Rental properties can be classified into long-term and short-term lease real estate. You can review both options to determine which offers the highest rate of return
Long-term Lease Real Estate
Typically, a long-term rental unit means a property being rented out to residents for a longer time frame, six months or more. This would typically refer to residential homes, apartments, and commercial units where regular rent is collected out over the rental term. It provides steady income, along with the potential for your property’s value to appreciate over time.
When computing the rate of return on long-term real estate, we cannot specify a fixed rate since this will vary based on the conditions of the market, location of the property, and the performance of the management. One can generally expect returns that range between 8 to 12% each year.
Note that the expected return will be the sum of the rental income proceeds and the possible capital gains coming from the increase in property value over the years. As an investor, you must take into account the costs of operating your rental, trends of the local real estate, and the taxes, which can have a significant effect on your investment property’s returns.
Short-Term Lease Real Estate
Commonly, short-term rental properties pertain to residential or commercial buildings rented out for a short time, which can fall below 30 days. You can find these ads on popular listing platforms that can include entire homes to single rooms inside a residential unit.
One can expect a return of around 10% when talking about short-term rentals. Long-term rentals often earn more consistent income returns than short-term rentals, which can be affected by the seasonal demand of their rental units. At times, returns can fall as much as 5% and rise up to 20%, depending on the peak and off-peak periods.
The location of the rental, type of unit, and how well the property is managed can lead to the variability in the returns you will receive as a property investor.
Calculating the Rate of Return
The three methods for computing ROI on your rental place are
Simple ROI Calculation
Here’s a clearer version of the sentence:
ROI is calculated by subtracting the cost of the investment from the income generated, then dividing that result by the cost of the investment.
For instance, if your initial rental property investment is $200,000 and you made a total profit of $240,000. Your rate of return from your investment is 20%.
ROI = ($240,000 – $200,000)/ $200,000 = 0.2 = 20%
This method is very straightforward and does not provide details on the profit you made compared with other methods.
Cap Rate
Another method commonly used by investors for property purchases is the cap rate or capitalization rate. It helps you learn if a specific rental is profitable over the other investment options.
However, cap rate is not the best way of calculating the profit you made from your short term rental investment since you need to assess its value in comparison with other properties around your neighborhood.
In general, it is best to use the cap rate when checking the profitability of commercial properties. It is the ratio between your property investment’s net operating income and the price you purchased the unit.
The formula is as follows:
- Net Operating Income (NOI) = Rental income minus operating costs.
- Cap Rate = (Net Operating Income ÷ Purchase Price) × 100%.
For example, if the purchase price of your rental property was $300,000, and you spent $3,000 on closing costs and $30,000 on renovations, your total investment would be $333,000.
Let’s say your tenants pay $2,000 per month in rent, giving you $24,000 annually. To calculate a more accurate ROI, we can deduct $4,000 for operating costs, such as insurance, taxes, maintenance, and property management fees.
Your annual returns from your investment property would amount to $20,000.
Calculating the ROI from the rental property, you must divide the annual return of $20,000 by your total initial property investment, which was $333,000.
Cap rate = ($20,000 / $333,000) x 100% = 6.01%
Cash on Cash Return Calculation (COC)
Compared with the above two methods, COC is a bit more complicated if you sought financing or a loan to buy your rental property. It is the ratio of your property’s annual NOI plus the total cash investment of the rental real estate.
The COC formula is
COC = Annual cash flow minus the total cash investment multiplied by 100%
For instance, you purchased a rental property for $300,000 and placed a 25% deposit and applied for a mortgage. The total expense would be $60,000 for the deposit, $4,500 for closing costs, and $20,000 for the property renovation.
You will have invested a total of $84,500 ($60,000 + $4,500 + $20,000)
Note that when you have a loan, you will be paying a monthly interest and you need to factor that in your computation. If your interest is at $2,000 per month and the renter pays $3,000 each month, then your cash flow is $1,000 monthly or $12,000 in annual returns.
Through the COC formula, we can divide the annual cash flow by the total invested cash in the rental unit to find out your ROI rate.
COC = ($12,000/$84,500) x 100% = 14.2% (annual return rate from your rental)
For cap rate calculation, around 10% is normally pegged as a good rate of return.
For cash on cash rate computation, you can consider 8 to 12% as a good rate of return. Still, some investors won’t choose a property if the predicted return does not produce a minimum of 20% rate of return. This will depend on each investor, and what metric of a good rate of return they are satisfied with.
Bottom line
Rental properties can be classified into long-term and short-term lease real estate, each with distinct advantages. When calculating the rate of return on rental investments, several methods are available, including simple ROI, cap rate, and cash on cash return.
While a cap rate of around 10% is generally favorable, many investors seek a cash on cash return of 8% to 12%, with some aiming for a minimum of 20%. Ultimately, understanding these classifications and calculations is essential for making informed investment decisions.
If you have any questions contact East Bay Property Management today! We will handle all aspects of property management so you can sit back and enjoy your ROI.
