Why are rental yields so important?
Rental yields are probably the most important investment metric used by landlords investing in residential investment property. It is an indication of the level of return on a investment. You wouldn't put your money in a savings account without knowing the APR - would you?
Calculating a rental yield
The rental yield is calculated by measuring the annualised value of rents as a percentage of the underlying capital value of the buy-to-let investment. So, a property valued at £100,000, generating an annual rent of £6500 would therefore have a gross rental yield of 6.5%. This gross rental yield is a useful starting point in calculating your potential returns and helps give a landlord a quick and easy metric by which to measure it against alternative property investments.
For example if you were lucky enough to have £100,000 in cash and invested it in a rental property; a 6.5% gross rental yield would appear to compare favourably with the current return on a cash deposit in a building society account.
However, gross rental yields don’t tell us the full story. Any landlord will tell you that, unfortunately, they don’t get to keep all the rent. Therefore a more accurate figure of the true cash return from the rental property is given by its net rental yield.
The net rental yield strips away the associated costs of generating the rental income. This might include any management charges, such as: letting agent fees, ground rent, service charges, repair costs and insurance charges. One cost that is excluded from this is the finance charges associated with any buy-to-let mortgage.
Calculating a net rental yield??
An examination of my most recent tax return shows that my expenses come in at around 16.5% of my total rent. Therefore applying this figure to my previous example would mean that the gross rent of £6500 becomes a net rent of £5427.50. This results in the gross rental yield falling from 6.5% to 5.4%. A rule of thumb is that the net rental yield is between 1-2% less than the gross figure.
My gripes on rental yield information
Rental yield data is often used in articles by journalists who really don’t understand what it is, or how to calculate it. Often their only goal is to use the data to lead to some headline grabbing title like - ‘rental yield hotspot.’ It's probably best to ignore these headlines as misleading media clap trap.
For a start, I frequently see journalists bundling rents in with the capital growth of the property (increase in the property's price). This is simply wrong. Yield reflects the recurring revenue stream from an investment. Measuring the relationship between an income producing asset and it’s underlying value. It’s not helpful to bundle the two together.
Historic rental yields
A recent conversation with my accountant highlighted another aspect of rental yields - time. He was toying with the idea of selling one of his own property investments currently rented for £550 per month. He had been advised by an estate agent that he should be able to obtain about £120,000 for the property. This means that his current gross rental yield was 5.5%. Not fantastic but ‘kind of acceptable’. However, it turns out that he had bought the property 10 years ago for £80,000. This meant that his historic yield was a wapping 8.25%. Now that’s more like it.
Lies & rental yields
Technically, historic yields are not that useful. By using past values of an asset it does not really allow a landlord to compare directly the opportunity costs and returns from their property investments with other current investment opportunities.
However, it’s a useful metric for individual landlords to measure their own investment returns on their properties. As I mentioned previously you may choose to ignore rental yields when making your investment decisions. The property you choose to buy or invest in could be simply one that you inherit, or just because it is convenient to manage, or you think you or one of your family might want to live in it one day. This is all fine, but make sure that you do understand the basics of rental yields too. That way you have a little bit of an insight on where your money is going, even if you choose to invest for other perfectly legitimate reasons.
What is a good rental yield?
Clearly the types of rental yield that a landlord should be looking for will depend on the type of investment property they are looking at, and where they are looking to buy.?? As a rule of thumb and in the current low interest environment I would say a landlord should be looking for a gross yield of about 8%.
This should roughly translate into a net yield of about 6% by the time expenses are taken off ( insurance, voids, deductions).?? In the case of properties which demand a higher amount of management time, such as Houses in Multiple Occupation ( HMOs) then this figure should be considerably higher. I would suggest more like 12% as a national average.??
The general rule with single lets, is the larger the property the lower the relative gross yield. Therefore, nationally a large house is likely to generate a yield of several percent below the average. Conversely, a studio flat is likely to potentially draw in a higher yield.?? Central London will have the lowest yields as will prime property location anywhere in the country. If a landlord is looking a purely income and prepared to look purely for a cash cow, it should be entirely possible to obtain a gross yield above 10%. With rents once again rising and property prices looking as if they may remain depressed for some time, landlords needs to switch focus to rental yields and not property price increases.
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