ROI Expectations When Investing in a California Rental Property
The objective of any investment is to turn a profit, and real estate is no different. Any purchase, whether to fix and flip or rent to tenants, is inherently designed to generate revenue. However, not all properties are made equal, and some have more potential than others.
When considering different real estate properties, calculating an expected return on investment, or ROI, is an important part of the due diligence process. Many different kinds of factors can play a role in ROI, so understanding the moving pieces and parts is essential to a robust portfolio. This is what you need to know about ROI and related expectations when investing in California rental property.
What Is ROI?
Return on investment, or ROI, refers to the amount of profit generated or that can be expected on a particular investment. ROI is considered a general way to quantify an investment’s profitability, whether in the present or the future.
Any amount of money earned in excess of the total investment made in an asset is considered a return. A positive ROI is a good thing – most investors aim to see the highest ROI possible – while a negative ROI indicates a loss on an investment. Prior to making an offer on a property, successful real estate investors take time to estimate the kinds of repairs necessary to bring a property up to par in order to determine total costs and thus the amount of return possible.
ROI is similar to profit margin, but not the same. Profit margin can never exceed 100% based on the nature of the calculation, but there is no limit to ROI. This is particularly true for something like a rental property, in which rental income continues even as loan payments and other expenses decrease over time. A wholly owned house with minimal annual repairs, for example, drives pure profit, increasing ROI as time goes on.
How Is ROI Calculated?
ROI is calculated by taking the difference between the initial value of an investment and the final value of an investment to get the net return, dividing this amount by the cost of the investment, and multiplying by 100.
For example, if you purchase a stock for $100 and sell it for $105, the net return on your investment is $5 and the ROI is 5%. This formula can get a little more challenging when the purchase price of an asset and the initial value of the asset are not the same – for example, a stock is purchased using an Employee Stock Purchase Plan at a sharp discount. Further investments after the point of acquisition, like improvements to a rental property, can also play a role in the overall calculation for ROI.
ROI is not a constant, either; additional time and asset use can alter ROI. As such, it can be beneficial to consider ROI under a number of different circumstances. For example, estimated ROI if a property is sold in the near future versus the ROI if a property is held for several more years before selling.
How Does ROI Apply to Real Estate?
Determining an estimated return on investment is a critical part of the due diligence process when evaluating a potential property purchase. While it is important to understand the current dynamics of the market, it is equally critical to determine a fair purchase price and the kind of repairs necessary in order to make sure you are making a favorable purchase. For example, a home that costs $100,000 and requires $25,000 in repairs needs to sell for more than $125,000 plus the aggregate amount of fees or costs associated with the transaction, in order for an investor to turn a profit.
However, as with any investment, using ROI to govern buying decisions does take reasoned estimates using industry knowledge. There is no way to guarantee how much home renovation processes will cost or how long it will take to restore a property and put it back on the market, but an experienced investor can call on expert knowledge to avoid major missteps. Inadvertently missing key expensive renovation requirements or misinterpreting a timeline can change ROI substantially in a way that potentially transforms a great deal into one that may not turn any profit at all.
As such, investors are encouraged to remain conservative and factor in worst-case scenarios to avoid facing a minimal or negative ROI.
ROI for Rental Properties
Based on the math surrounding returns on investments, it is easy to see why the ROI related to rental properties is a little more complicated than with other forms of assets. As rental properties are purchased, renovated to the extent necessary to accommodate tenants, and then held, a final return is not always clear from the onset. Profits will be impacted in a number of different ways, including the cost of both initial and ongoing repairs and maintenance as well as monthly rental income from tenants.
A fix and flip investment property is easier to estimate as the purchase, renovation, and sale process is quite straightforward. An investor chooses a property, determines how much to spend on acquisition, estimates the price point for necessary remodeling, and determines a reasonable sales price when finished with upgrades. However, this is not the case with a rental property that is intended to be held for years. ROI is constantly shifting, as a rental property is a long-term income-generating investment in a way fix and flips are not.
Calculating ROI for Rental Properties
ROI on a rental property is most commonly calculated on an annual basis. Property owners can determine annual return rather than net return by subtracting any expenses related to property ownership from income for a set one-year period.
Using the previous example in which a home is purchased for $100,000 and the investor puts in an additional $25,000 for repairs, and assuming rent of around $800 a month, that the property houses one tenant and average monthly costs of property maintenance of around $200, annual profit equals approximately $7,200. This annual profit amount is divided by the total cost of the property – $125,000 – and multiplied by 100 for an ROI of 5.76%.
The math works in a similar form for investors who prefer to calculate the lifetime returns of a rental property. Instead of taking the returns for a year into account, investors can instead consider the total amount earned from a property and the total cost of ownership.
How a property investor chooses to calculate ROI can depend on unique needs. An investor who wants to be sure current pricing strategies are working may want to look at ROI on an annual basis, while an investor who wants to determine who much a rental property has been able to return since acquisition may prefer a more holistic approach.
Challenges to ROI
In an ideal world, a property in good repair will continue to generate consistent income without many surprises. However, this is not always the case. Issues like flooding after a bad storm, a lull in renters, or necessary upgrades to remain competitive with surrounding properties can all impact ROI on a long-term basis. As such, it is necessary for investors who prefer rental properties over other alternatives to keep these kinds of situations in mind. A healthy property with a happy renter is not guaranteed to stay that way, even with proper attention to maintenance issues.
Looking at an annual ROI can help investors determine when a property is no longer a good investment. A property that yielded strong returns for the first few years but is now losing money may not be a valuable part of a portfolio anymore. At this point, investors must decide whether further renovations are worth it, or whether it is best to sell and invest capital elsewhere.
What Is a Good ROI for Rental Properties in California?
The concept of a good return on investment can be very subjective based on a number of factors. These can include:
- The current state of the rental market and average prices for comparable properties
- The state of the property and any repairs it may need
- The costs involved with property maintenance
- Individual income goals
- Future investment plans
However, regardless of unique circumstances, an ROI needs to be adequate to support both regular expenses as well as extraordinary incidentals. Prior to COVID-19, an ROI of around 15% was considered a benchmark of success, but this marker is currently a lot more flexible. In a challenged market, an ROI of at least 7% is considered acceptable. This is particularly true for those newer to investing without a solid and expansive portfolio on which to fall back.
Regionality can play a role, too, especially in a state like California. A good ROI in San Francisco may not be a good ROI in Sacramento, so one universal figure can be misleading. Above all else, California real estate investors need to ensure that their expenses are covered with adequate buffer.
COVID-19 and the Rental Market
Few industries have not felt the effects of a global pandemic, whether for better or worse, and this includes real estate. In some areas, rents are dropping as renters are taking advantage of the ability to work remotely by leaving high-cost areas of the country, like New York City, Los Angeles, and the Bay Area, in favor of nearby suburbs, which are consequently experiencing a rental boom. Since commuting is less of an issue and more living space is highly desirable due to increased time spent at home, a move from city centers has been a defining trend of the COVID-19 pandemic. Take San Francisco, the most expensive rental market in both California and the U.S. – apartment vacancy rates almost doubled in the first few months of the pandemic. Under these circumstances, a low ROI is better than no ROI.
For those who own rental property in areas that previously demanded sky-high prices, lowering rents to appeal to new tenants may be a necessity to rent out the property. Rent cuts can reduce or eliminate a return on an investment, but ideally only on a short-term basis. However, those with properties in more desirable areas for those relocating from cramped city apartments may have an opportunity to increase prices and boost cash flow, improving on prior circumstances. Again, this may be temporary, but can offer a profitable opportunity for those in-tune with changes in the local market and renter tolerance for rate increases.
The outcome of the pandemic impacts is still very unclear. While COVID-19 has been affecting daily life for nearly a year, how much longer this will last is unknown. Changes to rental strategies to manage ROI may be short-term or could persist for the foreseeable future.
Real estate investing has the potential to be very advantageous for those willing to take the plunge. As seasoned investors know, a strong ROI is an essential part of a stable portfolio. Rental properties with good ROIs can be very profitable on both short and long-term bases, providing regular income in the form of a valuable asset that can later be sold for additional profit. Understanding ROI expectations for California real estate can help investors make wise purchases, increasing the likelihood of a successful venture.