How To Calculate Returns On a Rental Property

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acegolfer
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How To Calculate Returns On a Rental Property

Post by acegolfer »

https://www.youtube.com/watch?v=MJOGECsbqUc

Leila used $200k house, $1400 rent + $40k down pmt as an example to show how to calculate ROI.

Results
ROI = 1.5% (if all mortgage pmt is considered as expense)
ROI = 18.5% (if principal pmt is not included as expense)
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snackdog
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Re: How To Calculate Returns On a Rental Property

Post by snackdog »

There are a lot of ways to calculate the ROI but they all work out to some form of income/investment. Income can be cashflow before financing, after financing, after interest charges only, before or after depreciation, before or after taxes. Investment is normally easier - down payment plus closing costs plus initial capital improvements or repairs.

Principal is a transfer, but it definitely comes out of cashflow so the cashflow and ROI in your example would be the smaller figure. The larger figure would only be realized later, if a sale occurred but then the complications of appreciation, depreciation, realtors fees, depreciation recapture, cap gains taxes, etc come into play.
rascott
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Re: How To Calculate Returns On a Rental Property

Post by rascott »

Why would principal portion of the payment be an expense? Just because there isn't monthly cash flow, doesn't mean it's not income. IRS certainly looks at it as income..... although the depreciation allowance kind of cancels it out.
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Uncorrelated
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Re: How To Calculate Returns On a Rental Property

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The video doesn't display the right approach to calculate the return, the figure of 18.5% is only true for the first year, and the analysis ignores the cost of selling the property and also the cost of buying the property.

My approach is to build a large table, with rows representing the years. In each row I calculate the value of the principal, the expenses, income.. etc. for that specific year. Any positive net worth is invested at the stock market at X%

Now comes the interesting part, I go back to the first row and calculate the return (in dollars) based on the assumption that I sell the house after a holding period of 1 year., the ROI will be negative (due to realtor costs, etc). Then I repeat the procedure for all other years. Then I do the same for a simple investment in the stock market, I can now graph the results:

Image

X axis is the holding period in years, Y axis is the dollar amount assumed the property is held for X years. As you can see for my specific numbers, real estate has a higher expected return than the stock market between 7 and 40 years. I work with inflation-adjusted numbers everywhere because it simplified the calculations greatly.

Cash on cash returns, cash flow and ROI as in the video are completely useless unless you are comparing with another property with exactly the same fees etc. It isn't suited to compare properties with different mortgage durations or downpayment amounts. Even a property with negative cash flow can be a good deal.

My method also has some flaws: although it is able to compare the expected return of real estate investments with the stock market, it ignores risks. Because individual real estate is much more risky than the stock market, you should be demanding much higher returns.
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acegolfer
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Re: How To Calculate Returns On a Rental Property

Post by acegolfer »

rascott wrote: Thu Feb 13, 2020 11:04 pm Why would principal portion of the payment be an expense? Just because there isn't monthly cash flow, doesn't mean it's not income. IRS certainly looks at it as income..... although the depreciation allowance kind of cancels it out.
Personally, I don't count principal pmt as expense. But a lot of BHs do. It's nice she addressed both cases.
1130Super
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Re: How To Calculate Returns On a Rental Property

Post by 1130Super »

Principle reduction and price appreciation are part of your return even if they don’t have positive effect on cash flow.

but people tend to compare leveraged real estate vs non leveraged stock market returns and expect a fair comparison they are 2 different asset classes it’s like comparing apples to lasagna
Last edited by 1130Super on Fri Feb 14, 2020 9:19 am, edited 1 time in total.
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Sandtrap
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Re: How To Calculate Returns On a Rental Property

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From a pure business perspective, adequate net monthly cash flow is a must. Nothing else pays the bills and profits.
In real business life, keep it simple is a good path.
Lot's of ways of approaching these things.

*(disclaimer) This perspective may be old fashioned and simplistic, and is limited to owning and growing a business, most any sole owned business, sweeping the parking lot, knowing the tenants by name, saving money, building another apartment building or high rise, and doing it over and over again over decades. No book knowledge. Nothing fancy.

j :happy
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1130Super
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Re: How To Calculate Returns On a Rental Property

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Sandtrap wrote: Fri Feb 14, 2020 9:01 am From a pure business perspective, adequate net monthly cash flow is a must. Nothing else pays the bills and profits.
In real business life, keep it simple is a good path.
Lot's of ways of approaching these things.
j :happy
I disagree you do not need cash flow If you have a significant price appreciation and principal reduction. But your reasoning contributing to a 401(k) is a negative cash flow investment until you start drawing off it.
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Uncorrelated
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Re: How To Calculate Returns On a Rental Property

Post by Uncorrelated »

Sandtrap wrote: Fri Feb 14, 2020 9:01 am From a pure business perspective, adequate net monthly cash flow is a must. Nothing else pays the bills and profits.
In real business life, keep it simple is a good path.
Lot's of ways of approaching these things.
j :happy
Cash flow is completely irrelevant unless you are primarily constrained by liquidity. But if you are primarily constrained by liquidity, you really shouldn't be investing in illiquid investments (real estate) anyway.
ignition
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Re: How To Calculate Returns On a Rental Property

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dcabler
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Re: How To Calculate Returns On a Rental Property

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ignition wrote: Fri Feb 14, 2020 9:59 am I like this calculator: https://www.calculator.net/rental-prope ... &x=58&y=33
Calculator above looks about right. The overall calculation is similar to a bond. Start with your investment, then create a table of cash-flows that include rent minus expenses. Then at some point in the future, include the sale of the property if that's the plan. Do an NPV calculation using all cash flows and the sale of the property with an appropriate discount rate and compare with original investment.
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acegolfer
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Re: How To Calculate Returns On a Rental Property

Post by acegolfer »

dcabler wrote: Fri Feb 14, 2020 12:00 pm
ignition wrote: Fri Feb 14, 2020 9:59 am I like this calculator: https://www.calculator.net/rental-prope ... &x=58&y=33
Calculator above looks about right. The overall calculation is similar to a bond. Start with your investment, then create a table of cash-flows that include rent minus expenses. Then at some point in the future, include the sale of the property if that's the plan. Do an NPV calculation using all cash flows and the sale of the property with an appropriate discount rate and compare with original investment.
What discount rate would you use to calculate npv?
dcabler
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Re: How To Calculate Returns On a Rental Property

Post by dcabler »

acegolfer wrote: Fri Feb 14, 2020 12:07 pm
dcabler wrote: Fri Feb 14, 2020 12:00 pm
ignition wrote: Fri Feb 14, 2020 9:59 am I like this calculator: https://www.calculator.net/rental-prope ... &x=58&y=33
Calculator above looks about right. The overall calculation is similar to a bond. Start with your investment, then create a table of cash-flows that include rent minus expenses. Then at some point in the future, include the sale of the property if that's the plan. Do an NPV calculation using all cash flows and the sale of the property with an appropriate discount rate and compare with original investment.
What discount rate would you use to calculate npv?
That question seems to come up pretty often in NPV discussions. Usually it's whatever you might have alternatively invested the original money in. On the conservative side, I've seen things like the current TIPs rate or CD rate all the way to a stock/bond allocation. Problem is that it's always just a point in time and, in the end, a lot of guessing for everything except the original dollar amount of the investment. Expenses may change over time due to inflation or the current market, you will have occasional large expenses (new roof, for example), rents may go up or down over time and you of course hope you sell the property for more than your purchased it, after inflation.
michaeljc70
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Re: How To Calculate Returns On a Rental Property

Post by michaeljc70 »

Sandtrap wrote: Fri Feb 14, 2020 9:01 am From a pure business perspective, adequate net monthly cash flow is a must. Nothing else pays the bills and profits.
In real business life, keep it simple is a good path.
Lot's of ways of approaching these things.
j :happy
The more you put down the more likely you are to have a positive cash flow.
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acegolfer
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Re: How To Calculate Returns On a Rental Property

Post by acegolfer »

dcabler wrote: Fri Feb 14, 2020 12:15 pm That question seems to come up pretty often in NPV discussions. Usually it's whatever you might have alternatively invested the original money in. On the conservative side, I've seen things like the current TIPs rate or CD rate all the way to a stock/bond allocation. Problem is that it's always just a point in time and, in the end, a lot of guessing for everything except the original dollar amount of the investment.
If anyone used cost of equity = TIPS or CD rate, then WACC would be smaller than the cost of debt (=mortgage rate).
rj342
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Re: How To Calculate Returns On a Rental Property

Post by rj342 »

michaeljc70 wrote: Fri Feb 14, 2020 12:21 pm
Sandtrap wrote: Fri Feb 14, 2020 9:01 am From a pure business perspective, adequate net monthly cash flow is a must. Nothing else pays the bills and profits.
In real business life, keep it simple is a good path.
Lot's of ways of approaching these things.
j :happy
The more you put down the more likely you are to have a positive cash flow.
That bit my dad in the end with his small rental empire of about a dozen houses. He was too leveraged and got to the point where interest deductions against his day job income were too big a component of what put him in the black overall, vs actual cash flow from the houses themselves.
He did not carefully unwind it to transition when retiring from work, and ended up losing it all.

P.S. An older big time landlord in town of mid to lower end houses told him that you should only count on 10 months of rent per year per property on average.
dcabler
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Re: How To Calculate Returns On a Rental Property

Post by dcabler »

acegolfer wrote: Fri Feb 14, 2020 12:37 pm
dcabler wrote: Fri Feb 14, 2020 12:15 pm That question seems to come up pretty often in NPV discussions. Usually it's whatever you might have alternatively invested the original money in. On the conservative side, I've seen things like the current TIPs rate or CD rate all the way to a stock/bond allocation. Problem is that it's always just a point in time and, in the end, a lot of guessing for everything except the original dollar amount of the investment.
If anyone used cost of equity = TIPS or CD rate, then WACC would be smaller than the cost of debt (=mortgage rate).
Yes. My answer was a generic answer for NPV calculations, not-specific to real estate. Sorry for the confusion.
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big bang
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Re: How To Calculate Returns On a Rental Property

Post by big bang »

Sandtrap wrote: Fri Feb 14, 2020 9:01 am From a pure business perspective, adequate net monthly cash flow is a must. Nothing else pays the bills and profits.
In real business life, keep it simple is a good path.
Lot's of ways of approaching these things.
j :happy
I agree too that positive cash flow is the most important factor in real estate investment. All other fancy calculations, only try to paint a nicer picture for the ROI.
All income for the year minus all expenses for the year divided by all your costs to acquire the property, is the formula that I use to evaluate.
(1) save a lot, (2) select an asset allocation containing both stock and bond asset classes, (3) buy low cost, widely diversified funds, (4) allocate funds tax-efficiently, and (5) stay the course.
CMD1
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Re: How To Calculate Returns On a Rental Property

Post by CMD1 »

The most common metric is CAP, which is what investors will be looking at if you decide to sell. CAP doesn't take into account whether you have a mortgage or not. It's simply your net operating income (Rent less expenses) / Price. Of course there are other metrics you may find valuable too but this is probably the most common.
Millennial
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Re: How To Calculate Returns On a Rental Property

Post by Millennial »

CMD1 wrote: Fri Feb 14, 2020 1:10 pm The most common metric is CAP, which is what investors will be looking at if you decide to sell. CAP doesn't take into account whether you have a mortgage or not. It's simply your net operating income (Rent less expenses) / Price. Of course there are other metrics you may find valuable too but this is probably the most common.
Cap rate does take a mortgage into account, as mortgage payments are included in the "expenses" part you mention. No mortgage means higher operating income means higher cap rate.
CMD1
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Re: How To Calculate Returns On a Rental Property

Post by CMD1 »

Interesting. That's not how I understand CAP rates.

https://www.biggerpockets.com/blog/2016 ... bt-service
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snackdog
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Re: How To Calculate Returns On a Rental Property

Post by snackdog »

It is easy to say "income minus expenses", but the tricky part is in defining expenses. HOA dues, insurance and taxes are easy. Repairs can be estimated. What about financing - principal + interest or only interest? Income tax - after depreciation? What about depreciation recapture when you sell in the future? If considering DR, then perhaps take 25% off your depreciation when estimating your income tax. What tax bracket are you in? Is this income on top of other income put this income at the of your brackets?
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acegolfer
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Re: How To Calculate Returns On a Rental Property

Post by acegolfer »

big bang wrote: Fri Feb 14, 2020 1:03 pm
Sandtrap wrote: Fri Feb 14, 2020 9:01 am From a pure business perspective, adequate net monthly cash flow is a must. Nothing else pays the bills and profits.
In real business life, keep it simple is a good path.
Lot's of ways of approaching these things.
j :happy
I agree too that positive cash flow is the most important factor in real estate investment. All other fancy calculations, only try to paint a nicer picture for the ROI.
All income for the year minus all expenses for the year divided by all your costs to acquire the property, is the formula that I use to evaluate.
This is how the video calculated ROI = 1.5%.
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