How to Calculate Real Returns on Your Rental Property?

Real estate investment, especially rental property, could be one of the most fruitful and safe investments you can make if done carefully. It can help you increase your wealth for various long-term needs with the several benefits that it offers, such as long-term property appreciation, monthly income through rent, tax benefits, etc. First-time real estate investors might find it intimidating, but investing in rental property is for everyone, no matter what your age is or how much experience you have.

If you are planning to buy a property for a rental house, it would help if you consider the challenges associated with it, like the expenses of repairs and maintenance of the property, the inability to liquidate the property immediately and partly, and finding the right tenant, etc. In the case of flats, you will have to bear a fixed monthly expense of maintenance charges, property tax, EMIs (in case you buy it on a home loan), and repairs, if any. Hence, although the monthly rent seems like an additional income, the real returns might not be as expected.

While investing in rental property, most people find the hardest part is finding the right property and knowing whether it will be a lucrative investment.

Let's first understand what is Return on Investment:

Return on Investment is nothing but how much profit is made on investment as a percentage of the cost of that investment. It gives you an idea about how effectively the investment generates profits and whether investing money into a particular avenue is a wise choice or not.

You can calculate the Rate of Return on all the types of investments like direct equity, savings accounts, real estate, etc. However, the calculation of the ROI of residential property could be challenging. Some experts believe that certain variables should be included when calculating the ROI of property, whereas others believe in excluding those variables.

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ROI can be used for any investment-stocks, bonds, a savings account, and a piece of real estate. Calculating a meaningful ROI for a residential property can be challenging because calculations can be easily manipulated-certain variables can be included or excluded in the calculation. It can become challenging when investors have the option of paying cash or taking out a mortgage on the property.

Let's see what all details we need to calculate Return on Investment on Rental Property:

1. Property Details:

Property details are the most important details you will need to calculate ROI. It includes property value, cost of repairs, and property area.

2. Mortgage Details:

If you have opted for a home loan to buy the property, you will need the loan details like down payment, rate of interest, the total cost of the loan, and loan terms.

3. Annual Expenses Details:

The fixed annual property expenses include property tax, maintenance cost, and insurance premium.

4. Rental Income Details:

The expected monthly rent is based on the area, size of the property, and construction.

5. Other Expenses Details:

Apart from the fixed expenses, there would be other monthly or yearly expenses that you need to consider, such as utilities, parking rent (if any), etc.

Knowing all these details in advance will help you realise whether the property aligns with your investment goals.

Here's how to calculate Return on Investment on a Rental Property:

Once you have all those mentioned above handy, you are set to calculate Return on Investment on a rental property. Here are some important metrics you need to calculate to know the real returns on your rental property:

1. Cash Flow:

Cash flow is the amount you will be left with every year from a rental property after paying all the operating expenses and keeping some amount aside for future repairs. So,

Cash Flow = Gross Rental Income - Expenses

Suppose your annual rental income is Rs 2,40,000 and your yearly property expenses, including mortgage, is Rs 1,90,000. In this case, your annual cash flow will be Rs 2,40,000 minus Rs 1,90,000, i.e. Rs 50,000.

2. Cash-On-Cash Return:

Cash-on-cash return is calculated from what you invest in the rental property. You can get the cash-on-cash return by dividing the before-tax annual cash flow by the amount you paid to purchase the property.

Cash-On-Cash Return = Before-Tax Annual Cash Flow / The Property Cost

3. Net Operating Income:

Net operating income is how profitable your investment is. You can calculate it by subtracting operating expenses from the gross income.

Net Operating Income = Gross Income - Operating Expenses

4. Cap Rate:

Cap Rate or capitalisation rate can help you gain insights to compare rental investment opportunities. It can be derived by dividing your net operating income by the price of the property.

Cap Rate = Net Operating Income / The Property Cost

5. Annual Gross Rent Multiplier:

It helps measure the value of the rental property and check if the asking price is reasonable. The annual gross rent multiplier can be calculated by dividing the total sales price by the annual gross rent.

Annual Gross Rent Multiplier = Total Sales Price / Annual Gross Rent

6. Internal Rate of Return:

It measures the rate of return earned on the property during a specific time frame. The internal rate of return can be calculated by adding the net cash flow and expected appreciation and dividing it by the target hold time.

Internal Rate of Return = Net Cash Flow + Expected Appreciation / Target Hold Time

Return on Investment:

Out of all the metrics given above, Cash-On-Cash Return is popularly used for calculating the real returns on your rental property. However, it does not consider taxation. Hence, another and the perfect way to calculate returns on a property is;

(Gross Rental Income from Property - Property tax) - Income tax liability / Cost of Property

Now, suppose your annual rental income is Rs 12,00,000, you are liable to pay a property tax of Rs 30,000, you pay an income tax of 39%, i.e. Rs 3,00,000 (assuming your annual taxable income is between Rs 2 Cr to 5 Cr), and the cost of the property is Rs 3 Cr.

The real returns on your rental property, i.e. Cash-On-Cash Return would be,

= (12,00,000 - 30,000) - 3,00,000 / 3,00,00,000

= 2.9%

So, the returns on your investment would be 2.9% p.a.

To Conclude:

There is no right or wrong method to calculate Return on Investment on a rental property as the different investors and experts believe in different methods. However, it is imperative to analyse your budget and potential returns. Generally, a Return on Investment above 10% p.a. to 15% p.a. is considered good. However, most real estate experts recommend buying/holding the property that generates returns above 7% p.a. to 8% p.a. Sometimes the property may seem ideal for rental considering its price, but still there could be hidden expenses you might not have thought about. Therefore, analysing the returns when investing in a real estate property is a wise decision.

Warm Regards,
Ketki Jadhav
Content Writer