If you’re new to real estate investing, understanding rental yield is key.
What is it and what makes it one of the most important elements for rental property investment success? It’s basically an important measurement for the kind of return on investment (ROI) you can expect on a rental property. A good rental yield could be a sign of a good return, but of course, there are more details involved. We’ll cover everything below.
Investing in rental properties is a great new venture for many people who’ve never considered real estate investing before. It’s a great way to diversify your investments while also realizing stable and positive cash flow for the long-term.
However, finding and maintaining a profitable income property won’t be easy if you don’t know how to actually evaluate its profitability. Rental property with a good rental yield is a good place to start.
There are two forms of rental yield: gross rental yield and net rental yield. Gross rental yield is a simpler metric that doesn’t take the property’s expenses into account, while net rental yield does. Net rental yield is usually a better metric to look at because expenses don’t always scale linearly with income, meaning that as you earn one dollar in income, the expenses associated with that income are not always the same for different properties.
Gross Rental Yield
Gross rental yield for your rental property is its annual rental income divided by your property’s value/price (multiplied by 100 to get the percentage). The property’s price is comprised of the purchase price, all closing costs, and any renovation costs.
If your rental property has a value of PHP 300,000 and rents for PHP 1,000 a month, the gross rental yield is:
Annual Rental Income: (PHP 1,000 x 12)= PHP 12,000
Gross Rental Yield: PHP 12,000/PHP 300,000= 0.04 x 100= 4%
Gross rental yield isn’t the most accurate measurement of an investment’s return because it’s missing a key part of the workings of a rental property- the expenses.
Net Rental Yield
A more valuable number, the net rental yield, also known as the capitalization rate (cap rate), includes the operating expenses for the property. Evaluating what is a good rental yield is more reliable using the “net” calculation because it takes into account key expenses which can cut into profits. These include legal fees, loan fees, building inspections, repairs and maintenance, management fees, vacancy costs, insurance costs, and other rates and charges.
It can be calculated by subtracting annual expenses from the annual rent, then dividing that number by the property’s value and multiplying the final number by 100 for the percentage.
Continuing with the same example, let’s now include your rental property’s total expenses for the year (PHP 3,000) and a vacancy rate of 20%. Net rental yield is:
PHP 12,000 * (1- 0.20) - PHP 3,000= PHP 9,600/PHP 300,000= 0.03 x 100= 3.2%
What Is a Good Rental Yield?
Since there is no definite ‘good yield’ percentage, it all comes down to each property’s various features. It’s easy to assume that a higher rental yield means a higher return or a greater property value, but this may not always be the case.
Typically, a property with a high rental yield implies that it is undervalued or below market value. This is usually considered to be between 8-10%. While a property with a low rental yield, which is anywhere between 2-4%, can mean that it is overvalued.
As an investor, high rental yields are better because they usually generate a steady cash flow. Investors generally aim for properties with a rental yield above 5.5% because of the stability in rental income. For potential home owners, looking at median rental yields across the country can help to determine what your interests and ideal outcomes might be.
Understanding what rental yield is and how it is calculated can help to determine your potential profits and losses on a property you already own or on one you’re looking to invest in. Evaluating and comparing property values and their respective rental yields can be useful to invest your money wisely and realize your home owning dreams.