Knowing the average return for residential real estate is critical for potential real estate investors. It's a key factor in deciding on what is and isn't a worthwhile property to look into. We've researched investment returns for real estate and provided all the details you'll need to start your investment.
For residential real estate, specifically, the average annual return is 10.6%.
Continue reading to gain more clarity of what makes a reasonable return rate.
Calculating Real Estate Return on Investment
To understand what would be a good return, first, you must have an idea of what the S&P 500 index is, also known as just the S&P. The S&P is a stock market index that evaluates the stocks of 500 big-name companies in the United States. Over the last 20 years, the S&P index shows the average rate of return on investment (ROI) is roughly 8.6%.
To conclude whether you're reaching a profitable ROI, you'll want to keep this equation in your memory.
Return on Investment = [(Annual Rental Income - Annual Rental Expenses) / Property Price] x 100%
For example, let's pretend you have a property worth $250,000. It brings in $2,000 a month in income, and monthly expenses are $1,400 a month. That means you bring in $24,000 in income yearly while paying $16,800 in yearly expenses.
Now, we'll plug in those numbers into the ROI formula:
ROI = [(24000-16800)/250,000] x 100
The annual ROI in this example would be 2.88%. Considering that the average ROI for real estate is 10.6%, this would be a poor return rate. Your return rate would be considered average if it falls between 4% to 10%.
What is a Reasonable Rate of Return on Real Estate?
Numerous investors will give you different answers to this question. That's because multiple factors go into this answer. For example, if the property is in a safe area, a lower ROI may be acceptable. A high-risk property will need a high ROI to be considered reasonable.
You can use real estate websites like Zillow to view average rental rates in a particular area; this will help give you an idea of that real estate market.
Another formula used to calculate the return on real estate is the capitalization rate. The formula works like this:
Cap rate = (Net Operating Income / Price of the property) x 100
- Net Operating Income = Real estate revenue - operating expenses
Let's say a $400,000 property brings in $42,000 a year and costs $13,200 a year.
Cap rate = [($42,000-$13,200)/$400,000] x 100=7.2%
The ROI in this example is a fair rate. Most investors agree that a cap rate above 8% is good. So a cap rate within 6-8% is a reasonable return rate.
If you manage a rate above 10%, you're doing excellent. If you're doing below 6%, you may want to look into other locations or properties to invest in. Just make sure you have permission from your mortgage lender to rent out your next property. Failing to do so may bring you many legal issues.
What is the 2% Rule in Real Estate?
The 2% rule isn't exactly a rule; it's more so a guideline that real estate investors suggest you use when investing in a property. The rule indicates that if a property brings in money equal to or greater than 2% of the purchase price, it's considered a good investment.
To calculate this rule:
(Purchase Price + Repair Costs) x 0.02
The result is the minimum price you should charge for rent. This rule will help you see if you can meet your investment goals at this rent price.
It's a good strategy to use at the beginning of the search process. Although, many more factors go into an investment decision that the 2% rule can't account for.
For starters, this is only a calculus that helps determine the possible cash flow. It doesn't consider factors such as the mortgage, acquisition fees, costs of repair and maintenance, and many others.
Additionally, it doesn't factor in the market. In some housing markets, meeting the 2% rule may not mean the property is in a safe location or good condition. Properties in Atlanta, for example, that meet the 2% rule, may still be questionable to investments. If you're looking in a nice, safe area and come across a property that meets the 2% rule, you should look into it.
In short: it's a good metric to calculate possible revenue, but it shouldn't be the only determinant in the investment decision.
What is the 1% rule, and How is it Different?
The 1% rule is essentially the same concept; purchase cost multiplied by 1%. This rule is somewhat better to follow at the very beginning. Because with the 1% rule, the number you calculate is the amount of rent you would charge to at least break even.
You also will want to have your monthly mortgage payments be less than 1% of the property purchase price.
Both rules will help you evaluate a property income potential. However, this rule shouldn't be used in markets where properties are cheaper (in price and quality). The 1% and 2% rule should primarily be a screening process; if a property meets the 1% rule (external factors ignored), then evaluate it with the 2% rule.
Is Residential Real Estate a Good Investment?
Residential real estate is usually an excellent investment choice. It's especially a great option to diversify your investment portfolio beyond just solely stocks, which leads to lower portfolio volatility. Other options to diversify your portfolio hasn't yielded phenomenal results. For example, a certificate of deposit doesn't have high returns; bonds have had low-interest rates for a few years.
The reason why we say it's "usually" an excellent choice is because of the ever-changing economy. It's not simple to predict whether we'll enter a bearish or a bullish market. That means the costs of real estate can go up or down at any given point. Pay attention to the housing market; a recession will not be kind to your ROI.
Don't let that fact steer you away from investing in real estate, however. One key benefit of making this investment is the control you have. You don't have much control over the ROI from stocks and bonds; it strictly depends on the economy. With real estate, you can personally take steps to increase a property's value, also known as house flipping. Doing so may increase your ROI.
Some added benefits of real estate investing include inflation, tangibility, and tax advantages. Rising inflation negatively impacts stocks and bonds, according to Forbes. With housing, inflation can help the residential property's value. The tax advantages you can gain from real estate include mortgage interest, depreciation, and property tax.
One great advantage to making this investment is that you're investing in a tangible asset. This means that you won't lose the full value as you would with some other investments. You can use that fact to your advantage. The equity you build over time can be used to invest in more houses.
Investing in a residential property can be a profitable journey, but it isn't an easy one. It takes time, research, and multiple calculations. It also may require many upfront payments, but you'll reap much larger rewards if you're smart about your investment.
Before deciding on a property to invest in, remember these rules:
- Evaluate the market: make sure you're not investing in a questionable area or property
- Use the 1% and 2% rules: you'll want to ensure you're happy with the numbers you calculated before proceeding
- Shoot for at least 8% return: of course, the higher return, the better but this should be your minimum
- Renovate for more returns: the more improvements you make, the more the property is worth and the more you can charge for rent
If you've decided on a home but haven't acquired the funding yet, check out our post on making down payments for a second home.