how to calculate rental property ROI

[sol]

I've been trying to run the numbers on our rental property, and confusing myself.

The expenses and profit part I mostly understand.  I take all collected rents and subtract off all mortgage payments including taxes and interest, and other associated costs like maintenance and credit checks.  For us, this unfortunately works out to a small loss.  Is this as far as most people go?

Then we figured out our realized tax benefits by deducting our rental expenses, taxes/insurance, and depreciation given our marginal tax rate.  This gets us about back to even.

Then do I count as profit the amount of principal that the renter has paid for us?  How about the property value appreciation/depreciation, if any?   This would put us squarely back in the range of positive cashflow because it technically adds to our net worth, but it's illiquid wealth tied up in the property value.

The part that most confuses me is that to compare our ROI to a hypothetical alternative investment, I need to know how much capital we have tied up in the property, and that's virtually impossible to compute due to a long record of appreciation, refinances, a divorce and associated buyout, and deriving value from living in the home for a bunch of years while paying the mortgage down.

One simple answer is to just look at how much money we could extract from the house if we sold it today, but due to the recent downturn this isn't very much money after closing costs.  If I just divide our net profit by our equity, then the ROI looks ridiculously good due to the crappy equity, which seems a clear distortion of what I'm trying to measure.

How do any of you make this ROI calculation on your rental properties?

[totoro]

I use some standard calculators.  Here is one:  http://www.biggerpockets.com/forums/88/topics/25519-free-property-analysis-worksheet

This worksheet calcs a number of ways of measuring this type of investment.

In terms of net worth, I calculate what I estimate I would receive from the property if sold today less all transaction costs.  This has to be adjusted up and down each year.  This value is not so important to me as I'm not selling for a longer period of time. 

[JohnGalt]

One simple answer is to just look at how much money we could extract from the house if we sold it today, but due to the recent downturn this isn't very much money after closing costs.  If I just divide our net profit by our equity, then the ROI looks ridiculously good due to the crappy equity, which seems a clear distortion of what I'm trying to measure.

I don't own an rental properties, so take anything I say on the matter with a grain of salt...

That said - I do think this is the correct way to measure current return.  I think of it as the same thing as a dividend yield at this point.  If you buy a company stock at $20 that pays a $1 annual dividend but then the stock drops to $10 while maintaining the $1 dividend, the yield has jumped from 5% to 10%.  Sure your yield on initial investment is still 5%, but if you're considering swapping it out for another dividend paying stock, you should be comparing to the 10% yield because you would be selling at the $10 level. 

This is why, especially with mortgaged (leveraged) real estate - your yield will tend to slowly decrease over time as your equity increases. 

Now, if you're trying to measure true total ROI - you probably need to be comparing total net rent + appreciation/depreciation to your total cost basis - but it doesn't sound like that's what you were looking for.

[sol]

Now, if you're trying to measure true total ROI - you probably need to be comparing total net rent + appreciation/depreciation to your total cost basis - but it doesn't sound like that's what you were looking for.

That's my goal, but figuring the cost basis seems impossible.

Figure 17k as downpayment, then 184k as mortgage payments over 11 years, then 92k to buy out the exhusband from the newly appreciated value.  The problem is that the 184k in mortgage payments was partially paid by the ex, and they derived some value from living in the house all that time, so I'm inclined to just call that part a wash and use the 17k+92k as the cash in, regardless of what the IRS says.  Except that the 17k was in 1999 dollars, so I'm not sure if I should adjust those.

If my cost basis is 17k+92k, then my annualized return is only about 3%, which I could live with considering we're stuck with the property for now.  If it's instead the equity we could extract, then the annualized return is more like 12% but that seems dumb because it is artificially inflated by the plummeting value of the house, and would go to infinity as soon as the place was underwater.

[totoro]

One simple answer is to just look at how much money we could extract from the house if we sold it today, but due to the recent downturn this isn't very much money after closing costs.  If I just divide our net profit by our equity, then the ROI looks ridiculously good due to the crappy equity, which seems a clear distortion of what I'm trying to measure.

That said - I do think this is the correct way to measure current return.  I think of it as the same thing as a dividend yield at this point.  If you buy a company stock at $20 that pays a $1 annual dividend but then the stock drops to $10 while maintaining the $1 dividend, the yield has jumped from 5% to 10%.  Sure your yield on initial investment is still 5%, but if you're considering swapping it out for another dividend paying stock, you should be comparing to the 10% yield because you would be selling at the $10 level. 

I would not measure it this way as it does not account for the loss in equity.  While your ROI may increase in relation to core value of the asset, the decline in value overall, while a paper loss until sold, is a real loss if you are trying to estimate your net worth.  There are all sorts of fancy accounting methods that don't actually work for retirement planning purposes.  I had a number of accountants tell me that proper accounting would include the lost opportunity costs on the equity gained (not just the principal which I agree with) on a rental property even though without the asset I would have never had the equity.  This did not make common sense to me and so I don't do it.

I estimate cash in less current value less transaction costs if sold and monthly net cash flow - these are the two areas of ROI.  In order to get to net worth I estimate equity if sold today.  Each year this is adjusted and could be negative if house prices decline.  The annual cash flow represents the dividend-like return on investment.  It ends when the property is sold but is accounted for in ROI vs. initial investment as is current asset value vs. equity in. 

There are calculators out that that can help you estimate the lost opportunity costs (loc) of your initial 17,000 and 92,000 if you wish to account for this in your overall view as to whether this asset makes economic sense.  I only use these to determine whether buying a property makes sense initially.  I don't account for loc for cost basis otherwise.

[Another Reader]

It looks like you may be confusing cash flow from income with return on investment.  Your overall return on your invested capital can only be calculated after the property is sold.  The ROIC can be calculated without considering the impact of taxes or you can calculate it after tax.  You can estimate your ROIC assuming a sale price and selling expenses and projecting your intervening income and expense.

Here's a simplified example:

Buy a house for $100,000, put $20,000 down.  Borrow $80,000 at 4 percent for 30 years.

For 10 years, rent the house for $12,000 per year, with annual expenses of $13,000 per year.  Net loss is $1,000 per year.

The house appreciates at 3 percent per year and you sell it at the end of 10 years for $134,400 with $4,400 of selling expenses.  The net sales price is $130,000.  However, the mortgage principal has been paid down to $63,027.  Your net from the sale, after paying off the mortgage, is $66,973.

For analyzing cash flows, money you put out is negative, and money you get back is positive.  Here are the cash flows for the equity position:

Year 0 (starting point) -$20,000
Years 1-10 -$1,000
Year 10 +$66,973

Using the most simple, EOY cash flow timing and a handy HP 12C calculator, it looks like you made about 9.85 percent per year (compound rate of return) on this investment of $20,000.

What you are after here is estimating all the cash flows in and out for you, the holder of the equity position in the property.  Then you determine at what discount rate the cash flows that happen after your initial investment will discount back to that initial investment.

This is a very basic example, but the principle is the same for more complicated cash flows. 

[CptMrPants]

You may prefer looking at it on a cash-on-cash return basis.  Here's how I figure it, with an example.

Find your yearly cash flow:

Total Rents: 20,000
- Mortgage (P&I): $6000
- RE Taxes: $1,000
- Insurance: $1,500
- Utilities: $1,200
- Repairs/Services: $1,000

Cash Flow: $9,300

Then divide that number over the down payment and any capital improvements you put in: $9,300 / $34,000 = 27% cash on cash return.

High return rate based on leveraging and getting returns on money you've financed.

Then you have a pretty accurate representation of what your cash is doing.




*Edit to say that your appreciation equity in the house isn't worth a dime until you sell it.  What matters is what you put into it.
** Edit #2:  Another Reader: " I think you mean $6,000 for the mortgage payment...."  Yes I do....

[Another Reader]

I think you mean $6,000 for the mortgage payment....

That's still a nice cash on cash return.

If I were looking at the performamce of Sol's rental, I would use the year zero start point as the day I turned the house into a rental.  Calculate the annual income and expense since then, and figure out how much you had into the property (down payments and capital improvements that were not expensed) as of that point.  Then estimate the selling price today and the selling expenses.  Subtract the remaining mortgage from the net selling price to get the net proceeds to the equity position.  The rate of return from those cash flows discounted for time will give you a good idea of what you are making on the rental.  If you made made major capital improvements, that's money in in the year you made the improvements.

Anything you did before turning the house into a rental muddies the waters.  You are mixing the amenity value of the house to you with the income-producing capability and value.