October 23, 2008

Calculating rate of return on rental property investments.

The three elements of a rental property return are: the cash flows from rents, the appreciation of the property and the decrease in principal due to principal payments. If you add these three elements together you get your returns. To figure the value of an investment you need to look at the value of the returns versus the value of money you put into the investment. So the return on investment (ROI) from the investment is returns / equity.

I'm going to present a simple way of figuring your return rate on a property. I'm not considering tax implications just to keep it a bit more straight forward. The example property I'm using is not a realistic property for most markets and I only use it for example purposes to show how the math works.

Lets look at the 3 separate return elements:

Cash flows are real receipts of cash from rents minus your expenses. You would figure your cash flow by subtracting all your annual expenses from your annual rents.

Cash flow = rents - expenses

For example, lets say you bought a duplex for $100,000 with a 6% fixed 30 year loan $20,000 down. Your monthly mortgage payment is $480 for an annual total of $5,760. Your property tax might be $1,050 and insurance of $400. Since you have a single meter pay the water bill which runs $80 every month or $960 a year. You had one vacancy and you paid $50 to advertise the property. Your total expenses for the year are $7,260. Your rents are $400 per unit and you had 1 month vacancy. So you collected a total of $9,200 rent for the year. Your cash flow for the year would be : rents - expenses = 9200 - 7260 = $1,940

Appreciation in the property is generally going to be an estimate of unrealized gains. Because of the cost you don't want to get professional property appraisals every year but you can use basic gauges of value to estimate the value. You could use a website like Zillow.com or skim the prices of properties currently selling at Realtor.com Realtor.com also tracks median home values for large markets and you could use those general numbers as a estimate of what your property may have increased (or decreased).

For example lets again look at the duplex you bought for $100k. If you look on Zillow and they say it is now valued at $105k and Realtor.com shows median prices in your area increased 5.2% then you can estimate that the property appreciated about $5000 for the year. But again this is just an estimate. If you go and try to sell the house you may or may not be able to get that price.

Reduction in principal is through the principal payments of the mortgage. Part of your mortgage payment will go towards principal (lets ignore interest only loans). SO at the end of the year you'll have a lower principal balance then at the start. At the start of your mortgage term the amount of the mortgage payment going to principal will be fairly small compared to the payment amount. But towards the end of your loan, your payments will be mostly principal and this amount can matter a lot. To figure your equity increase you need to look at your mortgage statements. Normally your statement will tell you the outstanding principal. Or you can also look at the original loan paperwork which ought to include a table of amortization showing the amount of principal paid on each month.

For the example duplex with a $100k loan you had $20k down so you start with $80k principal. After one year your mortgage payments would have put $982 towards principal. So your increase in equity is $982.

If you combine the cash flow, the appreciation and the reduction in principal then you have your total return for the year. To figure your return on investment you divide your investment by the return.

Return on Investment = (Cash flow + Appreciation + equity increase) / Equity

For our example duplex your cash flow was $1,940, the appreciation was $5,000 and the equity increase was $982. You put $20,000 so that is your equity. So that gives us:
= (cash flow + appreciation + equity increase ) / equity
= (1940 + 5000 + 982) / 20000 = 6176 / 20000 = .30 = 30%

That 30% return sounds great. However realize that this is not realized gain and doesn't represent cash in your pocket. The $1,940 in cash flow from rents is real cash in hand. However the appreciation and increase in equity is stuck in the value of the property and isn't realized. To obtain those gains you would have to sell the property. When you sell the property you'll probably have to pay realtor commission to sell it and you may also have to pay capital gains taxes. Another reason you're showing 30% return with this example is that the property is highly leveraged so you're taking risks. If you were unable to rent the property for a few months then that would eat all your cash flow, or if the property depreciated a small % then your return could easily be negative.

To get a view of the realized gains you could look at just the cash flows. If you just look at the real cash gains then your ROI would just be = cash flow / equity
In this case thats $1,940 / $20,000 = 0.097 = 9.7%.

To determine the real return you would have to include the cost of selling the property.

Lets look at another example where the returns aren't good. Lets consider the same property bought for $100,000 with 20% down. Lets say you had the same basic expenses but you had to replace a failed water heater for $550 and when the one unit was vacant the renter didn't pay 1 month rent and it took 2 months to rent it so you lost 3 months rent. That makes your expenses $550 more and your rents $800 less. So while before you had rent of $9200 and expenses of $7260 now you have rent of $8400 and expenses of $7810. So your cash flow = rent - expenses = 8400 - 7810 = $590 Lets say the property was in Little Rock Arkansas which has seen about 0.8% appreciation in the past 12 months. SO if the property started at $100k and increased .8% then it would have appreciated $800. Your principal reduction would be the same at $982.
So for this example you'd have:
= (cash flow + appreciation + equity increase ) / equity
= (590 + 800 + 982) / 20000 = 2372 / 20000 = .11 = 11%

Thats still not a bad return by any means. But what if the expenses ran over another $1000 or if the property didn't appreciate or depreciated as many markets are doing right now. With a little bad luck or a bad market you could actually see a negative return.

Generally you'll have positive returns from rentals in the long run. But you should measure and watch your return rates to make sure your property is giving a good return on your investment dollars.

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