People purchase houses in Buffalo for different reasons. Often, it’s to enjoy living in a beautiful and spacious home with your family. Other times, the goal is to use the real estate to make money, either by reselling it or renting it out. When you buy a house as a residential rental property, it’s important to consider the return on investment (ROI) from the very beginning. That way, you can maximize your profits and minimize any headaches.
What Is Return on Investment (ROI)?
ROI is a percentage that helps you calculate how profitable a potential real estate investment will be. It measures how much profit you obtain from the rental property versus the money you have to invest in it. Business owners often look at ROI before taking on any project, from purchasing a piece of equipment to launching a new product.
You can do the same thing with your residential rental property to choose the right house for your budget and goals. Ideally, you want a property that gives you back the highest potential profits for the lowest investment. What factors should you consider?
How Can You Calculate ROI for Residential Rental Properties?
The first and most obvious expense to consider is the purchase price for a residential property. To turn a profit, you have to generate rental income that goes beyond what you paid for the home. That isn’t the only expense to keep in mind, however:
- Remodeling costs to make the house attractive for rental
- Additional costs from the loan or mortgage used
- Ongoing repair costs
- Regular maintenance expenses
- Property taxes
Understanding the Formula for ROI
You don’t have to be an expert in mathematics to figure out the ROI for your preferred property. The basic formula is actually quite straightforward: net profit divided by cost.
What is net profit? It’s the profits you make after you subtract the total cost of the investment. For example, let’s say you buy a house for $100,000 and resell it for $150,000. Your net profit would be $50,000, or $150,000 – $100,000.
To find your ROI, divide the net profit by the original cost. In this case, it would be 50,000 ÷ 100,000 = 0.50. This means your property provided an ROI of 50%.
Calculating ROI for Cash Transactions
It’s generally easier to calculate ROI when you pay for the property in cash, perhaps using money from an inheritance or the proceeds from selling a different home. To make this simple to understand, let’s continue with our previous example.
First, write down all initial expenses:
- Purchase price — $100,000
- Closing costs — $3,000
- Remodeling expenses — $10,000
The total expenses so far are $113,000. If you’re looking at the ROI for a single year, include the expenses and profits generated during the year:
- Insurance costs, property taxes, and utilities — $3,000 or $250 a month
- Repair costs — $300
- Revenue from rent — $1,200 a month or 14,400 in the year
Your annual profits from the residential rental property would be $11,100, or $14,400 (revenue) – $3,300 (costs). Now for the final step of calculating ROI, just divide the annual return by the original investment. In other words, $11,100 ÷ $113,000 (initial costs). This gives you an annual ROI of almost 0.098, or 9.8%.
Is that good? In Buffalo, NY, anything over 8% is good, 10% is great, and 12%+ is phenomenal.
Calculating ROI for Financed Transactions
What if you purchased the residential property using a loan? The formula is roughly the same as above, but you need to include the ongoing costs of the loan as well. For your original expenses, here’s what you need to put:
- Just the down payment
- Closing costs
- Remodeling expenses
Next, let’s calculate your ongoing expenses and profits for one year:
- Total loan payments for the year
- Insurance costs, property taxes, and utilities
- Any repair costs
- Revenue from rent for the year
Now, you’re ready to calculate the annual ROI. First, subtract the ongoing expenses (mortgage payments, insurance, etc.) from the rental revenue you made. Then, divide your net profit by the original expenses (down payment, closing costs, etc.).
As you pay off the principal of your loan, you start to build up equity. Home equity is essentially the amount of money you could get for selling your property, minus what you still owe on the loan.
How do you add home equity to ROI calculations? First, you need to add up all of the mortgage payments you’ve made so far (but only the principal, not the interest). Next, add that amount to your other annual profits. This gives you a more accurate picture of your true return on investment.
How Can You Calculate ROI Ahead of Time?
If you haven’t actually purchased the property yet, you need to estimate several figures to get an idea of the potential ROI. How can you do this with residential rental properties in Buffalo, NY? Look at these details:
- Current property value after appraisal
- Square feet
- Remodeling costs (if any)
- Loan terms (including down payment and interest rate)
- Estimated annual rental revenue
- Estimated annual rental expenses
This information requires a little legwork, but it’s worth the time spent. Real estate agents, general contractors, and lenders can help fill in the blanks.
Why Is Calculating ROI for Residential Rental Properties Smart?
The housing market in Buffalo, NY, is in an excellent place for real estate investors. If you play your cards right, you can get a great property that gives you consistent passive income. The reason you want to calculate ROI is that going into a deal with both eyes open helps you make a smart investment.
Of course, you don’t need to handle residential rental property investment on your own. It’s much easier with the experts at Ellicott Development by your side. Contact us for assistance right away. Take advantage of amazing real estate opportunities in Buffalo.
Image Source: ktasimar / Shutterstock