Most people invest to increase their wealth. Of course, the reasons behind such a move can differ, but the primary motive is to generate a good return on investment (ROI).
The rise of new-age investment options has failed to convince most investors. It means that traditional assets, such as real estate and stocks, are more likely to rule the market, at least in the near future.
Real estate refers to a tangible property which includes the land and the structures built on it. It is considered an excellent form of investment, especially if people are looking to invest for rental purposes.
But how do investors calculate ROI, and is the internal rate of return on the rental property any different?
Let us find out. This article discusses the calculation of return on investment on rental property.
Why lending a purchased home for rent is a good idea?
While humans primarily buy a home for residential purposes, the idea of renting it out can help them generate passive income with little to no effort. The rental income is tuned to the current market conditions and usually follows an upward curve. It allows them to earn decent returns until they decide to sell it off.
In addition, if investors are investing in a rental property via a home loan, it minimizes the chances of financial stress and helps them earn valuable tax savings, too.
What is ROI on rental property?
Renting out property is an excellent investment option, allowing the owner to earn passive rental income. But they need a measure to know if they are making some money or ending up paying more than the inflow it achieves.
The best return on investment on rental property hovers between 3% and 4.6% in India. To understand what it means, the concept of return on investment needs to be understood.
ROI or return on investment refers to the profitability of a rental property in percentage terms. While some people follow cash on cash return, most look at ROI in net terms, i.e., how much returns rental property generates for the outflow required to maintain it.
What do investors need to calculate ROI on rental property?
If an investor has found the perfect property to invest in, they need to ensure they will make some money via it and not end up paying more in the form of expenses. So, for this, they will have to calculate the rate of return on investment in rental property, and here are the essential elements they will need -
Details of the property - ROI calculation requires details, such as the property’s value, area in square feet, repair cost incurred, and the number of rooms.
Rental expenses details - This includes outflow as to maintenance, repairs, utilities, and other monthly costs incurred by the owner.
Loan details - This includes the loan term, interest rate, closings costs, and premium payments.
Annual rental income - Calculate the yearly rental generated by the property after considering the possible vacancy.
An illustration to explain how to calculate real return from the rented property
Here is an ROI analysis illustration that would help understand the real returns generated from rented house property -
For example, Mr. X has let out a property worth Rs INR 1 crore for receiving rental income. He rents it out at a monthly rent of INR 30,000. Assuming he paid INR 40,000 annually, calculate his annual return from the rental property.
Particulars
Amount (in lakhs)
Gross annual rental (0.30*12)
3.60
Less: Property Tax
0.40
Net Rental Income (a-b)
3.20
Cost of the house
100
Rate of Return (c/d*100)
3.20%
Income tax on rental income after assuming 39% income tax and allowing a 30% standard deduction
0.87
Real Rate of Return (c-f)/d*100
2.33%
From the above example, Mr. X’s cash flow from the property is INR 3.60 lakh annually, but his gross return is only 3.20%. If tax outflow is considered, the real return comes down to 2.33% annually.
Ways to calculate the ROI
Now that how to calculate the real return on a rental property has been discussed, the next section introduces different ways in which investors can calculate the ROI of a let-out home -
Net Operating Income
The net operating income (NOI) represents the net profitability of the investment. It takes into account their operating expenses deducted from the gross rental income to calculate net operating income.
Cash-on-cash Return
Cash-on-cash return represents the cash ROI, i.e., the monetary return they expect from letting out a property on rent. To calculate it, divide the pre-tax annual cash flow by the amount of cash paid for buying the property.
Cap Rate
The most commonly used method to calculate the ROI of a rental property is Cap Rate. For this, divide the net operating income by the cost of the property. It helps compare this investment to other investment opportunities available.
Annual Cash Flow
Annual cash flow refers to the amount that remains after deducting interest on the debt from the net operating income from the rental property. It considers all the expenses and loan payments to help understand annual returns from the property.
Annual Gross Rent Multiplier
It represents the current ROI a rental property is generating. To calculate this, divide the total sales price by the gross annual rent generated by the property.
What is a good return on investment for a property?
In most parts of the world, the best return on investment on rental property hovers around 10% annually. However, in reality, anything between 5% and 10% is acceptable as most people perceive it to be passive income.
Unfortunately, rental yields are one of the lowest in India. As mentioned above, it hovers between 3% and 4.6% in most parts of the country. One of the major reasons why the yield is lower than the global average is because the country has not experienced a proportional increase in rent compared to property prices.
Another reason behind India’s low rental ROI is job mobility. Unlike in most parts of the world, where people prefer moving across the country to secure better job opportunities, people are content here and prefer to stay longer in the same city.
However, with more and more people willing to rent rather than own a property, the ROI can flourish in the next few years. So, owners shall make smart choices to maximize their property’s rental potential.
Wrapping up
Historically, rental ROI has not yielded the most terrific results in the Indian landscape. GenZ’s changing approach towards housing, however, makes for exciting times ahead and a chance for this market to explode and generate better returns.
So, if an investor is looking to jump the gun and make fresh investments in this ecosystem, the time is ripe, but they must get into the details instead of making hasty decisions. With real estate not coming cheap, one wrong move and they can see a significant dent in their cash flow. Investors would be glad to know that Tata Capital offers home loans of up to INR 5 crores at a special interest rate to its customers. So, if they want to build a passive rental income, getting a home loan from Tata Capital can be a key driver in making their dream a reality. Click here to explore Tata Capital’s Home Loan options.
08 February 2024
7 mins read
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