Operating rental properties is one of the best sources of passive income. However, before taking the plunge and acquiring a property or analyzing the success of a rental you currently own, investors much crunch the numbers and understand the return on investment (ROI).
We talked about analyzing ROI for cash-purchased properties, but what's the formula for investments purchased with financing? Having a monthly mortgage payment affects your long-term returns, so it's important to understand some additional factors that should be part of your calculations. Here are our expert Dallas, TX property management insights into ROI for a financed transaction!
Property managers understand thinking of return on investment calculations as best applied to a potential property to determine if it's a worthy investment or not. However, the most successful investors use ROI for properties that already exist in their real estate investment portfolio, too.
ROI can tell you if the cost of an investment and renovations are worth the potential rental income you'll generate over time. Return on investment also helps you determine if a property you've had for a while is generating enough income—or if it's a property you should consider selling because it's losing money.
As property management experts, we know that not all Dallas real estate investors can buy properties paid in full with cash. Financing a rental property is very common and often helps investors get into the business faster than waiting to save enough cash for the entire sale price of a property.
However, when evaluating returns, property owners must remember to factor in the down payment, mortgage principal and interest, and closing costs to get an accurate picture of a property's financial performance. Remember that ROI is a profitability ratio that evaluates income versus costs. Property management companies know that it's an excellent way to track progress on a new property and ensure that your rentals generate enough revenue to cover expenses and keep you moving toward long-term financial goals.
To illustrate, let's say the sale price of a new rental property is $150,00. You're financing the home, so to start the transaction, you pay 20% down, or $30,000.
Closing costs are often higher when taking on a mortgage than paying cash in full for a property. For this purchase, closing costs come in at $4,500 or 3% of the home's price. While the home is in pretty good shape, it does need some renovations before it's ready for new renters. You spend $10,000 for upgrades and repairs. At this point, your total out-of-pocket costs for this property are: 30,000 + $4,500 + $15,000 (or $49,500).
While it might be nice to think that you're start-up costs for this property leave you off the hook for a while, don't forget the mortgage payment! Since this is a financed transaction, you're on the hook with more monthly expenses than you would be with a cash-only investment.
To finance this property, you landed an interest rate of 4% for a 30-year home loan. After the $30,000 down payment, you financed the remaining $120,000 on the price of the property. The principal plus interest on the loan comes to $124,800 to repay over 30 years. That leaves you with a monthly mortgage payment of $347.
Add to that amount another $350 per month of additional ongoing costs that could include landlord insurance, utilities, and taxes. Your monthly expenses are now $697 (or $8,364 annually).
Since ROI is a profitability ratio evaluating income vs. expenses, it's time to include rental income in the formula. Estimating rent at .08% of the property's price, you charge $1,200 per month to your renters. Over twelve months, the rental generates $14,400 in income.
You're ready to learn the ROI for your Dallas rental property! Take your annual returns ($14,400) and subtract your annual expenses ($8,364) to get your net return amount ($6,036). Next, divide that number by your initial out-of-pocket costs ($49,500). This property has an ROI of .12 (or 12%).
Whether you're happy with a rental's ROI or you'd like to see a higher number, work with a Dallas property management company to maintain excellent returns or boost an ROI that's too low. A property manager can recommend upgrades that can justify a rent increase and help reduce operating expenses by applying expert property management services and insights!
Having cash in your pocket at the end of most months isn't always a sign that you're operating a profitable rental. Take time to run the numbers and evaluate annual returns to ensure more success! Work with Dallas, TX property management experts to help you evaluate a property's performance and reach your long-term income goals. If you're ready to achieve better returns, RentHub and our Dallas property manager team are here to help!
Learn more about calculating ROI! Get our free Rental Property ROI Calculator.