If I Do A Full Remodel On A Rental Property What Will Be My ROI?

One of the primary motivations for investing is to increase one’s wealth. Although investors’ motivations vary—some may want money for retirement, while others may want to save for other life events such as having a baby or planning a wedding—the goal of all investments is usually to make money. And it makes no difference whether your money is invested in the stock market, the bond market, or real estate.

Real estate is a type of tangible property made up of land that includes any structures or resources found on that land. One type of real estate investment is investment property. People typically buy investment properties with the intention of profiting from rental income. Some people buy investment properties with the intention of selling them quickly.

Regardless of the intention, investors who diversify their investment portfolio with real estate must calculate return on investment (ROI) to determine the profitability of a property. Here’s a quick overview of ROI, how to calculate it for your rental property, and why knowing a property’s ROI is critical before making a real estate purchase.

What Is Return on Investment (ROI)?

Return on investment quantifies how much money, or profit, is made on an investment as a percentage of its cost. It demonstrates how well and efficiently investment dollars are used to generate profits. Knowing ROI allows investors to determine whether or not putting money into a particular investment is a good idea.

ROI can be applied to any investment, including stocks, bonds, a savings account, and real estate. Calculating a meaningful ROI for a residential property can be difficult due to the ease with which calculations can be manipulated—certain variables can be included or excluded from the calculation. When investors have the option of paying cash or taking out a mortgage on the property, it can be especially difficult.

In this section, we’ll look at two scenarios for calculating ROI on residential rental property: a cash purchase and one financed with a mortgage.

Calculating ROI on Rental Properties

Keep in mind that there are a number of variables that can affect ROI numbers when it comes to real estate. These include repair and maintenance costs, as well as methods for calculating leverage (the amount of money borrowed with interest to make the initial investment). Of course, the terms of the financing can have a significant impact on the overall cost of the investment.

ROI for Cash Transactions

Calculating a property’s ROI is fairly straightforward if you buy a property with cash. Here’s an example of a rental property purchased with cash:

  • You paid $100,000 in cash for the rental property.
  • The closing costs were $1,000 and remodeling costs totaled $9,000, bringing your total investment to $110,000 for the property. 
  • You collected $1,000 in rent every month.

A year later:

    • You earned $12,000 in rental income for those 12 months.
    • Expenses including the water bill, property taxes, and insurance, totaled $2,400 for the year. or $200 per month.
    • Your annual return was $9,600 ($12,000 – $2,400).

To calculate the property’s ROI:

    • Divide the annual return ($9,600) by the amount of the total investment, or $110,000.
    • ROI = $9,600 ÷ $110,000 = 0.087 or 8.7%.
    • Your ROI was 8.7%.

The Importance of ROI for Real Estate

Knowing the return on investment (ROI) for any investment allows you to be a more informed investor. Estimate your costs and expenses, as well as your rental income, before you buy. This allows you to compare it to other, similar properties.

Once you’ve narrowed it down, you can figure out how much money you’ll make. If you realize that your costs and expenses are going to exceed your ROI, you’ll have to decide whether you want to ride it out and hope to make a profit again—or sell so you don’t lose out.

Other Points to Consider

Of course, there may be additional costs associated with owning a rental property, such as repairs or maintenance costs, which would need to be factored into the calculations, affecting the ROI.

We also assumed that the property was rented for the entire year. Vacancies occur frequently, especially between tenants, and you must account for the loss of income for those months in your calculations.

The Bottom Line

The return on investment for a rental property differs from that of other investments: It varies greatly depending on whether the property is financed with a mortgage or purchased outright. As a general rule, the less money paid as a downpayment on a property, the larger the mortgage loan balance, but the higher your ROI.

In contrast, the more cash you pay upfront and the less you borrow, the lower your ROI because your initial cost is higher. In other words, because your initial costs are lower, financing allows you to increase your ROI in the short term.

When calculating the ROI for multiple properties, it is critical to use a consistent approach. For example, if you include the equity of one property in evaluating it, you should also include the equity of the other properties when calculating the ROI for your real estate portfolio. This can give you the most up-to-date picture of your investment portfolio.

Are You Planning a Full Home Remodel?

 

If you’re considering a whole house remodel, New Key Construction, based in Walnut Creek California, is here to serve you. Our passion is to be the home for talented craftsmen who deliver beautiful projects to clients throughout the SF East Bay Area! Choosing the right general contractor for your project can be difficult, but we make things easy by focusing on Your Experience, Client Communication, Cutting Edge Technology, and Pushing Our Design and Build Limits!  If we could have one goal, it would be that when someone you know is looking for a contractor you highly recommend our company because of the experience we deliver for you! Check out our website, our portfolio, and our reviews to learn more – or give us a call today!