Rental property investing dangles the carrot of juicy returns in front of your eyes, but only the savviest investors will actually cash in. The rental yield calculation separates the winners from the losers — this metric indicates a property's true income potential versus its sticker price.
If the numbers don't pencil out based on the rental yield, you're likely staring at a dud investment that will leave your pockets empty. This is the hard truth that smart investors embrace upfront before pulling the trigger.
This article covers the concept of rental yield, providing you with the knowledge to evaluate opportunities objectively. You'll learn how to calculate both gross and net rental yields, complete with examples to strengthen your understanding.
We'll also cover other real estate analysis metrics so you can assess properties from multiple angles and avoid potential pitfalls. For real estate investors, this guide is your pathway to maximizing returns and building a profitable portfolio.
Understanding rental yield
Rental yield measures a property's ability to generate income relative to its value or price. This metric helps determine rental properties' profitability and return on investment.
Real estate investors commonly use rental yield in a few key ways:
- Assessing a specific property's income potential by calculating the expected rental income as a percentage of the purchase price or current market value.
- Comparing different investment opportunities across multiple rental properties by analyzing the respective rental yields.
- Making buy/hold/sell decisions based on whether a property's rental yield meets target return criteria.
The contributing rental yield factors
To calculate rental yield, you'll need three key pieces of information about the investment property:
1. Annual rental income
Gather the total income generated from the property through rent over one year. You calculate it by summing up the rent payments received from tenants.
You can find this information in the cash flow statement, which also tracks other income sources like paid utilities, pet fees, parking fees, etc. that should be included in the annual rental income figure.
2. Purchase price or current value
This is the amount paid for the investment property at the time of purchase. If you already own the investment property, you can get a valuation estimate by checking recent comparable sales in the area, hiring a professional appraiser, or using online tools.
3. Operating costs
These include all expenses related to the management, maintenance, and operation of the property. Operating costs come in the form of property taxes, insurance, repairs, and management fees, just to name a few. You can find these numbers in your income and expense tracking software or get them from the real estate agent if you're purchasing a property.
Calculating gross rental yield
Calculating gross rental yield provides a high-level look at a property's income potential relative to its market value or purchase price. This metric considers only the annual rental income and property value without factoring in operating expenses.
Of course, operating expenses can significantly impact the actual returns. But, if you need to assess a property quickly, you can calculate gross rental yield as an initial filter.
Let's use the following example. Suppose you purchase a property for $200,000 and rent it out for $1,500 per month. To find the gross rental yield:
- Calculate the annual rental income:
Multiply the monthly rent by 12.
$1,500 x 12 = $18,000 per year - Calculate the gross rental yield:
Divide the annual rental income by the property purchase price, then multiply by 100 to convert it into a percentage.
($18,000 / $200,000) x 100 = 9%
The gross rental yield of this property is 9%.
Calculating net rental yield
While the gross rental yield offers a quick, surface-level analysis, the net rental yield provides a much more accurate assessment of a property's profitability potential. To calculate net rental yield, you'll need to account for all operating expenses.
Gathering this expense data requires more time and effort upfront than calculating the gross rental yield. But the additional legwork pays off by delivering a realistic picture of what income you can expect after covering the costs of owning the property.
A property may look promising based on the gross yield, but the net number provides the actual yearly returns you can anticipate as a rental property owner. Factors like higher tenant turnover and vacancy rates, above-average property taxes for the area, or an older building requiring frequent repairs and maintenance can significantly erode profits.
To illustrate how the net rental yield accounts for these expense realities, let's walk through an example. Let's say you purchase a property for $200,000 and rent it out for $1,500 per month. To find the net rental yield:
- Calculate the annual rental income:
Multiply the monthly rent by 12.
$1,500 per month x 12 months = $18,000 - Subtract annual expenses:
We'll assume the annual costs, including maintenance, taxes, and insurance, total $3,600.
$18,000 (annual rent) - $3,600 (expenses) = $14,400 net annual income - Calculate the net rental yield:
Divide net annual income by the property price, then multiply by 100 to convert it into a percentage.
($14,400 / $200,000) x 100 = 7.2%
The net rental yield of this property is 7.2%.
What is a good rental yield?
A "good" rental yield in the United States typically ranges between 5-10%. Yields above 10% can be highly profitable but may also indicate properties in areas with higher risk factors.
This is because a higher rental yield typically indicates that the property's fair market value is lower compared to the amount of the property's annual rental income. The risk here could be that the property is in an area with economic instability or lower appreciation potential.
Related real estate metrics
Rental yield provides one data point, but investors also analyze additional measures to evaluate a property's potential. These related metrics allow you to view the investment from multiple angles:
- Net operating income (NOI): This is the actual income generated after subtracting operating expenses like maintenance and taxes (excluding financing costs) from the gross rental income.
- Capitalization rate (cap rate): Calculated as net operating income divided by current market value, this metric is the same as the net rental yield calculation. It shows the property's return on investment regardless of financing.
- Cash-on-cash return: The pre-tax cash income earned as a percentage of the total cash invested to purchase the property. A higher rental yield can correlate to a higher cash-on-cash return, especially for all-cash purchases.
Rental property yield
Rental yield is a helpful tool for evaluating rental property investments. Understanding this calculation is an important step for real estate investors to take, but the learning doesn't stop there.
Combine your knowledge of rental yield with other metrics like net operating income, capitalization rates, and cash-on-cash returns. Analyzing properties from multiple angles sharpens your ability to find great deals and avoid risks.
Continuous learning and growth will allow you to lead the pack in the real estate investment world. Focus on staying updated about evolving market conditions, regulatory changes, and innovative investment strategies. The most successful investors remain curious, adaptable, and committed to honing their skills. With rental yield as your foundation and a commitment to knowledge, you can build a thriving, profitable rental property portfolio.
What is rental yield? FAQs
What is a good ROI for a rental property?
A good ROI for a rental property typically ranges between 8% and 12%.
What is the 2% rule in real estate?
The 2% rule in real estate says that a rental property is a good opportunity if your monthly rent is at least 2% of the purchase price.
What is the difference between yield and ROI on a rental property?
Yield is the annual rental income expressed as a percentage of the property's value or cost. ROI (return on investment) includes rental income as well as any appreciation or depreciation in the property's value over time.
Important Note: This post is for informational and educational purposes only. It should not be taken as legal, accounting, or tax advice, nor should it be used as a substitute for such services. Always consult your own legal, accounting, or tax counsel before taking any action based on this information.
