How to Calculate Return on Investment for Real Estate Investments

By Matthew Frankel Markets

When investing in real estate, your return on investment (ROI) is equal to the property's cash flow, which is its income minus expenses, as well as the equity that builds up. Your long-term rate of return depends on several variables, many of which change over time, so here's a calculator you can use to analyze your potential investment properties.

Continue Reading Below

Real estate investment returns: The short version

When evaluating your real estate investment returns, there are two numbers you could be referring to. First and most obvious is your cash flow relative to your initial investment. For example, if a property you own generates $2,000 per year after expenses, and it cost you $40,000 out of pocket to acquire the property, your annual cash-on-cash return is 5%. Think of this like a stock's dividend yield.

Image source: Getty Images.

Just like a stock, the dividend yield is only half of the story. Over time, the resale value of your investment appreciates (hopefully), so you're also building equity, which adds to your return. The combination of your cash flow and the equity you build is known as your total return, or internal rate of return (IRR). For example, if you pay $40,000 to acquire a property, and it generates after-expense cash flow of $2,000 and increases in value by $2,000, your IRR is $4,000 for the year, or 10% of the amount you paid for the property.

As you might imagine, there's a lot more to these calculations than this, especially when evaluating a property over a long period of time. The rent you can expect to collect changes over time, as do expenses such as property taxes, insurance, and HOA dues. So, let's take a deeper look into the income, expenses, and equity considerations of owning an investment property, and later we'll use this in a calculator to determine your potential returns.

Continue Reading Below

Income considerations

The income the property is expected to generate is the first piece of the puzzle. This is the rental income, as well as any other sources -- for example, if the property has a coin-operated laundry facility, that should be included.

Two major variables to consider with income are vacancies and annual rent increases. As a rule, it's safe to assume your investment properties will be vacant about 10% of the time (90% occupancy). And rent has historically increased at an annualized rate of 3%-4%.

Financing costs

If you used some sort of mortgage to acquire the property, your first major expense will be your financing expense, a.k.a. your mortgage payment. I'll spare you the mathematics of mortgage amortization, as there are many calculators available that can do it for you (including the one in this article), but you'll need to know how much you're planning to borrow, a realistic interest rate you can obtain, the term of the loan, and whether your loan is "interest only," which is fairly common for investment property loans.

Other expenses

In addition to financing expenses, there are several other costs you'll have to pay, which may include, but are not necessarily limited to:

  • Property taxes
  • Insurance
  • Maintenance
  • HOA dues
  • Management expenses, if you plan to hire a property manager
  • Utilities, if you have to pay any of them

In addition, these expenses tend to increase over time. It's a good rule of thumb to use the same 3%-4% rate that you use for expected rent increases or home price appreciation. In other words, if your property increases in value by 3% per year, you can roughly expect your taxes and insurance costs to do the same.

Adding equity into the equation

In addition to generating cash flow, a major goal of real estate investing is for the property to increase in value over time. As the value of the property increases and the amount you owe on your mortgage decreases, you'll build equity, which you'll get when you sell the property.

Real estate has historically appreciated at an annualized rate of 3%-4%, so this would be a safe estimate. Many markets have had periods where appreciation has been much greater (just look at San Francisco), but it's best to be conservative in your analysis.

Tax implications

Depending on your personal situation, the cash flow generated by your property may be taxable. You get to deduct your expenses from the rental income you bring in, as well as depreciation of the property itself, and whatever is left can be considered taxable income.

In addition, if you sell your property at a profit, you'll have to pay capital gains tax. If you hold the property for more than a year, you'll enjoy more favorable long-term capital gains rates.

This calculator can make your analysis easier

As you can imagine, analyzing the combination of cash flow, expenses, and equity buildup over long periods of time can be quite complex, especially because these items tend to change from year to year. With that in mind, this calculator can do the math for you and help you analyze the potential of your next investment property.

* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.