Australian residential real estate market had a great run over the last 2 decades but has hit some splutter in the recent times. The strong price and rental growth in major capital cities (see our interest rate chart Australia) were driven by strong income growth, stable employment markets and 3 decades of uninterrupted economic growth.
The onset of the Covid has interrupted that record and introduced a higher level of economic and job uncertainty going forward.
Owning a rental property is one of the most popular ways of creating passive income and the yield on the property is the running income for the investment (similar to dividend investing).
The post below is focused on rental yield and income but that is not to say capital gains are not important. Capital gain plays just as an important role in the residential investment return in the long run however the gains from appreciation in value is only realised at time or exit / refinancing while the rental income is immediate.
What is Rental Yield
For the existing owners of investment property the property rental yield is often a quick shorthand on
1) the income stream of the property pre-finance costs and represent the income that the owner receives for the investment on an annualized basis.
2) representation of the value of the underlying investment property. From valuation perspective, it can also be used as a relative valuation tool in comparing it with other similar properties.
For example if two properties are mostly the same but one is offered at equivalent rental yield of 3% vs 3.5% on the other. Then the lower rental yield property can be considered overvalued in direct comparison.
Different Property Yields
There multiple ways of looking at investment property rental yields.
Gross Rental Yield is when you are looking at the headline yield of the investment property and simply what is the total rent achievable over the value of the asset. This is a shorthand and often quoted yield because costs of running the property are varies and people prefer a like for like comparison.
By rule of thumb the gross average rental yield of apartments is higher than houses. This could overstate the actual income return of the investment once all of the costs have been taken in to account.
Net Rental Yield is the Gross Rental Yield minus all of the unavoidable costs of owning the property. This is the true yield of the asset before take into consideration of finance structure. The Net Rental Yield provides a good like for like comparison metric in deciding whether a particular investment property is worth it.
Equity Yield is the yield of the property after paying interest expenses and is the true yield the investor receive from owning the asset based on their capital contribution.
Rental Yield Calculator – What goes into calculate investment property yield?
The net rental yield can be broken down into mainly 3 factors.
- Income (Rent)
- Property Operating Costs
- Investment Property Value
We have created a simple calculator which captures most of the major costs of owning an investment property as well as the outline in detail what goes into each revenue and cost line.
Investment Property Value – This is either the purchase price or the latest valuation / investor view on what the property is worth. The property value forms the basis or the denominator for the rental yield calculation.
The numerator or topline is the Net Rental Income which is made up of the difference between the gross rent and total expenses of running the investment property.
Property Income
Weekly Rent – This is the rental income of the property on a weekly basis.
Annual Gross Rent – 52 times the weekly rent which forms the Annual Gross Rent
Once the Annual Gross Rent is established the Gross Rental Yield is calculated as a reference.
Property Expenses
These are the major costs of operating an investment property. Whilst the list not comprehensive it does capture the larger items.
Property Management Costs – People often ask how much should I pay for property management? At first look we think that depends on if you want to self manage or hire an external agent.
We seen agents charge from 5% to 8% plus GST as standard. It is important to be aware of those agents that are quoting low rates such as 3% as this while looks good in the short run could indicate that there is not alot of effort will be put into the management of the property.
For most people the investment property usually is their largest investment and I suggest this is an area you don’t want to skimp on.
Other Property Management Fees – For some agents they would charge invoice or leasing fees / advertisement at the start when they find a tenant or on renewals.
Strata Fees – This is relevant for apartment owners where quarterly strata fees are payable. The quarterly strata fees can be split between the administration fund which pays for the day to day operation of the property and sinking fund which builds a capital reserve for bigger once in a decade projects like upgrading lifts, painting the building or refurbishing the foyer areas.
Council Rates and Land Tax – Council rates and land tax are payable quarterly and should be included here
Maintenance and Repairs – Things will always break and it is good to allow incase of emergency as well as standard touch ups on the wear and tear.
Insurance – In apartment buildings, the whole building is insured under the strata plan but it is up to the individual landlord to have landlord and rental insurance to protect from damages from the tenant or default
Smoke Alarm Testing – There is statutory requirement where the smoke alarm is required to be tested annually.
The Total Property Expenses line is the aggregate of the above individual cost lines.
Net Rental Income is calculated from Revenues minus the Expenses
The calculation of Net Rental Yield is simply Net Rental Income over the Property Value.
Property Yield Calculator
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Positive and Negative Gearing
We covered positive gearing and negative gearing in detail here but the simple idea is that if the yield of property is higher than cost of debt, it is known as positively geared and vice versa when the yield of the property is lower than the cost of borrowing, it is called negative gearing.
What is investment property landlord’s rental yield?
The above example does not take into account how the investment is structured i.e how much borrowing is used to finance the deal.
If we split the cost of the investment between equity and debt we can determine what is the yield on our at risk capital in the deal.
Rental Yield After Interest
The equity yield is the rental yield of the property after paying interest costs. The equity yield represent the true income yield for the investment before capital gains.
Interest cost – It is useful to separate cost interest cost from operating expenses in calculate rental yield as the total level of borrowing is within the control of the investor while the operating expenses are usually fixed.
Loan to value – The value of the property does not change based on how much borrowing you use. 80% LTV assumption is based on how much bank is typically willing to finance a deal before mortgage insurance.
Also we have excluded major capital expenditures. Investors should create a regular sinking fund to carry out major repairs so unexpected breakdowns can be fixed. After all, a property cannot be rented if it is not safe to live in.
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Beware of high yield real estate
Real estate is one of few asset classes where buyers can be driven by non economic factors such as cultural affinity for particular areas, a premium to pay for close proximity to key transport hubs or good school zones. While these points should be a factor in setting the price.
Some see housing as a necessity and not as an investment and will make the final decision based on emotions. This means that prices in an area could be set by factors other than the underlying income of the asset. Other sellers will take note and will not sell less than comparable transactions which means buyers either have to meet the market or move on.
A positive cash flow residential property after debt cost can be considered rare in the best areas. We are always biased towards cash flow positive investments. A negative cash flow investment means that we have a cost just in holding the investment and ultimately our returns is dependent on the price someone else is willing to pay at the time of sale.
Investors from recent experience in the search for yield have gravitated to weaker socio economic areas or mining towns in buying investment properties that provides a high yield. These areas provides a high yield for a reason which reflect the risk profile of the area. The initial cash income upfront provides a nice mental boost but it could be wiped out by the potential capital losses in commodity downturns or as the area turns worse.
As with anything in investment, there is no such thing as a free lunch. Assets prices are where they are for a reason, either a rational or a irrational reason. While there might be bargains to be had, we encourage everyone to do detailed research and see what is primary factor that leads to the yield to be higher than other areas.
By examining how the property value in the area performed in the last downturn is crucial to get an understanding of the potential future volatility in residential real estate investing.