Our investment basics series, looks into the practicalities and intricacies of making a property investment. In this article, we delve into rental yields and consider how indicative they can be of a property’s potential for investors.
Rental yields are often considered a prime indicator of a property’s potential as an investment. But just how much emphasis should you place on these figures?
What are yields?
When we talk about yields related to investment assets in general, this is the income an investment earns, disregarding capital gains, in the context of a certain time period. This figure is annualised on the basis that this income – usually in interest or dividend form – will continue to be received at the same rate. It’s a useful guide for investors who want to compare performance across different asset classes. It differs from returns in that these are what an investor has actually earned on an investment.
Rental yields express how much income a property is likely to generate in relation to the cost of the investment.
How do you calculate rental yields?
When it comes to property, rental yields are determined by calculating the annual rental income as a percentage of the purchase price. For example, if you paid USD200,000 for an apartment and you receive USD10,000 in annual rent, your gross (before taking any other costs into account) annual rental yield would be 5%. Rental yield expressed as a percentage is helpful as it means investors can easily compare properties of different values and rental returns with each other.
What can rental yield figures tell us?
Rental yields tell us the income a property generates as a percentage of its cost. High rental yields may suggest good investment potential as cost may be low while rental income is high. However, it is possible that yield is high because of falling property prices as opposed to rising rents. Lower yields might indicate potential rental growth in the future or strong capital growth, which could result in better overall return.
While rental yield figures help, it’s important to remember that rental income can fluctuate. Current or historical rental yields may not be accurate indicators for future performance, particularly in a market where, for example, property prices are increasing rapidly but rental rates are staying fairly level.
Rental yields often also use data that can be at least 12 months old so may not be an true reflection of current market value. It’s worth considering what has happened in an area or market over the last 12 months, or the period since data was last collected, and whether there is anything that could have seriously impacted rental or sales prices. It’s always prudent to research a market or area for yourself (see Overseas Real Estate Investment - A Buyer's Guide and How to Predict a Booming Property Market).
What needs to be considered when looking at rental yields?
Gross rental yields don’t take into account the various expenses and costs associated with purchasing and owning a property. Therefore a high rental yield may not be an accurate representation of actual yields. It’s often more useful for potential investors to calculate net yields when assessing their financial commitments and considering the sustainability of owning an investment property.
Net yield takes into account annual expenses such as management fees, council taxes, vacancy costs, maintenance and repairs, insurance, rates and charges. It also considers as part of the property price any transaction costs including stamp duty, legal fees, inspection fees, mortgage fees, and the cost of any renovations and furnishing required before the letting process can begin. Net yield is annual rental income minus annual expenses as a percentage of total property costs. If exact figures are not known, estimates can be substituted. Net rental yields will always help to paint a more accurate picture for an investor than gross rental yields.
Mortgage interest and tax on rental income are also costs that need to be considered. These will vary according to owner circumstances rather than being relative to the property but should be taken into account where possible as part of any financial assessment prior to a property investment commitment.
It’s a complicated and time-consuming process but it is always worth determining all of the potential financial and taxation implications of owning an investment property.
What is a good rental yield?
When it comes to gross rental yields, there is no such thing as a good rental yield as costs and expenses are missing from the calculation. While high rental yields may appear attractive and can indicate promise in an area, they can come at the cost of low capital growth and other risks. They are best used as a comparison tool across properties.
For net rental yields, higher yields are generally better but it’s very much dependent on an individual’s circumstances – what is good rental yield for one person, may not be enough for another. It’s also worth bearing in mind that with net rental yields, many of the figures will be estimates, some based on volatile factors that could change at any time and have a significant – and potentially detrimental impact – on final rental returns.
Overall, while rental yields are an important consideration, they are only an indicator and should be considered alongside a number of other factors. If you are interested in managing an investment portfolio that’s going to perform well, capital growth is a key factor to also consider alongside rental yields. We look at why both these factors should be considered in the next blog post in our Property Investment for Beginners series – check it out here.