Calculating Rental Yield
What is yield?
Yield tells you how much cash an income generating asset produces each year as a percentage of the asset’s value. For investment property it is the rental income as a percentage of the property’s purchase price or value. It is usually worked out on 50 weeks of the year to allow for vacancy.
What does yield tell you?
Yield is one part of your risk and return analysis. By calculating the yield, you can compare the income producing potential of different properties and help provide an overall assessment of the best place to purchase. A high yield means good cashflow. Thinking about it in a different way, if you paid $300,000 of your own cash for a property, the rent of $300 a week would give you a yield or gross return of 5.00%. Better than a bank deposit.
It is a general rule of thumb that yields are higher in cheaper areas. But the total return needs to be weighed up together with other factors like tenant demand, potential for capital growth and industry growth.
If you find a property with a higher yield, you’ll receive more rental income relative to the size of your mortgage. That means you’ll be able to cover more of those extra expenses with your rental income and your property will require less cash to maintain. You might even find properties that are cash flow neutral (or positive!) from day one, this likelihood increases when the size of your deposit increases.
Increasing the yield of your property, by increasing rent (or reducing the amount you are willing to pay) will not only increase your cash flow but also potentially increase the value of your home. This is one of the reasons why under renting is not a good idea. When it comes time to sell, a new investor buyer will be taking an added risk that the property will fetch the market rental rate and a higher yield than you have achieved.
If you increase the yield by improving the property to receive higher rent, the improvement value should be added to the purchase price to calculate the new yield.
Taupo offers yields of around 5 per cent, accompanied by very strong value gains.
Finding this sweet spot between value gains and high yielding property is a good goal to have!
Gross Yield Calculation
- Weekly rent $400
- Annual Income $20,000
- Purchase Price $380,000
- Gross Yield $20,000/$380,000 = 5.26%
Net Yield Calculation
Net Yield $15,200/$380,000 = 4.00%
(Note that interest isn’t in the calculation for net yield. Borrowing varies between each investor and isn’t directly related to the property itself).
You should however include mortgage interest and tax in your calculations of return on investment. You should also consider depreciation, capital gains tax should you be forced to sell within 5 years and mortgage insurance.
Reversing the Equation
Calculating Capitalisation Rate
Let’s say you want to achieve a net yield of 5% and the income and expenses are as above.
$15,200 / 5% = $304,000 is the price you would be willing to pay to achieve your goal.
This information sheet is given in good faith and is intended as a guide only. This is a complicated area of taxation. Please contact your chartered accountant for further advice.