The truth about rental yields

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Rental yield is one of the most quoted and often used indicators when assessing a property’s investment potential. However, there is more to the advertised number than meets the eye. Tony Winterbottom explains

The Holy Grail for property investors is a high yield dwelling in an area that promises large capital gains, a strong rental return and low management and maintenance costs. And a good many Australians have come close to achieving it. 

Prospective landlords in search of the Holy Grail often pin their hopes on advertised percentage yields, like the ones published in the back of this magazine. Those tables are a great place to start because they also set out price, rent and growth data, by suburb and property type, making it easy to compare market performance. 

Just remember, it’s usually the median (middle) figure quoted, not the average, and the data is historical – usually at least 12 months old – so it may not be reflective of current market value. For this reason, it’s a good idea to broaden your research and know how to make your own yield calculations. 

Yields calculations

Yield is a measure of how much cash an income generating asset produces each year as a percentage of that asset’s value. It’s calculated differently depending on the type of asset (i.e. property, shares, etc.) and is a useful measure for investors with a diversified portfolio to compare asset classes and their performance. 

For real estate, yield is the rental income as a percentage of the property’s value. It can be calculated as a gross percentage, before expenses are deducted, or as a net percentage, with expenses and purchasing or transaction costs accounted for. 

Gross rental yield is most commonly used as it allows you to easily compare properties with different values and rental returns. It can be expressed as a percentage of the property’s market value or purchase price, so make sure you’re comparing apples with apples. 

My preference is to use market rent and value as this will give you a measure of typical yields for the area and provide a better means of comparison. Purchase price can then be used to aid your negotiations (i.e. determine the gross rental return at different prices) or measure the impact on return if you’re willing to pay a slight premium. 

Calculating gross yield using market value

Gross rental yield = Annual rental income (weekly rental income x 52) / market value x 100 

I often seen gross yield calculations made using the current rent and original purchase price. These sorts of calculations can be misleading as they don’t take into account the time value of money or the change in value of the underlying asset. After all, a dollar today is not the same as a dollar yesterday. If you want to draw comparisons between historic versus current rental return, you’re better off making separate calculations. 

It’s also important to remember that a high gross rental yield is not the be all and end all. A property may have a high gross rental yield but the rental return may be low when expenses are accounted for. 

For these reasons, I think net yield is a better measure than gross yield when assessing returns. 

Calculating net yield

Net yield is particularly useful when determining your financial capability as it will give you a truer indication of whether you can afford to invest, what your financial position will be and whether your investment will be self-sustaining. 

To calculate net yield, you’ll need to know or estimate: 

Annual expenses: managing agent fees, vacancy costs (lost rent and advertising), repairs and maintenance, insurance(s), strata levies (if applicable), rates and charges, etc. 

Total property costs: purchase price plus transaction costs (e.g. stamp duty, legal fees, pest and building inspections, loan set up fees, etc.) and the cost of any renovations or furnishings needed before tenants can move in. 

Here’s how to calculate net yield:

Net yield = (Annual rental income – Annual expenses) / (Total property costs) x 100 

You’ll note that I haven’t included mortgage interest or tax in the above example. This is because these vary depending on the circumstances of the owner and aren’t directly related to the property itself. They should of course be included in any return on investment calculations. 

Calculating yield and determining the financial and taxation implications of owning an investment property can be complicated so don’t take chances. Run your own numbers, then seek professional financial, taxation and legal advice, and always make sure you’re comparing apples with apples. 

Tony Winterbottom is a general manager of Defence Housing Australia.

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.

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