Investments are all about making money, but in order to do so, you first have to spend it. So how do you make sure that you’ll make your money back on an investment, before signing the check? It helps to calculate your return on investment and your
capitalization rate on a property. A return on investment (ROI) is a measurement used to estimate the success of an investment. In this market, a good ROI percentage is about 8-10%. How do you calculate an ROI:
Annual Rent (AR) ÷ Purchase Price (PP) = ROI
So, let’s say you buy a home for $170,000 (PP) and are renting it out for $1,500/ month. Your annual rent (AR) would be $18,000.
18,000 ÷ 170,000 = 10.5%
This is your return before expenses. Think of the ROI as your gross return. A capitalization rate (CR) is your return on investment after expenses, or your net return. The ideal capitalization rate is between 6-7%. This is found by subtracting your annual expenses such as mortgage, taxes, insurance, or property management fees from your gross annual income, and then divided that figure by the purchase price.Gross Income (GI) - Annual Expenses (AE) = Net Income (NI)
Net Income ÷ Purchase Price (PP) = CR
Still using the figures from above, your property generates an annual income of $18,000. This is your gross income (GI). You allocate $600 per month toward expenses, giving you a total of $7,200 each year.
18,000 - 7,200 = 10,800
10,800 ÷ 170,000 = 6.35%
Perfect! You can use these formulas to factor what your profits would be on a property prior to purchasing in order to decide whether it’s a good investment or not. Happy investing!