When purchasing a rental investment, the ultimate goal is to the best return on investment (ROI). Knowing how much ROI you should be making to consider your investment profitable is important. You’ll also want to understand how interest rates can impact your ROI.

As interest rates continue rising, investors need to understand how to calculate and predict ROI so they know exactly what to expect when investing. We’ll help you understand exactly what ROI is, how to calculate it, and how loan rates and terms can impact your overall ROI.

What is ROI?

ROI stands for return on investment. ROI measures your property’s performance on the market after all other costs and expenses are paid. ROI measures the profitability and efficiency of your rental property and is the measurement of how successful the property is and can be in the future.

ROI is not cash profit, but rather a percentage to represent your investment’s profitability.

How Do You Calculate ROI?

ROI is always expressed as a percentage, rather than a dollar amount. To calculate ROI, you divide your return by your expenses.

Annual Return ÷ Out of Pocket Expenses = ROI

Calculating your actual ROI can be a bit more complicated, depending on whether you paid cash or financed your rental property. Let’s examine both scenarios to help you figure out your ROI.

ROI for Cash Real Estate Investments

Let’s say you paid $200,000 in cash for your real estate investment property. Between closing costs and upgrades, you spent an additional $15,000. Your total out of pocket expenses would then be $215,000.

If you rent it for 1 year at $2,200 per month, your annual return would be $2,200 x 12 months = $26,400. Now you have the numbers needed to find your ROI.

$26,400 ÷ $215,000 = .1228 or 12.3% ROI

That’s your property’s rate of return on your investment.

ROI for Financed Real Estate Investments

Let’s say you financed the same property. You put down $50,000 in cash for the down payment and paid for the closing costs and upgrades ($19,000) out of pocket. This means your total out of pocket costs were $69,000. (*Note, closing costs are generally higher when financing).

Since you put down a $50,000 down payment, you’ll be financing $150,000. Use a loan calculator like this one to help you figure out the next part. With a 30-year mortgage and 4.9% fixed-interest rate, your total interest + principal payment would be $796. You’ll also want to add your monthly insurance and taxes to this number, which we’ll estimate to be around $400 a month. That brings your monthly payment to $1,196.

If you rent for $2,200, that means you’ll have a profit of $1,004 monthly. Multiple $1,004 by 12 months and your annual return will be $12,048. Now, we can plug these numbers into our formula.

Annual Return ÷ Out of Pocket Expenses = ROI

$12,048 ÷ $69,000 = .1746 or 17.4% ROI

 

By using a mortgage, you’ll yield a higher ROI, even though your monthly return is less in cash.

How Does Rate Impact My ROI?

Let’s plug in the above scenario using three different interest rates to find out. We’ll compare 4.9% to 4.3% and 5.3% to see what happens to your ROI.

Our out of pocket expenses will remain the same, at $69,000.

Financing $150,000 with a 30-year loan at 4.3%, brings out monthly payments to $742. Add $400 for estimated taxes and insurance to get $1,142. Subtract this number from your rent ($2,200) and you’ll get a monthly profit of $1,058. Multiple by 12 months to get an annual return of $12,696.

Do the same using 5.3% and you’ll have a monthly payment of $833. Add $400 for insurance and taxes to get $1,233. Subtract this number from your monthly rent ($2,200) and you’ll get a monthly profit of $967. Multiply by 12 months to get an annual return of $11,604.

Now, plug in these new numbers to your formula:

Annual Return ÷ Out of Pocket Expenses = ROI

4.3% interest rate = $12,696 ÷ $69,000 = .184 or 18.4% ROI

4.9% interest rate = $12,048 ÷ $69,000 = .175 or 17.5% ROI

 

5.3% interest rate = $11,604 ÷ $69,000 = .168 or 16.8% ROI

 

As you can see, the lower interest rate you can secure, the higher your ROI.

Other Rate Factors That Impact ROI

So far, we’ve calculated ROI on standard fixed-rate loans. Adjustable rate mortgages will have different effects on your ROI and are trickier to calculate and can increase and decrease your ROI from year to year.

Loan terms also impact ROI, but in general, a shorter loan term can increase your ROI if the loan rate is at least .75% lower than your 30-year loan rate (which is fairly standard).

Property appreciation (which averages a 4-5% increase per year) is also likely to increase your ROI over time.

Takeaway: How to Maximize ROI

While paying cash for a rental property can put more money in your pocket each month, financing an investment property can help you maximize ROI. Shopping around for the best mortgage rates will help increase your ROI significantly. Seeking a 15-year mortgage over a 30-year mortgage can also improve your ROI, though it’s not a requirement to continue maximizing your profit.

The first step you should take when searching for a rental property is to speak with an experienced real estate agent, who can walk you through the buying process. Clever Partner agents can offer advice on financing so you can apply for loans with lenders offering the lowest interest rates.

Get connected with a local Clever agent near you here.