Total return is one of the most important metrics when evaluating potential property investments.
Total return measures the capital growth and rental income you will likely achieve from an investment property.
Calculating total return will help you compare different property opportunities and make better-informed investment decisions.
In this post, I’ll explain how to determine the total return on real estate investments.
Table of Contents
Why Total Return Matters in Property Investing
Total return combines two primary sources of gains from rental properties:
- Capital growth – The increase in the property’s value over time. It is the profit you make when selling the property.
- Rental yield – The rental income the property generates yearly as a percentage of the property value.
By looking at total return, you get a complete picture of the overall performance of a rental property investment.
High total returns mean you benefit from good capital growth and rental yields. The higher the total return, the better the investment property’s performance.
Let’s go through the formulas for calculating capital growth and rental yields. We’ll then combine them to determine the all-important total return metric.
Capital Growth Return Formula
Capital growth measures the increase in a property’s value over time. It represents the potential profit you will make when selling the investment property.
Strong capital growth is a key component of total return. The higher the annual capital growth, the better.
To calculate it:
Capital Growth % = Current Value of the Property – Original Purchase Price ÷ Original Purchase Price x 100
- Original Purchase Price: £300,000
- Current Market Value: £330,000
- Capital Growth % = £330,000 – $300,000 ÷ £300,000 x 100 = 10%
In this example, the property has appreciated by 10% annually.
When analysing potential deals, research historical price growth in the area.
While past performance doesn’t guarantee future results, it provides an expected benchmark.
Consistent capital growth year-over-year leads to significant gains when selling.
Even minor differences of 3-4% annually add up over time.
Rental Yield Return Formula
Rental yield is the annual rental income received as a percentage of the total property value. It helps investors estimate the yearly return from rents.
There are two main rental yield calculations:
- Gross rental yield – This only accounts for rental income and property value.
- Net rental yield – This factors in expenses like maintenance, insurance and voids.
The formula for gross rental yield is:
Gross Rental Yield % = Annual Rental Income ÷ Current Property Value x 100
- Annual Rental Income: £20,000
- Current Property Value: £300,000
- Gross Rental Yield % = £20,000 ÷ £300,000 x 100 = 6.67%
Net rental yield is calculated as:
Net Rental Yield % = Annual Rental Income – Expenses ÷ Current Property Value x 100
Let’s continue with an example of net rental yield calculation.
Using the same example property:
- Annual Rental Income: £20,000
- Annual Expenses: £5,000
- Current Property Value: £300,000
- Net Rental Yield % = £20,000 – £5,000 ÷ £300,000 x 100 = 5%
In this case, the net rental yield is 5% after accounting for £5,000 in annual expenses.
The gross rental yield will always be higher than the net rental yield.
Investors should look at the net rental yield to understand the actual rental income after expenses.
Putting It Together: Total Return Formula
Now that we have covered how to calculate both capital growth and rental yields, we can combine them to determine total return:
Total Return % = Capital Growth % + Net Rental Yield %
Using the examples above:
- Capital Growth: 20%
- Net Rental Yield: 5%
- Total Return = 20% + 5% = 25%
So, the total annual return on this hypothetical property is 25% per year.
A simple way to interpret total return is that for every £100 invested in the property, you would earn £25 in profit each year through capital appreciation and rental income.
Let’s look at what makes for a good total return and how to maximise your total investment returns.
What is a Good Total Return on Property?
What can be considered a good total return when looking at rental property investments?
It depends on factors like:
- Property type – Houses typically see lower returns of 8-12% than multifamily units, which average 15-20%.
- Location – Strong job and population growth areas have higher demand, leading to better returns.
- Strategy – Fix-and-flip projects get higher returns over shorter periods vs. long-term rentals.
As a general benchmark, a 15% or more return can be considered a good and profitable rental property investment.
Total returns under 10% start to become less attractive. Especially when accounting for expenses, taxes, and the relative illiquidity of real estate investing.
It’s essential to research average returns for properties in your target investment area.
Historic returns don’t guarantee future performance but provide a baseline for expectations.
How to Improve Total Return on Property
There are two main levers to increase total return on rental properties:
1. Boost Capital Growth
- Invest in up-and-coming urban areas poised for price growth: research population, jobs, and infrastructure trends.
- Buy discounted properties below market value with high upside potential through renovations or redevelopment.
- Add value through expansion or renovations. Permitted additions like an extra bedroom can significantly increase property prices.
2. Increase Rental Yields
- Negotiate discounted purchase prices to get positive leverage from the start.
- Keep expenses low through property management automation and DIY maintenance.
- Implement regular rent increases above inflation to improve yields incrementally.
Let’s continue looking at other vital considerations around total return.
Limitations of Total Return Formula
While total return is a valuable metric for property investment analysis, it does have some limitations to be aware of:
- Past performance may not predict future returns – Historic returns don’t guarantee future results as market conditions change over time.
- Short-term vs. long-term outlooks – Total return metrics can differ over 1-2 years vs. 5-10 years. Assess your investment time frame.
- Costs and taxes not accounted for – Initial purchase costs and capital gains taxes can significantly impact net profits.
- Liquidity not considered – Total return doesn’t factor in the tradeoff of liquidity you make with real estate vs. stocks.
- Risk not measured – Two properties could have the same return but different risk profiles based on factors like location and tenants.
So, while total return is helpful, it should be considered alongside qualitative factors like market conditions, costs, liquidity needs, and risk tolerance.
Total Return vs. Other Investment Metrics
In addition to total return, there are other key real estate investment metrics to look at:
- Cash-on-Cash Return – Annual cash flow compared to total cash invested. Measures immediate income returns.
- Equity Gains – The increase in net equity over time after accounting for debt paydown and appreciation.
- Cap Rate – Compares annual net income to property value. Similar to a stock’s P/E ratio.
Total return best captures overall profitability, combining income and appreciation. Other metrics provide additional angles to analyse potential rental properties.
Consider total return alongside 2-3 other key metrics in your investment analysis to make data-driven decisions.
Determining the total return is crucial for analysing deals and maximising profits before buying a property.
You can accurately estimate your potential gains by understanding how to calculate total return using capital growth, rental yields, and expenses.
Aim for at least 15% returns while being wary of properties under 10%. Research average returns in your market based on residential property type and location.
Keep in mind the limitations of total return.
While a helpful metric, you should consider qualitative factors like future market potential, costs, risk, and liquidity needs.
Use total return as part of your overall real estate investment analysis alongside other key metrics like cash-on-cash return, equity gains, and cap rate.
Thoroughly vetting properties using total return and other metrics will help you build a profitable rental portfolio.
If you invest wisely and manage properties efficiently, rental real estate can be an excellent way to generate passive income and long-term wealth.
Frequently Asked Questions
Q: What Is the Total Return on Real Estate Investments
A: Total return in real estate investments is a measure of the overall profitability of an investment property. It considers the capital appreciation (property value increase) and the rental income generated.
Q: How Is the Total Return Calculated?
A: Total return is calculated by adding the capital appreciation and the rental income and then expressing it as a percentage of the initial investment. The formula for calculating total return is Capital Appreciation + Rental Income ÷ Initial Investment x 100.
Q: What Is ROI (Return on Investment) In Property Investing?
A: ROI, or Return on Investment, is a measure of the profitability of an investment property. It represents the percentage return on the initial investment based on the net profit generated by the property.
Q: How Do You Calculate Rental Income for ROI Calculation?
A: To calculate the rental income for ROI calculation, you can take the annual rental income generated by the property and subtract any relevant expenses such as property management fees, maintenance costs, and voids.
Q: How Do You Calculate ROI?
A: ROI is calculated by dividing the net profit generated by the property by the initial investment and then expressing it as a percentage. The formula for calculating ROI is Net Profit ÷ Initial Investment x 100.
Q: What Is the Importance of ROI in Investment Property?
A: ROI is an essential metric for property investors as it helps them evaluate the profitability of a potential investment. It allows investors to compare different investment opportunities and make informed decisions about where to allocate their capital.
Q: Can You Calculate ROI on a Rental Property?
A: Yes, you can calculate the ROI on a rental property. The rental income generated by the property is considered part of the net profit in the ROI calculation.
Q: What Other Factors Should You Consider in Real Estate Investing Calculations?
A: Besides ROI, other factors you should consider in real estate investing calculations include mortgage payments, rate of return, potential appreciation in property value, and the overall investment strategy.
Q: What Is the Role of a Mortgage in Property Investing?
A: A mortgage is a loan taken out to finance the purchase of a property. It enables investors to leverage their capital and invest in properties they might not be able to afford outright. The mortgage payments need to be accounted for in the investment calculations.
Q: How Can Real Estate Investors Calculate the ROI of Their Investment?
A: Real estate investors can calculate the ROI on their investment by dividing the net profit (rental income minus expenses) by the initial investment and then expressing it as a percentage.