earn as much cash as possible. No one wants to lose money on the property, but breaking even each month may be acceptable.
For example, perhaps you want to buy your retirement home now while the market is low. You can rent it out in the meantime, but perhaps your return is low. You may not care because the main goal isn’t massive cash flow.
Or, perhaps you want a small apartment for your kids when they go to college so they don’t have to pay rent. You could buy it now and rent it out until your kids need it, but it may not be a huge profit center in your portfolio. That may be just fine for your goals.
Lastly, it’s possible that you’re convinced your rental property is located in an area that will experience high growth in the near future. But for now, you’re looking at breaking even. If you have enough cash elsewhere to support this, a gamble on future appreciation may pay off big in the end.
