Rental yield is the rate of rental income offset against the costs of an investment property. It is a very good indicator of a property’s investment potential; however, you need to keep some perspective when you factor it into your decision to purchase a property.
Calculating rental yield
When you examine the impact of rental yield on the investment potential of a property, it’s important to recognise that there are two types of rental yields – gross and net – and they are calculated differently.
Gross rental yield
In property, gross rental yield is calculated by dividing the annual rental income you receive by the property value, and then multiplying this figure by 100.
For example, if you collect $20,800 rent annually ($400 per week) and your property value is $450,000, it will look like this:
$20,800 (annual rent) / $450,000 (property value) = 0.0462
0.0462 x 100 = 4.622
The gross rental yield is expressed as 4.622 per cent.
Knowing a property’s gross rental yield is a quick way to make a rough comparison of how its rental returns fare compared with others in an area. Generally, the higher the rental yield percentage, the better, as it suggests a more efficient return on your investment, i.e., more bang for your buck. However, gross rental yield doesn’t give a full picture of the investment potential a property offers so it can be misleading.
Net rental yield
Net rental yield offers a more detailed picture of a property’s rental return because it factors in the costs and expenses incurred by the investor. Costs and expenses include stamp duty, legal costs, building inspections, and recurring expenses such as maintenance and repair work, council rates and loan interest repayments.
In the example above, if you deduct $5,000 for annual costs and expenses from the annual rental income, the net rental yield is just 3.5 per cent.
Obviously, the accuracy of the net rental yield depends on the accuracy of the assumptions you make about the cost of repairs, the property’s market value and the property’s occupancy rate. A building inspection might reveal dormant issues that will drastically increase future repairs and maintenance expenses. You should also factor in the effect of vacancy, as the example above assumes the property is always occupied.
Other factors to consider
Calculating rental yield should only be part of your evaluation of a property’s investment potential.
You should also examine market reports such as sales trends and vacancy rates in the area, determine the property’s potential for capital gain, understand the demographics of the area and your tenant target market, assess the condition and durability of the property’s features to determine ongoing maintenance costs, and research any future plans for development and infrastructure in the area.