How to Calculate ROI on a Rental Property

What is a good ROI on rental properties? 

Before you start investing in, well, anything, you need to understand how the return on investment (ROI) works for that asset class. Rental investing is no exception. 

As you explore buy-and-hold property investing, learn how to forecast the return before buying. That includes both income yield and appreciation in property value over time. 

Having owned dozens of rental properties in my life, I certainly wish I’d known how to calculate ROI on a rental property before I dove in the deep end. 

What Is Return on Investment (ROI) in Real Estate?

Different types of real estate investments emphasize different ways to measure returns.  

For example, investors in real estate syndications tend to focus on internal rate of return (IRR), equity multiple, and cash-on-cash return. House flippers tend to focus on project-level returns — how much they earn on an individual flip. Real estate wholesalers calculate their returns by comparing their marketing costs to their finder’s fees. 

So how do rental investors run the numbers on income properties? 

Rental Properties’ ROI

Landlords earn returns on rental properties in two ways: rental cash flow and appreciation. 

For example, imagine you buy a rental property for $100,000. In the first year of ownership, it generates $6,000 in net cash flow, and appreciates by 4% to a value of $104,000. You earned 6% net cash flow plus 4% appreciation for a combined return of 10%. 

As simple as that reads on paper, the real world is far messier however. For instance, even though the market value of the property rose to $104,000, you wouldn’t walk away with $104,000 in cash if you sold after that first year. You’d pay thousands of dollars in closing costs in most cases, including a Realtor’s commission. 

And that says nothing of debt financing, entry closing costs, or any initial renovation costs required. Or how we glossed over your gross rents versus operating expenses by just referring to “net cash flow.” 

Before going any further, it’s worth introducing another way to measure returns, based on the actual cash you had to put up to buy the property. 

Cash-on-Cash Return

Most investors borrow a rental property loan to cover the bulk of the purchase price. So, what matters most to them is the return they’ll earn on the cash they invested out-of-pocket. 

Continuing the example above, say you borrowed a 30-year mortgage that covered 80% of the purchase price (80% loan-to-value ratio or LTV). In addition to the down payment of $20,000, you also come up with $4,000 for purchase closing costs, for a total of $24,000 of your own cash invested in the property. 

Your loan charges 6% fixed interest, which leaves you with a monthly loan payment of roughly $480. That comes to $5,760 per year, which leaves you with a modest $240 in cash flow in Year 1. 

The annual cash flow of $240 divided by the cash investment of $24,000 equals a cash-on-cash return of 1%. Not very exciting, is it? 

Fortunately, the news gets better from there. You also gained $4,000 in equity in the property from appreciation, plus you paid down your mortgage balance a little. Let’s call it $4,300 in combined cash flow and equity gains. 

That makes for a much more impressive total return of 17.9% ($4,300 / $24,000 = 17.9%). 

In the second year, you’ll be able to raise rents, and your cash flow will improve significantly. More on that later. 

How to Calculate ROI on a Rental Property

You get the high-level overview about “what is return on investment in real estate.”  

But running actual numbers requires you to know how to pinpoint market rents, estimate future appreciation, and forecast expenses. 

Researching Market Rents & Appreciation

It’s hard to calculate cash flow if you don’t know the market rent for a property. 

Start by researching the rents charged by comparable properties in the same neighborhood. Check out rental listing platforms like Zillow, ForRent.com, and Apartments.com. Then take it a step further and actually walk through comparable units to get a sense for how they compare to your prospective property. 

You also need to make sure you’re not overpaying for the property. Repeat that process all over again to run a comparative market analysis on the property value. 

Also start researching historical appreciation in your target market. From 1987-2023, US homes averaged around 4.8% annual appreciation, but that doesn’t mean you can count on similarly strong appreciation in the future. Consider a more conservative 2-4% appreciation rate in your forecasts, for a typical US housing market. 

Now that you have a firmer grasp of the rent and value side of the equation, you need to know how to forecast expenses as you master how to calculate ROI on a rental property. 

Rental Property Expenses & Cash Flow

If the average person realized how many expenses come with rental properties, perhaps they wouldn’t vilify landlords so much. 

Too many people assume that net rental income simply equals “the rent minus the mortgage.” Don’t make that mistake when you evaluate prospective rental properties. 

Beyond the mortgage payment, other rental expenses include:

• Property taxes
• Property insurance 
• Rent default insurance (optional)
• Vacancy rate
• Property management costs (including your labor if you self-manage)
• Repairs and maintenance
• Accounting and bookkeeping costs (including more complex tax returns)
• Property management software
• Travel 

In the industry, rental investors use a rule of thumb called the “50% Rule.” It states that around 50% of the rent will go toward non-mortgage expenses such as those listed above. More experienced rental investors can do better of course, but it works as a quick shorthand for running mental numbers.

Note that nowadays, landlords can buy rent default insurance to protect against, well, rent defaults. If the renter stops paying, the insurance policy kicks in and pays the rent until you’ve evicted them and placed a new paying renter in the unit. 

Cash Flow Example

In the example outlined above, you bought a property for $100,000, with net cash flow of $6,000 in the first year. Let’s break that down to include expenses. 

The property rents for $1,000 per month, for an annual gross potential rental income of $12,000. You also pay the following expenses:

• Property taxes: $1,200
• Property insurance: $1,500
• Vacancy rate: $480 (4%)
• Property management: $960 (8%)
• Repairs and maintenance: $1,500
• Other: $360

Your non-mortgage expenses totaled $6,000, or 50% of the gross rental income of $12,000. Again, a mortgage changes the numbers, both for the up-front cash required from you and the cash flow you can expect to collect each month. 

Formula for How to Calculate ROI on Rental Property

If you buy a rental property with cash, the formula stays simple:

Net Operating Income (NOI) / Purchase Price & Closing Costs = Yield

The net operating income is the property’s annual gross rental income minus all non-mortgage expenses. 

Not all real estate investors include closing costs when they calculate ROI on a rental property. But they should, because acquisition expenses add to your total cash investment. 

A related concept is the property’s cap rate, which doesn’t include closing costs. However cap rates don’t measure ROI as much as they help you compare yields on different income properties or markets. 

If you finance a rental property with a loan, you can calculate the cash-on-cash return as follows: 

Annual Net Cash Flow / Your Cash Investment = Cash-on-Cash Return

Both of these formulas measure income yield only. For a complete measure of ROI on a property, add the expected annual appreciation rate to the yield calculation above. So, the total formula reads as:

(Annual Net Income / Total Costs) + Appreciation Rate = Total ROI 

To make life even easier, run the numbers with a rental property calculator that includes a mortgage payment calculator. 

What Is a Good ROI for a Rental Property?

Talk about a loaded question. 

As a general rule, I aimed for my rental properties to return a similar total return as the stock market. The S&P 500 has returned an average of around 10% per year since its inception in 1926. Of that, around 2% historically came from dividend yield, while the other 8% came from growth. 

With rental properties, the return split often looks more like 6% coming from income yield (cash flow) and 4% coming from growth (appreciation). If you were to buy properties in cash, that is — more on that momentarily.

These numbers vary by market and property type, of course. Some markets offer higher cash flow yields, while others experience faster appreciation. Multifamily properties ranging from duplexes up to full apartment buildings often generate greater cash flow than appreciation. 

As a general rule, many rental investors aim for total returns in a similar range of 8-12%. Beware of investing in a rental property that won’t pay at least 8% however, because rental properties require far more labor on your part than truly passive investments such as stocks, private notes, and real estate syndications or equity funds. 

Lastly, beware of speculating on future appreciation. For example, many San Francisco rental properties offer little or no cash flow (or negative cash flow), yet I’ve known investors who kept buying them anyway, counting on the previously high appreciation rate to continue indefinitely. Meanwhile, property values in San Francisco have fallen 15.18% since mid-2022. 

Cash flow is measurable in today’s numbers. Appreciation requires forecasting future price changes. Investors beware. 

How Leverage Changes the Math on Rental Property Returns

When you finance properties with a mortgage, that can create some distortions in the short term. Consider the example above, where you only earned $240 in the first year, after making a $24,000 cash investment. In the second year, rents rise by 4% to $1,040 ($12,480 per year). 

But only your non-mortgage expenses rose alongside them. Your mortgage payment remains locked in yesterday’s dollars. In this example, your non-mortgage expenses rise to $6,240 per year, and your debt service remains fixed at $5,760, for a total of $12,000 in expenses. 

That leaves you with $480 in net cash flow for the year. Your net cash flow doubled — even though rents only rose by 4%. That’s the power of leverage. 

And it doesn’t end there. Say the property appreciated by another 4% in Year 2, from $104,000 to $108,160. 

In Year 2, you earned $480 in net cash flow on your $24,000 investment (a 2% yield), plus $4,160 in appreciation (a 17.33% gain), for a total return on capital of 19.33%. Not too shabby, eh?

In Year 3, say rents again rise by 4%, going from $1,040 to $1,082 ($12,984 annually). Running through all the same math again, your expenses rise to $12,252, putting your net annual cash flow at $732. Your cash-on-cash return rises to 3.05% ($732 / $24,000 = 3.05%). 

Over time, the combined rent growth and appreciation drive your total returns on capital to incredible heights. As you build equity, you can then refinance the property and pull out your initial investment plus more cash for investing. When you can reinvest the same down payment over and over, there’s no limit to the returns you can earn on it. Some investors refer to this strategy as pursuing “infinite returns” for that reason. 

The Importance of ROI for Real Estate

Sure, real estate investing can and should be fun — but it’s not a hobby. You invest to earn a return on your hard-earned money. 

Specifically, you want to earn the highest risk-adjusted return that you can. That requires you to learn how to calculate ROI on rental properties before you consider buying. 

Should you invest in this housing market or that housing market? Should you buy Property A or Property B? Do multifamily or single-family homes make more sense? 

Returns are a yardstick you can use to make informed investment decisions. 

Imagine you have the choice between a property that you forecast will yield 6% versus another likely to yield 8%. All else being equal, the higher-yield property makes more sense to buy.

Of course, all else isn’t necessarily equal. What if the higher-yielding property sits in a neighborhood less likely to appreciate in value? That changes the calculation, but the decision still comes down to an ROI calculation. 

Hidden Costs that Can Impact ROI

Not all rental property costs show up clearly on a spreadsheet. 

When I first started investing in rentals, I bought properties in high-crime, low-income neighborhoods, because they were cheaper and I mistakenly thought I could reduce risk by spreading my money across more neighborhoods. 

What I didn’t understand was all the hidden costs of investing in these neighborhoods. High crime rates not only lead to far greater maintenance and repair costs than in other neighborhoods, it also led many of my better tenants to move out. 

The rent default rates were sky-high, leading me to constantly chase down delinquent tenants for rent. I had to repeatedly send eviction warning notices and file in court. Which was labor that I couldn’t charge for. 

High turnover rates led to higher vacancy rates, and even higher maintenance and repair costs. 

Then there was the string of bad property managers. I learned the hard way that good property managers don’t work in bad neighborhoods. Why would they? They get paid a percentage of the rent that they collect, so in better neighborhoods, they earn more money for less work and fewer headaches. That leaves the dregs of the property management industry willing to work in the worst neighborhoods. 

Eventually, I discovered just how much I was subsidizing the returns on these properties with my own labor. And your labor matters — passive investments such as stocks and real estate syndications don’t require any labor on your part. To compare apples to apples, you need to calculate and include the cost of your labor. 

I sold all of those properties and haven’t looked back since. 

Final Thoughts

What is return on investment in real estate? 

Investors have a few ways of calculating returns on rental properties. You can and should calculate the cash flow that a property generates, and estimate a conservative appreciation rate to boot. 

If you finance the property, focus on calculating its cash-on-cash return. Again, you can take on the appreciation to calculate the total return on your investment capital. 

As you master how to calculate ROI on rental properties, you can avoid ever making a bad investment again. Dial in an investing strategy that can consistently earn you strong returns, and look for ways to benefit from an economy of scale. 

For many investors, that means buying larger multifamily properties as they scale, given the efficiencies of having more units under a single roof. Each transaction also requires time, effort, and closing costs, so buying more doors with fewer transactions helps you scale faster. 

Ultimately, every investment decision needs to come down to ROI — adjusting for any hidden costs that might not be obvious at first glance.