What Is Rental Yield?
A Rental yield can be defined as the annual returns from an income-generating property as a percentage of its net asset value. This measure aims to provide a metric that helps real estate investors assess the potential profitability of rental property investment.
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The rental yield is an essential parameter for property owners who rent out their properties. The value differs depending on the type of market. Therefore, property owners can compare their yield with the market average; if it falls short, they can make necessary changes and maximize their returns. Hence, it is similar to calculating the return on investment and measures the capacity of an asset to provide reasonable income to the owner.
Table of contents
- What Is Rental Yield?
- Rental Yield Explained
- Types
- Formula
- Calculation Example
- Rental Yield vs Capital Growth vs Cap Rate
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- Rental yield refers to the income generated from rental property as a percentage of its total purchase value.
- The property owner can also account for the additional expenses, such as insurance, taxes, maintenance and repairs, advertising, etc.
- Computing this value will help property owners assess renting or leasing their property. They can compare their returns with the market average and adjust their income or expenses accordingly.
- Therefore, this yield differs from the cap rate in that the former considers the property’s purchase cost, and the latter considers the current market value.
Rental Yield Explained
The rental yield refers to the income generated by a rental property relative to the property’s value. Significantly, for some, it is a secondary source of income, while for others, primarily retirees, it is the primary income source. Hence, when a person rents or leases their house, it is their investment. The rental income they receive is the return on the investment. Furthermore, the expected rental yield is just an estimate, and it depends on factors such as the location, type of property, rental market conditions, and rental prices in the area.
Nevertheless, analyzing and studying this concept can be of great help to property owners. There are a few reasons for this. Firstly, any investment requires a minimum amount of time and effort from the investor/ owner. Thus, if a person rents a property, they will incur certain expenses for maintenance, insurance, taxes, etc.
Thus, comparing yields will help property owners understand the average market returns. Based on this, they can maximize their returns by cutting down on costs or demanding reasonable rent from the tenant. Therefore, property owners should carry out sufficient research before renting or leasing their property. Moreover, the average rental yield varies depending on the location and type of the property.
Types
This yield itself is of two types – gross and net yield. The distinction between the two is the same as between gross and net profit. Hence, gross yield is broad and considers the income and asset value. On the other hand, the net yield is more comprehensive since it thinks the owner’s expenses too.
Therefore, an average rental yield of 5%-8% is considered reasonable for residential properties, while commercial properties may have lower or higher yields depending on the type of property and location. But no matter what, a net yield of less than 1% is a red flag.
Formula
The income generated from the rental properties formula is a simple calculation.
Hence, the formula is as follows:
Rental Yield = (Annual rental income / Property value) x 100
As already discussed, it is possible to calculate gross and net yield.
#1 – Gross rental yield
(Annual rental income/ Total asset value ) x 100
This value shows the income one generates from a property. However, in reality, there are a bunch of other expenses an owner will incur towards the property. These expenses should be accounted for to understand the actual yield.
#2 – Net rental yield
(Annual rental income – Annual expenses) / Total asset value x 100
Annual expenses include:
- Maintenance of property
- Property taxes
- Insurance
- Depreciation
- Advertising expenses
Calculation Example
Let’s work out a hypothetical example to understand the concept better.
Example #1
Let’s assume Lily works in New York. She rents out her parent’s house in Alabama to George. George pays $2000 per month. After 11 months, George informs Lily that he will move out by next month. Lily starts looking for new tenants. How much is her yield from rental income?
Asset value = $350,000
Taxes = $5000
Insurance = $3000
Maintenance = $2000
Advertising = $1000
Annual rental income = $2000 x 12 = $24,000
Annual expenses = $ (5000 + 3000 + 2000 + 1000)
= $11,000
Gross yield:
(24,000 /350,000) x 100
= 6.85%
Net yield:
(24,000 – 11,000)/ 350,000 x 100
= 3.71%
Therefore, property owners can use online rental yield calculators that help make faster and more accurate computations.
Example #2
Let’s say John owns a rental property that generates an annual rental income of $20,000, and the property value is $400,000. Hence, to calculate the rental income
Rental Yield = (Annual rental income / Property value) X 100
= ($20,000/ $400,000) X 100%
0.05X 100%
= 5%
Therefore the rental yield of the property is 5%
Hence, this means that the property generates a rental income of 5% of its value per year.
Rental Yield vs Capital Growth vs Cap Rate
All three metrics are essential for evaluating a property investment, and investors should consider each of them while making investment decisions. Hence, let’s look at the differences to understand them better.
| Metric | Definition | Formula | Importance |
|---|---|---|---|
| Metric | Definition | Formula | Importance |
| Rental Yield | Income generated by a property relative to its value | ( Annual Rental income/ Property value) x100 | Indicates a cash flow from a property investment |
| Capital Growth | Increase in the value of a property over time | ( Sales price- Purchase price)/ Purchase price x 100 | Essential for long-term capital appreciation |
| Cap Rate | Refer to the rate of return on a property investment | Net operating income/ Property value X100 | Assesses the overall return on a property investment |
Frequently Asked Questions (FAQs)
Yes, these account for expenses associated with owning and operating a rental property. The costs included are property taxes, insurance, maintenance, and property management fees.
Several factors affect the rental income of an investment property. These include
· Location
· Property type
· Rental rates
· Vacancy rates
· Maintenance costs
Financing costs
It can be improved in several ways,
· Increasing rental rates
· Reduce expenses
· Renovate or upgrade the property
· Increase occupancy
· Refinance the property
Gross yield is determined by dividing rental income by asset value. Instead, a net profit is calculated by deducting any additional expenses the property owner incurs for maintenance, insurance, and taxation. This value is then divided by the property cost. Hence, a higher gross rental income indicates that the property generates more income relative to its value.
Recommended Articles
This has been a guide to what is Rental Yield. Here, we explain its formula, calculation, examples, and comparison with capital growth and cap rate. You can learn more about it from the following articles –
- Capital Growth
- Alternative Investments
- Investment Property
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
