How to calculate ROI on property investment

Having a clear understanding of the numbers is vital to achieve success in property investment. However, there are several different ways to measure returns so it can often be confusing, especially for new investors. In this article, we teach you how to calculate ROI on property investment so you can be confident when analysing and comparing property deals.

It’s important not to confuse the ROI with the yield. Rental yield is simply the annual rental income as a proportion of the property value. That can be useful to compare two properties at a high level but is too basic to be relied upon alone.

Return on Investment (ROI) is often the most useful calculation for an investor because it shows your profit based on the capital you have invested. This will be different from the yield and will be more relevant especially when using a mortgage.

How to calculate ROI on a property investment

You will need to know two numbers:

• Annual Rental Profit
• Total Cash Invested

The Annual Rental Profit is your total income minus all costs (such as mortgage payments, letting agent fees, insurance, service charges, maintenance, etc).

Be aware that everyone calculates their profit slightly differently. There are some costs that you won’t know until later (maintenance for example), so some investors won’t include it at all while others may include an estimate. Both ways are fine; the important thing is to be consistent with what you include and what you don’t.

The Total Cash Invested is everything you spent to purchase the property (including deposit, stamp duty, broker fees, solicitor fees, agent fees, etc).

Once you know those two numbers, the simple equation to calculate ROI is as follows:

Annual Rental Profit divided by Total Cash Invested, then multiplied by 100 to get your ROI as a percentage.

What is a good ROI for a property investment?

It depends!

As a minimum, any property investment must generate a positive cashflow, but beyond that it depends on several factors.

• The way you calculate your numbers
• Your goals and objectives
• Your strategy

The way you calculate your numbers

The figures you use or costs you include could be different to another person, so this will affect the ROI figure. For example, your mortgage interest will always be your biggest cost, so if you use a different rate of interest, that will have a big impact on the ROI, even if everything else is the same.

Another difference is which costs you include or exclude. For example, some people put in an estimate for maintenance, others don’t include maintenance costs at all. There will be a big difference in maintenance costs on different property types, so you need to dig deeper than the headline numbers.

You should consider that a new build property will likely have a lower ROI compared to an older property. However, maintenance costs will be almost zero on a new build and much higher on an older house, so it’s important to be honest with your numbers.

Once you know how to calculate ROI on a property investment, it’s important to be consistent and calculate in the same way every time.

Your goals and objectives

These are a vitally important consideration.

Typically, properties with a very high rental ROI will have less capital growth, and vice versa. So, if you have a long-term goal and are prioritising capital growth, you may accept a lower rental ROI than if your goal was to maximise short-term income.

Your strategy

This will have a big impact upon what ROI is achievable and realistic.

If you are buying a simple high-end vanilla Buy to Let property, this is a strategy focused mainly on long-term capital growth, so your rental ROI will be comparatively low.

If you are buying a HMO or Serviced Accommodation property, these are strategies focused on maximising income, so your rental ROI will be comparatively high.

Before looking at properties, it’s vital to understand your goals and have a clear strategy. If you would like some advice to better understand your options, or more help to understand how to calculate ROI on property investment, you can book a call here.

How to improve the ROI on your property investment

An important thing to remember is that your ROI will naturally change over time. In fact, day one when you first buy a property is usually when the ROI will be at its worst!

The key to this is that rents will rise over time with inflation.

Once you have purchased a property your acquisition costs are fixed, but as your rental income rises with inflation, your profits should rise too, and so will your ROI.

It’s often the case that nicer properties in high demand areas will see rents grow faster than in a less desirable low demand area. This is an important consideration when looking to buy a property. It’s important to look for fundamentals like transport links, amenities, and strong employment options that are vital for demand.

How capital growth affects the ROI on a property investment

Another way to improve your ROI on a rental property is by adding value and then refinancing. Adding value could be through refurbishment or simply from natural market growth over time.

Once the value of your property has increased, you can remortgage based upon the new higher value, allowing you to take some equity out of the property. With less of your original cash left in the property, your Return on Investment will be higher.

Here is a simple example:

You purchased a property for £200,000 with a 75% LTV mortgage, borrowing £150,000 and your total cash invested was £65,000 (comprising £50,000 deposit plus £15,000 total purchase costs).

Your mortgage payments at 5% interest are £7,500 per year and assuming £12,000 rental income per year, that’s £4,500 annual profit, equating to 6.92% ROI.

Assume the value increases to £240,000 and you refinance, again with a 75% LTV mortgage, so you can now borrow £180,000. This additional £30,000 borrowing is equity you can release, so you now only have £35,000 of your original £65,000 cash still invested in the property.

Your new mortgage payments at 5% interest would now be £9,000 per year, so your profit would be slightly reduced to £3,000 annually, but your ROI has increased to 8.57%.

Not only has your ROI increased on this property (and will continue to increase as rents go up over time), but you have also released equity that can be used to invest in further properties and grow your portfolio.

Is comparing ROI the best way to assess a property investment?

Understanding your ROI is important to know the cashflow that your property is generating. However, it won’t tell the full story.

Rental income is a very small part of the potential returns from property investment. Most of the returns over time come from capital growth.

Although in isolation a higher ROI may look more attractive than a lower ROI, if it comes at the expense of capital growth, it won’t be the best investment overall.

There are various fundamentals that you must consider when assessing any rental property for it to be a strong potential investment. Here are a few examples:

• Strong rental demand
• Good tenant profile
• Strong re-sale potential
• Plenty of good jobs nearby
• Desirable location
• Good transport links
• Plenty of local amenities
• Good schools (if renting to families)

These fundamentals can’t be measured by ROI, but they are vitally important for a profitable investment.

Over the long term, the properties with the highest rental ROI on day one are unlikely to be the best investments if they don’t have strong fundamentals.

Getting this balance right only comes with experience.

If you would like to benefit from our experience and gain support to find the best investment properties, we offer advice and a fully tailored property sourcing service. Contact Fintentional to find out more about what we do here.