The Smart Investor's Guide to Calculating Investment Property Profitability | Labrosse Real Estate Group (2024)

• September 17, 2023
• Nick Labrosse

Do you know that real estate investments, particularly rental properties, are the safest and long-term investment sources? The investors owning a rental property can generate a good cash flow, increase their wealth and achieve long-term benefits.

This article will discuss the important steps of calculating the rental property profitability, particularly for the people who invest in the real estate market of Ottawa. These tips are for newbies as well as seasoned investors.

The term investment property profitability refers to estimating the profitability of a rental property over a certain time period. If you want to find out the profit generated by an investment property, you have to find out the income generated by that property in relation to the expenses incurred for its maintenance.

Estimating the profitability of a rental property really helps investors. They can easily determine the worth of a property and whether a property can generate positive cash flow and a desirable return on investment (ROI) or not.

Rental properties can be a great way to make passive income, but it’s important to know how much profit you should be expecting from your investment. Evaluation of profitability helps investors in decision-making and managing all kinds of risks. It also helps them set long-term financial goals and rental property mortgages.

This section lists some of the benefits of evaluating the profitability of an investment property:

Real estate investment always involves lots of risks. These include fluctuations in the property purchase price, vacancies and repairs.

The evaluation of the investment property profitability has advantages as the investors can always identify the risks of renting the property in the very beginning and can devise strategies to eliminate all such risks. They can also find ways to avail tax benefits.

The evaluation of the ROI calculation is also very important for the management of the cash flow. The investors can also have a positive cash flow if the amount of rental income is more than the amount of expenses on the property.

A positive cash flow shows a good return on a rental property. The investors gain financial stability and sustainability with the help of positive cash flow.

The real estate market always fluctuates with the changing market trends. These fluctuations impact the supply and demand of rental properties.

If the investors keep themselves updated with these changing market trends, they can make timely decisions to increase the profitability of their investments.

Investors must always keep various factors in mind while they make decisions regarding investment. These factors include changing market trends, investor goals and property appreciation. For accurate and personalized analysis of the investment property profitability, it is always advisable to consult real estate professionals and financial advisors.

Here is a step-by-step guide on how to calculate ROI for rental property:

The NOI is the difference between the total annual operating expenses and the annual rental income. The investor has to subtract the operating expenses from the potential rental income.

NOI = Potential Rental Income – Operating Expenses

The fourth step is to get the capitalization rate or Cap rate. This key calculation actually determines the return on investment or ROI on rental properties. The investor can get the Cap rate by dividing the NOI by the current price or market value of the property.

Cap Rate = NOI / Property Value

Step 5: An Estimation of Cash on Cash Return

The investor needs to estimate cash on cash return at the fifth step. The investor can get the cash on cash return by dividing the annual net operating income by the total cash investment.

Cash on Cash Return = (NOI – Mortgage Payment) / Total Cash Investment

There are specific tools and software that assist in the profitability calculation. However, these tools do not eliminate the need for extensive research on the local market.

Each property is unique and requires a different combination of tools and techniques for profitability calculation. Here is a list of certain tools and techniques for the calculation of investment property profitability:

In the real estate market, there are multiple software which are specifically designed for investors. These software automatically perform all kinds of mathematical calculations, such as calculating expenses, taxes and market data.

Some examples of these software are RealData, BiggerPockets’ calculators, and DealCheck.

Local realtors and property managers can help in gathering data from the local real estate market. The local market reports provide all the details regarding rental rates, property values and market trends. The comparative market analysis also proves to be very beneficial as the investors can get an insight into the recent market sales, the potential rental income and the investment property profitability.

The real estate investment groups and educational resources also help in the calculation of investment property profitability.

The investors must adopt a very careful approach, conduct thorough research, and always take guidance from experienced professionals for the calculation of profitability.

If the investors are keen on achieving all the desired investment goals, they must also use a combination of different tools and techniques. Here is a list of some common errors in the calculation of profitability and how should the investors avoid them:

Investors sometimes underestimate the expenses. They are unable to calculate all the potential expenses, which include repair costs, maintenance costs, and the management fees of the property. It is very important to never underestimate the expenses. Otherwise, it disturbs all the profit projections.

How to avoid it:

Conduct thorough research about all the expenses of the property. You must always keep a margin for all kinds of unexpected costs.

The overestimated unrealistic rental income can result in an inaccurate profitability calculation.

How to avoid it:

This error can only be avoided if you do sound research on the market trends and rental rates of the local market. In this way, you can accurately assess the market value of your own property.

The condition of your property can play a critical role in determining the profitability of your property. If your property has been well-maintained, it might result in lower maintenance costs and higher profits. On the other hand, if your property hasn’t been well-maintained, it might result in lesser profitability. Investors often ignore this important factor and miscalculate the value of a property.

How to avoid it:

Always hire people for professional inspections so that you can get an accurate estimate of the due repairs and maintenance costs.

Sometimes investors misjudge the market trends. As a result, they are unable to put up the appropriate rental demand.

How to avoid it:

Investors must always keep themselves updated with recent market trends.

Investors can have incorrect assessments of the profitability of a property if they use incorrect formulas to calculate the Cap Rate, Cash on Cash Return etc.

How to avoid it:

It is always advisable that the investors must double-check the calculations and formulas.

• Single-family rental property.
• The location of this one rental property is a suburban neighbourhood in Ottawa.
• The purchasing price of the property is $300,000.
• The 20% down payment on the property is $60,000
• The annual property tax amount is $3000.
• The annual insurance amount is $8000.
• The property management fee is 10% of the rental income.
• The estimated repair and maintenance cost is around $1500 per year.
• The monthly rent of the property is $2000.

• The operating expenses are the sum of property taxes, insurance, property management fees, and the management and repair costs.

• Operating Expenses = Property Taxes + Insurance + Property Management Fee + Repairs/Maintenance

• Operating Expenses = $3,000 + $800 + ($2,000 * 12 * 0.10) + $1,500 = $8,800 per year

• The potential rental income is actually the monthly rent of the property for a year. The investors can calculate rental income by using the following formula:

• The net operating expenses are the difference between the potential rental income and the operating expenses.

  NOI = Potential Rental Income – Operating Expenses

  NOI = $24,000 – $8,800 = $15,200 per year

• Cap Rate = NOI / Property Value

  Cap Rate = $15,200 / $300,000 = 0.0507 or 5.07%

• The estimated monthly mortgage payment = $240 (Principal & Interest)
• The annual mortgage payment = monthly mortgage payment × 12 = $240×12 = $2,880
• Cash on Cash Return = (NOI – annual mortgage payment) / down payment
• Cash on Cash Return = ($15,200 – $2,880) / $60,000 = 0.204 or 20.4%

This single-family rental property can make a profit as it generates a positive cash flow, has a Cap Rate of 5.07%, and a Cash on Cash return of 20.4%.

In real estate businesses, it is very important to calculate the profitability of an investment property. The investors just need to follow the above-mentioned steps for the calculation of profitability. These include steps like the calculation of the operating expense and potential rental income etc. Investors can achieve their financial goals if they make good and informed decisions.

Are you ready to find the profitability of your investment property? You can always try the free rental property calculator by Labrosse Real Estate and make informed decisions. Just visit https://www.labrosserealestate.com/ultimate-canadian-rental-property-calculator/. All you need to do is enter all the relevant details and increase your return on investment measures.