Understanding and Calculating Property Yield
Understanding ‘rental yield’ is important for any investor wanting to assess the potential income and cash flow of an investment property.
If you are considering buying an investment property, one of your main priorities will be working out what the potential cash flow the property will give you, i.e. its ‘rental yield’.
In a nutshell, rental yield is a measure of how much cash an income generating asset produces each year as a percentage of that asset’s value. When taken into account with other key factors, such as location, aspect and potential capital gain, calculating your rental yield can be a helpful tool in identifying properties with potential.
There are two types of yield – gross yield and net yield. Gross rental yield is the most commonly used and is calculated by using just the rental income and purchase price (or market value) of a property alone. It’s a quick and rough way of comparing properties with different values and rental returns.
In contrast, net rental yield requires you to research and estimate all of the costs and expenses associated with buying and maintaining the property, such as purchasing, transaction costs and ongoing fees but the outcome is a more accurate prediction of rental return.
Yield will initially be calculated on purchase price, then more than likely market value to reflect a more accurate yield as market values move over time.
Calculating Gross Yield
A property’s gross yield is the rental income communicated as a percentage of the property’s purchase price or value.
Gross yield can be calculated as follows:
Gross rental yield = Annual rental income (weekly rent x 52) / purchase price or market value x 100.
For example, a property purchased for $300,000, with a weekly rent of $300 (or, yearly rent of $15,600) has a gross yield of 5.2%.
$15,600 ($300 x 52) / $300,000 x 100 = 5.2%
To put it another way, the yearly rental income ($15,600) is 5.2% of $300,000.
Calculating Net Yield
The equation for net yield is essentially the same, but factors in all other costs (both upfront and ongoing).
- Purchase price (or market value)
- Stamp duty
- Building and pest report
- Legal costs
- Cost of getting the loan
- Renovations or repairs done to make it more rentable.
If you add up all of these costs you will come up with the total property cost.
Ongoing annual expenses:
- Interest repayments
- Strata levies (if applicable)
- Council rates
- Water rates
- Land tax (if applicable)
- Property management and rental listing expenses
- Repair and maintenance
- Loss of rent (in the case of vacancy periods)
The total of these costs will be your total annual expense. Then, apply it as follows:
[(Annual rental income – total annual expense)/ total property cost] x 100 = net rental yield
Essentially you are subtracting the total annual expense from the yearly rent. Then, you divide this net amount by the total cost of the property. Multiplying this figure by 100 will give you the percentage. For example:
A property has a purchase cost of $390,000 and a weekly rent of $500, however the overall cost of purchase was $430,000 and the annual expenses are $4,500. Therefore its current net rental yield would be 5%.
Important Questions to Ask
Ask the following questions to gain a more accurate indication of a property’s value:
- Is the yield gross or net?
- If the above answer is ‘gross’, what would the net yield be?
- Is the property located in a good growth area?
Benefits of Higher Net Yields
For those concerned about being out of pocket to pay a loan repayment due to the effect of interest rate rises and cash flow issues, higher yields will give you more peace of mind. In the end, paying off a mortgage using someone else’s money and some capital growth is always better than nothing.
Benefits of Lower Net Yields
Lower net yields will be suited to buyers who rely on capital growth to make their money. For example a $1,000,000 property with a $900,000 loan, $750/week rent and $800/week repayments results in a little over $2,000 per annum. Not terribly impressive. But when you look at the growth of the property at say 5% per annum, which is $50,000, suddenly $2,000 out of pocket hurts a lot less.
The higher yields are essentially properties assessed with lower market value, which is why they are so high in the first place.
How Can Yields Be Misleading?
Many properties will advertise high yields and not specify whether it’s net or gross. Always assume it’s gross. Typically net yields are from -6% to 6% less.
Commercial property exceeds this to be a net yield of 3%–10% in metro areas and 8%–12% in rural areas, due partly to the lessee paying many of the outgoings, such as electricity etc. However the market value of commercial property, more so than residential, can waver over time.
Additionally, with property that is not sold yet, these yields are calculated using today’s market value, which is fine if your settlement is 42 days (a standard term for a contract in NSW) however with off-the-plan (OTP) the yield is calculated at today’s market price but settles 12-24 months outside exchange. The moment a new large block of units has finally been settled and actually goes on the market to potential tenants there is suddenly a lot more supply than there is demand and the yield can change overnight. As an example, if all units are for rent at the same time, you only need one investor with a unit similar to yours to lower their weekly rent and then there’s pressure for you to do the same to stay competitive. The outcome is a very different yield figure to the one originally advertised.
Another place Cohen Handler often sees people fall short is with property in rural areas. Towns with one source of economy such as a mining town, have high yields for a reason – there is no market value or good growth behind the property you are purchasing. It could be an indicator that the property market is about to cycle back up, as higher yields sometimes indicate but cannot be looked at independently.
Don’t Get Caught Up on Yield Alone
It is important to remember that yield is only one part of finding a good foundation property. While a property may have an 8% yield, it may also be in a location where capital growth stagnates or even goes backwards over time. Some properties are advertised as ‘great investment opportunities’ because they are high yielding. Don’t get caught up on the yield alone.
You may find that a property with 8% gross yield comes with so many ongoing costs that the cash flow is barely neutral. You may also find that the property is located in a ‘dodgy’ area, where rental demand is driven by just one industry (yep, we’re talking about all those mining towns that went bust). On the flip side, a property might have a modest 3%–4% gross yield, but its holding costs are low and rental demand is strong which makes the net yield very attractive.
The best way to avoid making costly mistakes is to have the right team of experts to help you understand what type of property to focus on at each investment stage depending on whether it is cash flow or capital gains you are after.
Cohen Handler’s team of expert buyers agents are specialists in finding the right property for you at the right price. If you are interested in purchasing an investment property and would like to know more about rental yields, contact us now.