4 Ways to Calculate the Rate of Return on a Rental Property

(This advanced blog summarizes real estate investing tips and insights Lofty AI has acquired from working with thousands of investors and institutional funds.)

The 4 types of ROI calculations

This post teaches you the 4 most common rental property rate of return calculations.

You want to use these calculations to determine which properties are sound investments, and which properties are not.

The 4 methods to calculate the ROI of a rental property are:

• Cash on cash return
• Cash flow
• Capitalization rate (cap rate)
• Internal rate of return (IRR)

Each method is useful in certain situations. This can make it challenging to determine which real estate real estate investment calculations you should be using.

This post teaches you each method in detail.

I. Cash on cash return

Cash on cash return measures your received pre-tax cash flow relative to the amount of money you invested to acquire the property.

Cash on cash return is the easiest and most popular method to calculate the ROI of a rental property.

How to calculate Cash on Cash return

Otherwise known as the equity dividend rate, the cash on cash return real estate ROI calculation is the following:

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Because pre-tax cash flow is used in the calculation, investors should be aware of the tax treatment of their investment. If the cash on cash return calc is low, high taxes may erase any potential investment returns.

Why Cash on Cash return is a good metric

Your first step, when analyzing a potential investment property, should be to calculate the cash on cash return.

Here are a few reasons why:‍

• ‍Simplicity - Cash on cash return is simply the physical cash you have in hand after 12 months, divided by the physical cash you’ve invested. It’s a prescreening tool for rental property owners that can instantly give you a good idea of how lucrative an investment property may be.‍
• Comparing properties - It provides you with a speedy and simple way to measure the long-term profitability of multiple investment properties all at once. This allows you to more easily choose the investment property with the highest potential return.‍
• Adding up expenses - Cash on cash return helps you to think ahead about the expenses associated with a potential investment property. Whether expected or unexpected.‍
• Answering financing questions - Cash on cash return is a great indicator of the effect of leverage. This is because it's only looking at the net cash flow and comparing it to the actual amount of cash invested.
  

Cash on Cash return example

Say you're looking to buy a duplex for $300,000. 

Below is the step-by-step process to calculate your cash on cash return:

• On the $300,000 duplex, you decide to put in a down payment of 20%, or $60,000, and finance the rest.
• Taking into account closing costs, a bit of rehab, and loan fees, that takes the cash invested number up from $60,000 to $70,000. 
• Next, you want to calculate the net cash flow. You know that the home is currently being rented for $2,000 a month and grosses $24,000 annually.
• You then want to add up the annual expenses associated with the rental property. This includes plumbing, insurance, utilities, etc. Those expenses total $4,000 per year.
• Then, calculate annual debt costs. Remember, you put down $60,000 and took out a mortgage to finance the remainder of $240,000. A 5% interest loan on $240,000 financed is equal to $12,000. 
• This takes your total annual expenses to $16,000 ($4,000 in operating expenses plus $12,000 in mortgage payments).
• Your annual net cash flow ($24,000 of gross returns minus $16,000 in expenses) equals $8,000. 

In this example, your cash on cash return is 11.4% ($8,000 / $70,000). 

This means the property’s annual profit for that year will be 11.4% of the cash initially invested.

Downside of using Cash on Cash return

While cash on cash return is a very simple real estate ROI calculation to compare properties, it does have its downsides:

• It doesn't factor in appreciation - Cash on cash return does not factor in property appreciation. Appreciation is one of the most important aspects to think about when buying a rental property. It’s entirely possible for a property with poor cash flow and rent returns to produce excellent returns because of an increase in its market value over time. When determining how to make money from real estate investing, future appreciation should always be taken into account.
• It's based on before-tax cash flows - Real estate taxes can be quite complicated. The taxable portion of your rental returns can vary greatly from one property to another.

For example, you might buy one property in California, where the state income tax at the highest bracket is 13.3%. Your next property might be in Texas, where the state income tax is 0%. Your cash on cash return would look very different in each market because of the tax differences.

• It underreports your profit potential - Cash on cash return may also underreport your actual profit. This is because it doesn’t take the mortgage, principal pay-down, and appreciation into account.
• It doesn't account for the time value of money or compound interest - Cash on cash return only provides insight into a building’s financial performance at a given moment in time. This snapshot is, of course, separated from other economic factors.

What is a good Cash on Cash return?

There is a consensus amongst investors that a cash on cash return between 8 to 12 percent indicates a worthwhile investment. Others argue that in some markets, even 5 to 7 percent is acceptable.

At the end of the day, it comes down to your personal preference and risk tolerance.

Say you're investing in a property in a neighborhood that's appreciating 20% per year, but you only have a cash on cash return of 3%.

In that scenario, you'd make much higher returns than if your cash on cash return was 10%, but your property was only appreciating 5% per year.

It depends on if you're able to wait until you sell the property to collect the additional income from appreciation. Or, if you're looking for more consistent cash flow throughout the lifecycle of the investment.

II. Cash flow

When you hear real estate investors use the phrase “mailbox money”, they’re referring to cash flow. 

Cash flow is income generated when your rental returns exceed your monthly expenses.

It's one of the most popular ROI calculations.

Cash Flow = total income - total expenses

For buy-and-hold investors, cash flow is king.

Example of calculating cash flow:

• John is looking to buy a home.
• His broker tells him that the home will rent for $1,350/month.
• She also says he'd be responsible for paying $50/month for garbage and $100/month for water/sewage.
• Based on her experience, John's broker knows vacancy rates in the area are 5% for the year ($50/month). She tells John to also allocate 10% each month for repairs ($120/month).
• John is also planning on setting aside 5% each month ($50/month) for capital expenditures. Capital expenditures includes anything from new appliances or a new plumbing system.
• He then calculates his mortgage payment at $500/month (taxes and insurance not included). The property taxes are $100/month, and the insurance would be $50/month.
• Finally, John will be using a local property management company. This company charges 10% per month to manage the property ($120/month).
  

How much cash flow, if any, can John plan to receive each month?

Income:

• $1,350/month (rent)

Expenses (per month):

• Mortgage: $500
• Taxes: $100
• Insurance: $50
• Repairs: $120
• Vacancy: $50
• Water: 50$
• Sewage: $50
• Garbage:$50
• CapEx: $50
• Property management: $120

Add all these expenses up and it comes to $1,140 per month.

Remember, Cash Flow = Rent – Expenses

$1,350 (rent return) – $1,140 (expenses) = $210/month

This means that John will be receiving $210/month in profit from this rental property.

That's what we call positive cash flow or mailbox money. 🤑

Calculating cash flow using the 50% rule

The 50% rule is a back-of-the-envelope formula. Similarly to cash on cash return, investors use it to analyze a potential deal quickly.

The rule says that you should estimate your operating expenses to be 50% of your rental income.

Example:

If a rental property makes $50,000 per year in gross rental income, you should assume that half, or $25,000, will go towards expenses,

Only operational expenses, not mortgage payments.

The 50% rule is an estimate created by experienced real estate investors. It allows you to quickly compare potential investments to identify which properties will cash flow and which ones will not.

Keep in mind that this rule is based on assumptions that have yet to be verified.

We'll be discussing the 1% rule next.

What is the 1% rule?

The 1% rule is a back-of-the-envelope ROI calculation.

According to the 1% rule:

For a $100,000 property to be considered a good investment, it must rent for $1,000/month or more.

1% rule formula = Monthly Rental Income ≥ One Percent of Purchase Price

The 1% rule is helpful for a few reasons:

• It helps you narrow a large list of properties into a smaller list of the best properties.
  
• It helps you determine if the monthly rent returns will exceed the monthly mortgage payment.

If the rent is only $500/month, the $100,000 price will not meet the rule.

Or if you had to pay $150,000 for a property that rents for $1,000, it would not meet the rule either.

There's also the 2% rule.

The 2% rule states that a rental property is only a good investment if the monthly rental income is equal to or higher than 2% of the total price. Finding a property that fits the 2% rule mostly happens in areas like the mid-west and the southern US. Properties meeting the 2% rule can often become harder to find in more expensive cities like New York, Los Angeles & Boston.

III. Cap rate

What is cap rate in real estate? Cap rate, or capitalization rate, is an ROI calculation used to compare similar real estate investments.

The cap rate is the rate of return you can expect on your investment based on how much income you believe the property will generate for you.

The higher the cap rate, the better.

Cap rate formula:

Cap Rate = NOI/Purchase Price × 100%

Net operating income (NOI) is the annual income generated by the property after deducting all operational expenses.

This includes both property management fees and taxes.

Cap rate example

You can run a calculation for the cap rate by using the net operating incomes and recent sales prices of comparable properties.

The cap rate is determined and then applied to the property you're considering purchasing. This helps to determine its current market value based on income.

Below is an example of a calculation for cap rate for three different properties:

• Property A - On the market for $750,000, has an annual income of $85,000 and annual expenses of $50,000
• Property B - On the market for $700,000, has an annual income of $75,000 and annual expenses of $35,000‍
• Property C - On the market for $1,000,000, has an annual income of $130,000 and annual expenses of $60,000‍

Which factors influence a good cap rate?

There are many factors that influence what a good cap rate is.

Remember, just because you buy a property that has a good cap rate initially, doesn't mean it's going to perform well in the future.

Current rental income of the property

The current rental income of a property determines its cap rate.

Cap Rate = NOI/Purchase Price × 100%

Ideally you want the rent to be as high as possible when you first buy the property, which will cause the NOI to increase giving you a higher cap rate. Remember, the NOI is calculated by subtracting operating expenses from the total revenues of a property.

The issue with most investors is that they'll only look at the rental income at its present value.

What you want to do instead is determine the cap rate once you add value to the property. This could mean replacing roofs, mowing the lawn, or any other work which helps to increase rents. When rents increase, so does the cap rate.

Rent pro forma

Unless you're buying class A properties, you will most likely be doing work on your properties. Once the value-add work is complete, the goal is to be able to both charge higher rents and reduce your vacancy rate.

To predict what rent and vacancy rates will be in the future, investors will use a rent pro forma.

A rent pro forma is a detailed break down of the income and expenses of a rental property once it is fully stabilized and operating at peak efficiency.

Peak efficiency means that it has the market rents, income, vacancy rates, and operating costs compared to other properties with a similar class and age in that market.

Risk tolerance

Like most ROI calculations, determining what is "good" has a lot to do with your risk tolerance.

To further explain, let’s take a look at two investments, one that’s a 5% cap and one that’s a 7% cap rate.

The property with a 5% cap rate may be a good fit for an investor looking for more of a passive and stable investment. It might be in a better location currently, but has a lower chance of rapid future appreciation.

The property with the 7% cap rate is a better fit for an investor that’s willing to take more of risk. But with risk, often comes reward. Though less stable, this property will have higher upside potential for appreciation.

Future appreciation

Some real estate investors consider appreciation a "nice to have" compared to cash flow. This is due to the fact that it's simple to project cash flow. But it's extremely difficult to predict appreciation. 

Throughout history, predicting appreciation has always been a guessing game. Luckily, there are tools today which make predicting appreciation accurately, possible. For example, Lofty AI uses artificial intelligence and real-time social data to accurately predict appreciation down at the block level.

Let's say you buy a property with 5% cap rate and another property with a 10% cap rate. Right off the bat, the 10% cap rate property is doing much better. It's generating more revenue and is in a more stable neighborhood. But, what if the 5% cap rate property was in Williamsburg, NY 10 years ago? Or The Arts District in Los Angeles 7 years ago?

Property prices literally doubled in value within a 2 year period in both of those markets. The 5% difference cap rate is negligible when you take into account returns you'd get by owning a property in one of those neighborhoods.

Why is cap rate important?

The cap rate is an important ROI calculation for many reasons:

• Determine profitability - Cap rate is the best ROI method to determine if a property is immediately profitable. This is because it's comparing the income you're receiving to the actual price you're paying for the property.

• Compare investment properties - Cap rate is a great tool to compare investment properties at their current state. This is helpful if you have three properties right next to each other, of a similar property type, and are all the same price. Whichever property is generating the most income will have the highest cap rate, and will be the obvious decision which property to buy.

• Estimate the payback period - Cap rate is helpful to quickly calculate a payback period for an investment property. To calculate the payback period, you'd divide 100 by the cap rate. For a property whose cap rate is 10%, for example, you'd be looking at a 10-year payback period.

What is a good cap rate for rental properties?

Like cash on cash return, there is no exact answer to the question of "What is a good cap rate?"

Again, it really depends on your preferences and risk tolerance.

To further explain, let’s take a look at two investments, one that’s a 5% cap and one that’s a 7% cap.

The 5% cap property might be a good fit for an investor looking for a more stable and passive investment. It may be in a better location with a better chance of appreciation.

The 7% cap property may be a good fit for an investor that’s willing to take more of a gamble and risk. It might have a better upside as well but is less stable.

Defining a good cap rate also depends on the future potential of the investment property. If you're able to increase rents and maintain a similar occupancy rate, you'll naturally drive up the cap rate over time.

IV. Internal rate of return (IRR)

A property’s internal rate of return (IRR) is an estimate of the value it generates during the time frame in which you own it.

Effectively, the IRR for real estate is the percentage of interest you earn on each dollar you have invested in a property over the entire holding period.

For example, say you purchase a triplex to rent out and you plan to hold the property for 5 years. You’d earn interest on the rental income you receive during the first year for the remaining four years. Income received in the second year would earn interest for the next 3 years, with each new year generating more interest.

All the interest earned over the full 5-year period would represent the IRR.

How to calculate IRR

Formula to calculate IRR:

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Where:

N: Total number of years

Cn: Cash flow in the current period

n: Current period

r: Internal rate of return

Or, similarly:

(Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)2 + Cash Flow Year 3/(1+IRR)^3) - Initial Investment=0

IRR example

Say you purchase a property for $123,400, the year 0 cash flow, and your cash flow in year 1,2, and 3 are the following:

then the IRR r is given by:

In this case, the IRR is 5.96% (in the calculation, that is, r = .0596).

Doing the internal rate of return calculation by hand can get long and messy. We recommend that you use Excel or an internal rate of return calculator that you can find online such as this one.

You can also calculate IRR using excel, here is an excellent walk-through on how it works.

Pros of using IRR

• Unlike the cap rate, the IRR is a well-rounded way to estimate a real estate investment’s profitability
• Because the IRR looks beyond the property’s net operating income and its purchase price, (which are used to calculate the cap rate) you get a clearer picture of the kind of returns the investment will generate from start to finish.
• Very helpful if you’re planning buy-and-hold for a long period of time

Cons of using IRR

• Involves a certain amount of guesswork because you're effectively making assumptions about the amount of cash flow the property will generate and how the overall market will perform
• If any surprise costs pop up (which they usually do) or you can't sustain the rental income you initially projected, your original IRR calculation may be effectively useless
  

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