How to calculate the ROI on rental property

How to calculate the ROI on rental property

I often get asked if someone’s rental property is a good investment. I normally ask a few questions to figure out what type of property they’ve invested in and what their strategy is with the property. Once these are aligned, it’s easier to tell if the property is really good, average or bad.

For example, I received an email a few months ago from a reputable investment firm where the sender queried about a Krugerrand property with the returns of a cash flow property. The misalignment meant that he wasn’t able to find a property where the 1% rental factor rule applied to the quality of property he wanted.

But I also know that buying a property is only the beginning – it’s sustaining the property investment through the rough times that will make it a good investment in the long run. This article will be a good balance between simple calculations, tax and drinking coffee in between.

For this article, let’s focus on the numbers.

Calculating property investment profitability

There are many calculations you can use. I like the 1 % rental factor rule, as it reveals enough for me to decide if the property is worthy of my investment.

The cap rate and return on investment (ROI) calculations allow you to compare your rental property with other investments. The cap rate reveals what the return from an income source currently is, while ROI tells you what the return on investment could be over a certain period.

I’m going to use the following case study of one of my properties as the base:

Monthly Rent: R 4 700 pm
Monthly levies/rates R 200 + R 1300 = R 1 500 pm
Purchase Price: R 360 000 (+ R 40 000 for bond/transfer costs and petties here)
Bank repayment (Prime): R 3 415 pm
Out-of-pocket expenses per month: R -215

Calculating the return on investment (ROI) of your rental property

ROI is calculated as follows: ROI = Annual Return / Total Investment

Therefore – I am splitting the bond and transfer costs over 20 years, for ease of use in this calc.

(R 3 200 x 11) / (R 40 000 / 20 years + R 215 x 12 months) =
R 35 200 / (R 2 000 + R 2 580) = 7.68 %

It’s worth noting that ROI uses the annual return compared to what you put in.

The Cap Rate 

Another method that is used in the property industry is called the cap rate. This can be calculated by dividing the property’s net operating expenses by its purchase price.

  • Start with the average monthly rent – I prefer using 11 months to allow for a one-month vacancy¬†
  • Minus the monthly operating expenses – this should include rates, taxes, and levies – but not the home loan repayment
  • Divide your net income by the¬†purchase price. This will give you the cap rate. You can x 100 to find a percentage.

Therefore:

R 4 700: Monthly Rent
(R 200 + R 1550 ) x 12 = R 1 750: Monthly levies/rates
(R4 700 – R 1750) = R 2 950
(R 2 950 x 11) / R 400 000 = 0.081125 (or 8.1125 %).

The cap rate assumes you’ve bought the property in cash. It then allows you to compare the return on investment (ROI) of a property bought cash to other assets that are also bought cash. As you’re taxed at your normal tax rate for all rental income, many people decide to buy a property on a bond. As leveraging property with a bond makes it difficult to compare to other investments, I suggest doing a combination of the cap rate and 1 % rental factor when looking at profitability from a numbers perspective.

The 1 % rule

The first question I ask when doing property coaching with investors is checking how profitable their existing portfolio is. The 1 % rule has historically been used as a guide to this: If a property costs R 400 000, you need to earn rent of R 4000 per month. I have however found that this rule is outdated due to rising levies and other costs.

My measuring stick is a 1 % rule AFTER the monthly running costs have been deducted. Therefore, on a property that costs R 400 000, you would need R 4 000 per month in your pocket after rates, taxes and levies have been paid.

But this only works on cash flow properties where the rental income covers the bond. It also doesn’t negate the need for a property emergency fund.

Tax brackets and profits

Rental property offers excellent tax breaks such as Section 13sex, 13quin and 13quat. While Section 13sex required 5 or more new or unused properties, there are certain tax breaks, especially for buying flats n special designated urban regeneration regions that you can exploit from the first property.

Just using a tax break is just the start for many property investors – it’s a single tool in the toolbox to make a property portfolio profitable from a tax perspective. As rental income is taxed at your normal tax rate (specific to your tax bracket), it might be worth exploring other ways to lower your taxable income.

A combination of leveraging property through a mortgage as well as taking advantage of tax breaks can be exceptionally lucrative. As you don’t pay tax on losses in the early years of your property investments due to higher interest, you can postpone the tax breaks up until later – meaning you spread your risk of tax clawbacks in case you urgently need to sell.

You will still need to pay capital gains tax on your property when selling. You can however lower this by bettering your property. This includes remodelling the kitchen or bathroom or adding a pool/fireplace.

As tax is a very specialised field, it’s highly recommended to speak to a property tax expert who can guide you in paying fewer taxes.

Calculating rental property risks for profitability

As with any investment, long-term sustainability is only as good as the tenant and property management. Protecting your income from your property is vital to profitability. The following needs to be considered for the long-term sustainability of your property investment:

  • Tenant management and screening – always do a credit check, check bank statements and previous landlord referrals. If you don’t know what to do, hire a rental agent.
  • Make sure to do proper maintenance on your property. Choose durable fittings rather than pretty ones.
  • If you have a sectional title property, try and get on the board of trustees so that you have more control over your investment’s decisions

At times, your property will be vacant between tenants moving in and out. Having a property emergency fund for this and/or a plan to make sure you don’t suffer loss when a tenant decides to do a human sacrifice on your Persian carpet in the lounge is also recommended.

Conclusion

Using calculations such as ROI and cap rate allows you to compare your rental income investment with other asset classes. I do, however, prefer the 1% rental factor calculation, as it puts the value of the property in perspective to the rental income – similar to the dividends of a stock or ETF.

Remember that property investing is about more than just rental income – it’s about capital appreciation of the property value. Especially when you’re investing in a property where a new property development is happening close by such as a Gautrain station or new shopping complex.

Just because you can’t always compare property investments with other asset classes side by side, doesn’t mean it’s not a good investment – it’s just different.

Happy investing!

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