What is Rental Yield?
Purchasing an investment property might seem easier to understand than other types of investments, yet finding the right investment property can be overwhelming.
To help potential investors make more informed decisions, there are a number of metrics which can give the savvy buyer a more informed view of a property and it’s potential value. Knowing what to look for, what these metrics mean, and how they relate to your target property can help take the guesswork out of buying your investment property.
What is Rental Yield?
If you’ve been looking into property investment, chances are you’ve come across the term ‘rental yield’. As an investor it’s an important concept to understand in order to assess the potential income and cash flow of an investment property, and hence the inherent value of your investment.
The yield of an investment refers to the rate of income return, or how much cash an income generating asset can produce each year, as a percentage of the asset’s value. For real estate investments, yield is the rental income generated over the course of a year as a percentage of the properties value. It can be calculated either as a gross percentage before expenses are taken into account, or by deducting expenses to get the net rental yield.
By comparing the specific rental yield percentage of an investment property to both the suburb and surrounding areas, you can begin to build a picture of the value proposition of the property. But take care, because it’s important to understand that current or historical rental yields are not necessarily accurate indicators of future performance, especially in a heated property market where prices are soaring but rental prices are stagnant. However understanding the rental yield of a potential investment should form part of your property identification process.
Rental yield can be an extremely helpful tool in determining the potential value and return of an investment property, however the metric does have some limitations. Gross rental yield isn’t an accurate indicator of overall investment value, as costs and expenses are not factored into the equation; and net rental yield is often based on many assumptions and factors beyond your control, such as vacancy periods, mortgage interest rates and maintenance costs which can be highly volatile and impact the rental return significantly.
So while it’s important to take into account the rental yield, it should be used as an indicator only. When assessing an investment property, rental yield percentage should be used together with other key metrics and factors such as location, aspect and potential capital gain, when assessing the overall return and value of an investment property.
Calculating Gross Rental Yield
Gross rental yield = Annual rental income / property value x 100
- Annual rental income: Weekly rent x 52
- Property value: This can be either purchase or market value, depending on whether you are interested in current performance or predicting future yields.
A property that was purchased for $550,000 and has a weekly rental income of $500 would have a rental yield of 4.72%
Annual Rental Income: $500 x 52 = $26,000
Property Value: $550,000
Gross Rental Yield: $26,000 / $550,000 x 100 = 4.72%
Calculating Net Rental Yield
Net rental yield = [(annual rental income – annual expenses) / total property cost] x 100
Getting an accurate Net Rental Yield figure requires a deeper understanding of the property, it’s operating expenses and any foreseeable costs involved with the purchasing process. The accuracy of the data used in the calculations is extremely important. While it is possible to research and accurately asses the value of most of the standard property costs and expenses associated with a rental, some will need to be estimates. The below list of expenses included in each category is not exhaustive, and may change depending on your property and circumstances.
Continuing from the above example where the investment property was purchased for $550,000 and has a weekly rental income of $500, if the property has an overall purchase cost of $590,000 and the annual expenses are $4,500, the current net rental yield would be 3.64%. This is significantly lower than the gross rental yield of 4.72% and will greatly affect any assessment of value.
Annual Rental Income: 500 x 52 = $26,000
Property Value: $550,000
Property Costs: $40,000
Ongoing Expenses: $4,500
Net Rental Yield: [($26,000 – $4,500) / $590,000] x 100 = 3.64%
By adding more factors and metrics to your calculations, the accuracy of the net rental yield will improve and your overall value proposition will become clearer. The difficulty lies in accurately estimating ongoing expenses, however there are online tools and calculators which can help. Some of these tools may have a cost attached to their use, and hence will need to be added to the property cost calculations for complete accuracy.
What makes a ‘Good’ rental yield?
As with all investments, taking one specific metric as a basis for overall value will not give you an accurate assessment. Specifically, if you’re just looking at the gross retail yield of a property then there is no such thing as a ‘good’ yield percentage as expenses are not taken into account. A property with a low gross rental yield and low expenses could give you a higher rental return, than a property with a high gross rental yield percentage and higher expenses. However when examining net rental yield percentages it’s possible to get a more accurate picture of value.
Comparing specific properties to wider rental yield trends can give you insights into whether the yield is ‘good’, and hence the value of a property as an investment. If the net rental yield of a property is higher than the suburbs yearly average and close to the median price, then it’s safe to say that the property has a ‘good’ rental yield. Comparing suburb rental yields is a smart way to begin your investment property search, as it can narrow your focus and help to identify trends in the market over time – to inform your investment plans.
The type of property is also an important factor when comparing rental yields, as market forces like supply and demand can have different effects on each property type. In the below example, the 2015 yearly average rental yield for houses in the suburb of Toowong was 3.5% according to data released by realestate.com.au. Compare this to a 4.9% average yearly rental yield for units in the same suburb, and a clearer picture of the market for a specific suburb begins to emerge. It’s also possible to compare rental yields of similar properties by it’s features, like number of bedrooms, bathrooms and block size.
Disclaimer: The information in this article is of a general nature only and should not be relied upon as financial advice. You should seek professional advice for your particular circumstances before entering into any transaction.