Understanding Rental Yield: A Key Metric for Evaluating Investment Properties - 2023 Edition
In January 2022, we published a blog post explaining the concept of rental yield. However, we received feedback from consumers that the article lacked sufficient detail. As a result, we have created a more comprehensive version for this year. Our hope is that this updated version will provide you with all the necessary insights on the topic.
What is rental yield?
Rental yield is a financial metric that measures the amount of money you make on an investment property less the overall costs to maintain the property and loan. It is calculated using a formula and expressed as a percentage. There are two types of rental yield: gross and net.
Gross rental yield: is calculated by dividing the annual rental income by the property's value or purchase price. Calculating the gross rental yield can be helpful but it may not give you a completely accurate picture of your investment potential.
Net rental yield: This type of yield takes into account additional expenses such as property taxes, insurance, and maintenance costs. This is calculated by subtracting these expenses from the annual rental income and then dividing the result by the property's value or purchase price. Net rental yield will give you a much more accurate picture as it factors in total expenses as well.
Regardless of which calculation method you use, it’s important to understand rental yield as an investor to help give you a clear picture of your overall investment and how you can reach your total investment goals. It's also a good idea to conduct an annual review of your property or properties using these methods.
How to Calculate Rental Yield?
There are two (2) ways to calculate the rental yield, gross and net percentages.
The formula for the gross rental yield: Rental Yield = (Annual Rental Income / Property Value) x 100
This formula is a simple calculation based on the annual rental income and the property's value or purchase price. For example, if a property has an annual rental income of $23,400 and a value or purchase price of $600,000, the rental yield would be 3.9%.
The formula for net rental yield is slightly more complex as it includes total expenses to give you an indication of an accurate figure of the properties rental return:
( (Annual Rental Income - Annual Expenses) / Property Value ) x 100
Note: Annual expenses in the above formula for net rental yield can include property taxes, insurance and maintenance costs.
Why is rental yield important?
There are several reasons why rental yield is important to consider when evaluating or conducting a review of your investment properties.
- Rental yield provides an immediate return on investment: Rental yield calculates the annual return on investment based on the rental income generated by the property. This allows investors to quickly assess the profitability of a property and compare it to other investment options.
- Rental yield helps to evaluate the long-term potential of a property: Rental yield can provide insight into the long-term potential of a property investment. Properties with higher rental yields are generally considered to be more profitable in the long-term, as they generate more income and have the potential for appreciation in value.
- Rental yield helps to identify properties that may be overpriced: Properties with low rental yields may be overpriced, as the cost of the property is not justified by the rental income it generates. By considering rental yield, investors can avoid overpaying for a property and minimize the risk of loss.
- Rental yield helps to identify areas with high demand: Properties in areas with high demand and low vacancy rates will have higher rental yields, as landlords are able to charge higher rents. By identifying areas with high rental yields, investors can identify areas where there is strong demand for rental properties, which can be a good indicator of potential for future growth and appreciation in property values.
- Rental yield is a key indicator of cash flow: Rental yield gives an investor an idea of the cash flow generated by a property. This helps them understand how much they can expect to earn from the property and how much they need to pay in expenses. This gives them a better idea of the property's overall financial performance and how it can help them achieve their financial goals.
How does location impact rental yield?
Across the majors cities of Australia (i.e. Sydney, Melbourne, Perth, Brisbane etc.) there is usually a high demand for rental properties, consequently this could result in higher rent. However, due to the higher property prices in these areas, the rental yield will be lower. On the other hand, in regional and rural areas, there is often (although not always) less competition for rental properties, which allows rent to be lower. The lower property prices in these areas can equate to a higher rental yield.
The location can also impact rental yield, depending if the property is located in an area with good transportation, amenities, such as schools, shopping centers, and hospitals, and job opportunities. In these cases the demand is usually higher, therefore have higher rental yields.
What is a good rental yield in Australia?
A "good" rental yield can vary depending on the location and the type of property, as well as the current market conditions. However, in general, a rental yield of 5-6% is considered to be average in Australia, while a rental yield of 7% or higher is considered to be above average.
In Australia, rental yields tend to be higher in regional areas and lower in major cities like Sydney and Melbourne. For example, rental yields for houses in regional areas might be around 6-7%, while rental yields for units in major cities might be around 4-5%. It's also important to note that rental yields can vary depending on the state and the city in Australia. For example, rental yields are generally higher in areas with strong population growth, low unemployment and high demand for housing, like Queensland and Western Australia.
What are the key factors that affect rental yield?
Whilst there are some general rules that hold true about rental yields (i.e. rental yields tend to be higher in regional and rural areas where there is less competition for rental properties and lower in major cities where there is a higher demand for housing). There are also various factors that impact and affect what the rental yield might be. These include:
- Location: Properties in high-demand areas, such as major cities, will generally have lower rental yields than properties in less competitive markets, such as regional and rural areas.
- Property type: Houses typically have higher rental yields than apartments. This is because houses are in higher demand and can command higher rents.
- Economic conditions: A strong economy can lead to higher rental yields, as more people are able to afford to rent. Conversely, a weak economy can lead to lower rental yields, as fewer people are able to afford to rent.
- Interest rates: Higher interest rates can lead to lower rental yields, as they make it more expensive for landlords to borrow money to purchase properties.
- Maintenance and repair costs: Properties that require a lot of maintenance and repairs will generally have lower rental yields, as landlords will have to spend more money to keep the property in good condition.
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Other frequently asked questions:
Question: How to make sure you are getting a good rental yield while keeping the property well-maintained and tenant-friendly?
Answer:
- Research the market: Before purchasing a property, research the local rental market to understand the typical rental rates and yields in the area. This will help you set realistic rental rates and ensure that you are getting a good return on your investment. Location, Location,
- Location: Invest in a property in a desirable location, with good access to transportation, amenities and local services. This will make it easier to find and retain tenants.
- Keep your property in good condition: Regularly maintain and update your property to ensure that it is in good condition. This will help attract and retain tenants, and it will also help to increase the value of your property.
- Price it right: Set a competitive rental rate that is in line with the market. This will help attract tenants and ensure that you are getting a good rental yield.
- Provide amenities: Offer additional amenities such as air conditioning, on-site laundry facilities, or a backyard to attract tenants and increase your rental yield.
- Be a good landlord: Be responsive to your tenant's needs and requests, and address any issues that arise promptly. This will help to maintain good tenant relations, reduce turnover, and increase the likelihood that tenants will renew their lease. Keep an eye on your expenses:
- Keep an eye on your expenses: Such as property taxes, insurance, and maintenance costs, to ensure that you are not overspending and eating into your rental yield.
Question: How to use rental yield as a metric when evaluating property investments in a portfolio?
Answer: When rental yield is used as a metric in conjunction with other metrics, it can help to give a more complete picture of the investment opportunity. Here are a few ways to use rental yield when evaluating property investments in a portfolio:
- Compare the rental yield of the property you are considering with other investments, such as stocks or bonds, to determine if the return on investment is attractive.
- Compare the rental yield of the property with the average rental yield for similar properties in the area. This will give you an idea of how the property compares to the market.
- Compare the rental yield of the property with the purchase price. This will give you an idea of how long it will take to recoup your investment.
- Analyze the rental yield of the property over time to see how it has changed. This will give you an idea of how the property's income-generating potential has changed and how it might change in the future.
- Look at the net rental yield, which takes into account additional expenses such as property taxes, insurance, and maintenance costs, to get a more accurate picture of the property's profitability.
- Look at the location of the property and its proximity to amenities, public transportation, schools, and other factors that may affect the property's rental yield.
Question: How does rental yield compare to other investment metrics such as capital growth?
Answer: Rental yield and capital growth are two different investment metrics that are often used to evaluate property investments. Rental yield is a measure of the income-generating potential of a property, calculated as the annual rental income divided by the property's value or purchase price. It is expressed as a percentage and it represents the return on investment (ROI) for the property. A higher rental yield generally indicates a better investment opportunity, as it suggests that the property generates a relatively high income compared to its value.
Capital growth, on the other hand, is a measure of the increase in the value of a property over time. Capital growth can be calculated by comparing the current market value of a property to its purchase price. It is also expressed as a percentage and it represents the potential for appreciation of the property value. A higher capital growth generally indicates a better potential for long-term appreciation of the property value.
Both metrics are important to consider when evaluating property investments. Rental yield is more indicative of the short-term profitability of the property, while capital growth is more indicative of the long-term potential of the property.
Question: How does the state of the housing market impact rental yield?
Answer: When the housing market is strong and property values are increasing, rental yields tend to be lower. This is because property values are rising faster than rental income, which means that the proportion of the property's value represented by the rental income is decreasing. On the other hand, when the housing market is weak and property values are decreasing, rental yields tend to be higher. This is because property values are not rising as quickly as rental income, which means that the proportion of the property's value represented by the rental income is increasing. It's also worth noting that when the housing market is strong, the demand for rental properties is generally lower, as more people are able to buy their own homes. This can also lead to a decrease in rental yields. However, if the market is weak, people are not able to buy their own homes as easily, so rental demand tends to be higher. This can lead to an increase in rental yields.
Summary:
Rental yield is a financial metric that measures the return on investment (ROI) from renting out a property. It is calculated using a formula and expressed as a percentage. There are two types of rental yield: gross and net. Gross rental yield is calculated by dividing the annual rental income by the property's value or purchase price. Net rental yield takes into account additional expenses such as property taxes, insurance, and maintenance costs. This is calculated by subtracting these expenses from the annual rental income and then dividing the result by the property's value or purchase price.
Rental yield is important to consider when evaluating investment properties because it provides an immediate return on investment, helps to evaluate the long-term potential of a property, helps to identify properties that may be overpriced, and helps to identify areas with high demand. Properties with higher rental yields are generally considered to be more profitable in the long-term and can provide insight into the long-term potential of a property investment. Properties with low rental yields may be overpriced and investors can avoid overpaying by considering rental yield. Additionally, properties in areas with high demand and low vacancy rates will have higher rental yields, which can be a good indicator of potential for future growth and appreciation in property values.
The information in this blog article is current as of February 15, 2023 and is general in nature and should not be considered personal or financial advice. You should always seek professional advice or assistance before making any financial decisions.
