WHAT IS RENTAL YIELD

Article by Charlotte Cossar

Anyone considering buying an investment property will be interested in what return the property will give them – in other words, its yield.

Before seriously considering a property, most investors work out the yield on the property to see if it makes their shortlist.

Although some investors buy property for other reasons – landbanking, infrastructure potential or lifestyle reasons – most are only concerned with its current return and potential yield.

But before we break down how to calculate a property’s yield, let’s first explain the jargon that comes with it.

Investment terms explained

Yield

A yield is a measurement of future income on an investment. It is generally calculated annually as a percentage, based on the asset’s cost or market value. It has nothing to do with capital gain.

Gross yield

A gross yield is the income on an investment prior to expenses being deducted. For property, these expenses can be quite substantial, so there can be a huge difference between gross and net yield.

Net yield

A net yield is the income on an investment after expenses have been deducted. The costs and expenses will likely include purchasing and transactions costs, such as stamp duty, legal fees, pest and building inspections, loan start-up fees, advertising, and rent lost through vacancy.

There might also be repairs and maintenance costs, management fees, insurance, rates and charges. Most of the time, you won’t know the exact amount of these costs and will have to estimate them.

Return or total return

A return is the gain or loss made on an investment, over a specified period. It includes capital gains and is either expressed nominally, in dollars, or as a percentage derived from the ratio of profit to investment.

Unlike the property yield, the return is focused on the property’s past performance, rather than its future earning potential.

What is the difference between yield and return?

As explained in the definitions above, a yield is only based on rental income, whereas a return includes capital gains.

Both are generally used in the sales patter, but be sure to clarify the time periods associated with the statistics the agents provide – i.e. find out whether they are calculated on an annual basis – before determining whether the property’s a good investment.

Remember, too, that one is retrospective (return) and the other looks at the future (yield).

How do you calculate yield?

You calculate an investment property’s net yield in three steps. First, you deduct the property’s ongoing costs and costs of vacancy (i.e lost rent) from the property’s annual rental income (weekly rental x 51). Second, you divide the result of the first step by the property’s value. And then, finally, you multiply the result of the second step by 100.

This method gives you the property’s yield as an annual percentage.

Gross yield = annual rental income (weekly rental x 52) / property value x 100

Net yield = annual rental income (weekly rental x 52) – annual expenses and costs/ property value x 100

Case Study

For example, let’s say you buy a property for $450,000. You rent out the property for $375 a week, and have annual expenses totalling $2875 ($1,075 on lost rent and advertising, $600 on repairs and $1200 on insurance).

Your net yield would be = annual rent of $19,500 ($375 x 52) – annual expenses of $2875 / property value of $450,000 x 100 = 3.69%.

When you’re in the market for an investment property, you will notice agents dropping in comments on yields. What you have to be aware of is that most of them will be referring to the ‘gross’ yield and not the ‘net’ yield, as this provides a higher percentage.

So, be sure to ask which one they are quoting, before you decide to invest.

What should your yield be?

Choosing an investment property isn’t an exact science, and there isn’t an ideal property yield to strive for, either.

A high rental yield will be good for your cash flow, but it doesn’t necessarily indicate the property will offer you a strong capital return in the long run – that’s determined by a whole host of factors.

For example, a large two-bedroom unit in inner Melbourne might command the same rent as a two-bedroom house in the same suburb but cost several thousand dollars less to buy. The former would have a higher rental yield and therefore be better for your short-term cash flow, but the value of the latter could increase by much more over the long term and offer a higher capital gain.

So, rental yield is a helpful measure – and there are ways to improve it – but it shouldn’t be the only measure you use when trying to pick out an investment property.

Ultimately, you’ll need to think about your goals and your financial circumstances when trying to choose the best property to invest in.

What does a ‘hard’ or ‘soft’ yield mean?

Demand for property drives property prices up, and this can affect the yield of your investment property.

The more prices go up, the lower your rental income, as a percentage of the property value, becomes.

When you hear people talking about yields hardening, they mean that the yield is falling or reducing, as a result of property prices increasing; softening yields, meanwhile, means the yield is increasing.