How do Landlords calculate ROI and compare it to stock market ROI?

[MrGreen]

I thought I had this figured out but now I don't think I'm doing it right. Previously, I was looking at what we would clear if we sold our rental and dividing that by cash flow plus mortgage pay down to give me a percentage. So say we'd clear 300k from the sale of the house and cash flow plus mortgage pay down is 15k per year. That's a 5% return. I think this is flawed math because it doesn't include appreciation (or depreciation) of the asset.

I'm struggling to wrap my brain around this. With index fund investments, the yearly return is the whole equation. The math is simple. But the house can appreciate in addition to providing income. I guess what I'm not sure of to make it an apples to apples comparison is what initial value I'm supposed to put on the house? Would I say the equity we have in the house at the time we converted to a rental is our basis and each year appreciation, cash flow, and mortgage pay down is used to determine a yearly ROI?

How do other landlords make their calculations in trying to compare ROI to index funds to determine if keeping a rental is worth it? Hoping maybe some folks here have done this exercise or has their own methodology they'd be willing to share.

[GilesMM]

https://www.investopedia.com/articles/basics/11/calculate-roi-real-estate-investments.asp Works for me.

[MrGreen]

https://www.investopedia.com/articles/basics/11/calculate-roi-real-estate-investments.asp Works for me.

I had read that article but it didn't seem particularly helpful because we owned our home as a primary residence first. And we had 100% financing. So when I'm calculating a year's return, I don't really understand what I'm supposed to be dividing by.

[MrGreen]

What I'm really trying to wrap my head around is "how would the equity we have in this rental have otherwise performed if we sold at different times and invested the money?" I don't want to buy other rentals. I just want to know if this rental has held its own vs. the stock market or is it a dog.

I *think* what I've landed on is determining the sale proceeds from a hypothetical sale each year and then using appreciation, mortgage pay down, and cash flow values to calculate a return. That's a true apples to apples comparison. I can even take this a step further and compare the amount we would have received had we sold the house when we moved out at the end of 2017, and subsequent market returns had we invested those funds, compared to the gains in appreciation, mortgage pay down, and cash flow over the last 6.5 years.

If that's the comparison, the rental is actually the winner by a significant margin. Had we sold the house at the end of 2017 and invested the proceeds, our total return (if invested 100% S&P 500) would have been 93%. By contrast, the appreciation, mortgage pay down, and cash flow amounts represent a 225% return on the proceeds of having sold the house in 2017. Mortgage pay down and cash flow are 84% of that and appreciation is the other 141%. Selling costs and taxes will be slightly higher now that the house is worth more and more depreciation has been taken so we could knock a few percentage points off of that 225% figure but that's still a pretty compelling number.

I suppose the wildcard is how you view housing and price appreciation. It doesn't have to appreciate. The area this house is in actually lagged behind the bigger pandemic home price explosion so the appreciation hasn't been as extreme as some other places. Without that component, the house under-performed the S&P and, considering the additional risk compared to index fund investing, that's a dog.

Something for me to chew on a little more.

[clarkfan1979]

You can actually take it one step further and take the monthly cash flow from the rental and put it in to the S & P 500. This isn't that far from the truth for us because we fully fund our Roth IRA with rental cash flow. If we didn't have the rental cash flow, we most likely would not be fully funding our Roth IRA.

[FINate]

https://www.investopedia.com/articles/basics/11/calculate-roi-real-estate-investments.asp Works for me.

I had read that article but it didn't seem particularly helpful because we owned our home as a primary residence first. And we had 100% financing. So when I'm calculating a year's return, I don't really understand what I'm supposed to be dividing by.

What was the equity in the home when you converted it to a rental? That was your cost on the investment, because you could have instead sold and put that to use elsewhere. That's what you should be dividing by.

[SilentC]

I think it makes a lot of sense to know the ROI. That said, if you are trying to decide whether to keep a rental, the historical ROI should be a factor but not the guide.  Sometimes the most exciting investments have had a really poor 5-10 year return and that’s exactly where you should put your money, and vice versa.  For example chemicals companies have had decade long stretches of near-zero ROI followed by long periods of high teens or low 20s annualized ROI depending on when you invested in the cycle.  Real estate is also cyclical albeit less than chemicals. Forward looking ROI on rentals will require forecasting appreciation, rent growth rate and expense growth rate and looking at a variety of ranges around these assumptions. 

[aasdfadsf]

Real estate ROI is roughly rents + appreciation - debt interest, insurance, property taxes, HOA/other fees (if applicable), maintenance. That's not necessarily an easy thing to figure out, but that's your basic equation. Ask yourself how much equity you have and then after adding all that up, you can figure the return you're getting on your vested capital.

Index funds are basically just dividends + appreciation. The dividends are relatively low and the appreciation is volatile in the near-term, but will almost always be strongly positive in the long-term if by that you mean at least 10 years.

Then there are tax liabilities. Those are too specific to each situation to get into, but that's a thing too.

You should not expect that real estate crazily wins over index funds or vice versa, because if there's any kinda-sorta market efficiency, they'll both give somewhat similar returns. You can of course get lucky in either case. Good or bad in either direction.