Calculating your return on investment (ROI) is important for all stages of the real estate investment lifecycle.

Investors use ROI to compare different homes and investments in the early stages of the buying process. ROI is one of the major factors you should consider when you ultimately make your buying decision. Later, ROI can also be used to measure your profitability against previous years' returns and give you a sense of any changes in your cash inflows and outflows (revenues and expenses). In addition, it will give you a way to compare your investment with other comparable or prospective investments.

There are multiple methods for calculating your ROI, and this post will show you the applications for each.

ROI Limitations

It is first important to first lay out exactly what ROI is and is not. Or in other words, what ROI is good at measuring and what its limitations are.

ROI is a financial metric that will always compare some form of gain or loss against the cost of the investment. It calculates the gain & loss or cost will change the measurement and change the metric’s application. However, all ROI calculations are great at measuring your profitability over a period of time.

And that’s basically it.

ROI is a quantitative measure and will ignore all qualitative attributes to some degree. This is not only where the metric’s limitation is, but this is also where most people’s analysis of a potential investment falls short. You should never ignore financial metrics but weight your analysis accordingly and do not forget about the investment’s attributes that aren’t so easily measured by numbers, such as; school district quality, neighborhood quality, neighborhood reputation, etc.

ROI has one other major limitation/consideration. This goes back to its quantitative side: ROI will generally not consider your home’s appreciation, tax benefits, or equity buildup from buying the home with leverage.

Considering the significance of the above in determining your investment’s profitability over the long run. You can certainly factor in these aspects by calculating your after-tax savings from deductions, increased ownership in the home from paying off your mortgage with the rental income, and the yearly increase in the home’s value, but most ROI calculations will not consider these.

ROI: Basic

The basic way to calculate your ROI is as follows:

ROI = (Current Value of Investment - Cost of Investment) / Cost of Investment

This is the basic formula that can be applied to all sorts of investments. You are comparing your overall return to your initial investment. This is not the most applicable formula for cash flowing real estate investments, however.

Calculating returns for real estate requires a slightly different formula. The next one presented is better, but not necessarily the best.

CAP Rate

A (possibly) better way to calculate your ROI is by using the CAP Rate. The CAP Rate compares your net income to the full purchase price of the home. This is best used when you pay for the entire home in cash (if you are financing your purchase, read on to the next formula). The formula for CAP Rate is as follows:

CAP Rate = (Net Operating Income / Purchase Price)

Net operating income is your net rent revenue (after all expenses) divided by full purchase price of the home.

For example: If your rent revenue for the year is $2,000 per month, your expenses are $1,500 per month, and you paid $190,000 in cash for the home, your CAP rate would be 3.16%.

CAP Rate = (6,000 / 190,000) = 0.0316 (or 3.16%)

Cash-on-Cash (CoC) Returns

Generally, the most applicable measure of returns is the cash-on-cash (CoC) method. This metric is best used when you are financing your purchase, as it compares your net rent receipts (cash in the bank after expenses) with your initial cash investment (down payment). The formula is as follows:

CoC Return = Annual Cash Flow / Total Cash Invested

For example:  If your rent revenue for the year was $18,000, your expenses for the year were $13,200, and your down payment on the home was $35,000, your CoC returns would be 13.7%

CoC Returns = (4,800 / 35,000) = 0.137 (or 13.7%)

Best Method

Unless you are paying for your entire home in cash, it will generally be best to calculate your cash-on-cash returns. Making the denominator your actual cash outlay (down payment) gives you a better sense of how much cash you are taking based on your initial investment.

No matter which method you choose, though, be sure to remember that this financial metric is the only way to analyze an investment. Don’t forget to consider appreciation, the tax benefits (deductions), equity buildup, and other qualitative attributes. The overall quality of an investment home is greater than the sum of its parts.