How Do You Calculate ROI on a Mortgage?

Calculating Return on Investment (ROI) on a mortgage isn't about the mortgage itself, but rather about the profitability of a property that has been financed with a mortgage. It measures how much money you've made (or lost) relative to the capital you've invested, taking into account the impact of the loan. Understanding ROI is crucial for real estate investors to assess the performance of their assets and make informed decisions.

Simplest Approach for Rental Properties

For a rental property, one straightforward way to gauge its return is by focusing on its annual net income relative to the loan value. This method involves:

1. Calculating Annual Net Income: Subtract all annual operating costs from the total annual rental income generated by the property.
2. Dividing by Mortgage Value: Take the calculated annual net income and divide it by the original mortgage loan amount.

This provides a quick snapshot, but real estate investors often use other calculations to get a more comprehensive understanding of their expected returns from a property investment.

Key ROI Metrics for Mortgaged Properties

While the above method offers a basic look, several other crucial metrics provide a deeper understanding of profitability, especially when a mortgage is involved.

1. Cash-on-Cash Return

Cash-on-cash return is arguably one of the most important metrics for properties financed with a mortgage, as it focuses specifically on the actual cash invested. It measures the annual pre-tax cash flow generated by the property against the total cash you initially invested.

Formula:

$Cash-on-Cash Return = \frac{\text{Annual Pre-Tax Cash Flow}}{\text{Total Cash Invested}} \times 100$

• Annual Pre-Tax Cash Flow: This is your total annual rental income minus all operating expenses, including your annual mortgage payments (principal and interest).
• Total Cash Invested: This includes your down payment, closing costs, and any initial renovation or repair expenses before the property became rentable.

Example: If you invested \$50,000 cash (down payment, closing costs, repairs) and the property generates \$5,000 in annual pre-tax cash flow, your cash-on-cash return is (\$5,000 / \$50,000) * 100 = 10%.

2. Capitalization Rate (Cap Rate)

The capitalization rate helps investors compare the potential profitability of different properties regardless of their financing. It's a measure of the unleveraged rate of return, meaning it doesn't consider the mortgage.

Formula:

$Cap Rate = \frac{\text{Net Operating Income (NOI)}}{\text{Property's Current Market Value}} \times 100$

• Net Operating Income (NOI): This is your total annual rental income minus all operating expenses excluding mortgage payments (principal and interest), depreciation, and income taxes.
• Property's Current Market Value: The current estimated value of the property.

While not directly tied to the mortgage, understanding the Cap Rate helps you evaluate if a property is a good investment before factoring in financing.

3. Total ROI (Upon Sale)

For a complete picture of your return, especially when you plan to sell the property, you must account for all gains and costs over the entire holding period. This includes rental income, appreciation, and principal paydown on the mortgage.

Formula:

$Total ROI = \frac{\text{Total Return (Profit)}}{\text{Total Investment}} \times 100$

• Total Return (Profit): Calculated as (Sale Price - Selling Costs) - (Original Purchase Price + Total Mortgage Principal Paid + All Operating Expenses Over Holding Period). It also includes the total net cash flow received from rentals.
• Total Investment: This includes your initial down payment, closing costs, initial repairs, and any capital expenditures made during your ownership.

Components of ROI Calculation

To accurately calculate ROI, whether for a quick estimate or a comprehensive analysis, you need to understand and track various financial components:

Annual Rental Income

This is the total money collected from tenants over a year.

• Monthly Rent: The primary source of income.
• Other Income: Late fees, pet fees, laundry income, etc.

Annual Operating Costs

These are all the expenses associated with owning and operating the property annually.

• Mortgage Payments: Both principal and interest portions of your loan.
• Property Taxes: Annual taxes assessed by local government.
• Homeowner's Insurance: Coverage for the property.
• Utilities: If paid by the landlord (e.g., water, sewer, trash, HOA fees).
• Maintenance & Repairs: Regular upkeep, unexpected repairs (budget 5-10% of gross income).
• Property Management Fees: If you hire a property manager (typically 8-12% of gross rent).
• Vacancy Costs: Account for periods when the property might be empty (e.g., 5-10% of gross income).
• Capital Expenditures (CapEx) Reserve: Funds set aside for major repairs or replacements (e.g., roof, HVAC).

Total Cash Invested

This represents the actual out-of-pocket money you put into the property at the beginning.

• Down Payment: The upfront portion of the purchase price not covered by the mortgage.
• Closing Costs: Fees paid at closing (e.g., loan origination fees, appraisal fees, title insurance, legal fees).
• Initial Renovation/Repair Costs: Expenses incurred to get the property ready for tenants or to increase its value.

Comparing ROI Formulas

Here's a summary of the various ROI formulas discussed:

By utilizing these various ROI calculations, real estate investors can gain a comprehensive understanding of their property's financial performance and make strategic decisions regarding their mortgaged assets.