ROI measures the efficiency or inefficiency of an investment and indicates how lucrative it will be (or not). It’s always expressed as a percentage or a ratio, so to calculate it, you divide the dollar amount of the return by the total dollar amount you paid out of pocket for the investment. Or:

Return ÷ Total Amount Paid Out of Pocket = ROI 

How do you determine ROI for rental properties when an investor has the option of paying cash or financing, and ROI will vary with the amount of the down payment and the interest rate?

ROI when it’s an all Cash Transaction

The easiest way to figure ROI is on a cash transaction:

You buy a home for $200,000 with cash, spend $15,000 on closing costs plus remodeling, and then rent it out for 12 months. My total out of pocket is thus $215,000. The tenants pay $2,000 per month in rent or $24,000 for the one-year period. What’s my ROI for that year?

To calculate, we divide $24,000 (the annual return) by $215,000 (the total investment), so our total ROI is 11.2%.

$24,000 (annual return) ÷ $215,000 (total investment) = 0.1116 or 11.2% ROI

That’s a good return.

Keep in mind that this is a gross, not net, because we haven’t calculated in other necessary costs throughout the year, such as taxes and insurance. The net ROI is more likely to be around 7-9% after those expenses.

ROI for Financed Real Estate Deals

But instead of using cash, what if we take out an investment loan, with a 20% down payment? Figuring out the ROI with a mortgage creates a lot of numbers, so please read the next section slowly and carefully.

My out-of-pocket expense on this transaction will be $40,000 ($200,000 sales price x 20% down payment), plus $15,000 for remodeling and closing costs, for a total of $55,000.

$40,000 (downpayment) + $15,000 (remodeling + closing) = $55,000 (out-of-pocket expense)

The amount I’m financing is $160,000 ($2000,000 less my $40,000 down payment), and let’s say I take a 30-year loan at 4.5%. My principal and interest come to $810.70 a month. For the sake of simplicity, let’s say that my taxes and insurance add $500 a month. That gives me a total payment of $1,310.70.

Assuming that the tenant pays rent every month for 12 months, each month I’ll have a positive cash flow of $689.30 ($2,000 rent less the $1,310.70 mortgage payment). Multiply $689.30 x 12 months and my annual cash flow is $8,271.60.

$689.30 (monthly cash flow) × 12 = $8,271.60 (annual cash flow)

Now divide $8,271.60 by $55,000 (original cost out of pocket from the down payment and closing costs) and we get 15%.

$8,271.60 (annual cash flow) ÷ $55,000 = 0.150 or 15% ROI

The ROI from your annual cash flow alone is 15%. But what about paying down the principal, which builds equity in the property every month and is paid by your tenant via rent?

You can see that although paying cash will return more income each month, using a mortgage increases the percentage of your return, or in other words, the ROI. You can also increase your ROI by shorter term financing, appreciation and sweat equity.

So you can see that financing a rental property offers a real estate investor the potential for a huge ROI. Of course, some investors may want higher monthly cash flow, so they pay cash for investment properties.

Maximize your ROI on every rental property you purchase, and you’re well on your way to building great wealth as a real estate investor.