There are two forms of rental yield: gross rental yield and net rental yield. Gross rental yield is a simpler metric that doesn’t take the property’s expenses into account, while net rental yield does. Net rental yield is usually a better metric to look at because expenses don’t always scale linearly with income, meaning that as you earn one dollar in income, the expenses associated with that income are not always the same for different properties.
Gross Rental Yield
Gross rental yield is simply the annual rental income of the property divided by the value of the property.
Where:
- Annual Rent = the total amount of rental income earned in a year
- Property Value = the value of the property
Gross Yield Example
Suppose you are looking at investing in another property in the same neighborhood as a property you currently own, and you want to compare the rental yield of the new property to that of your current property. You feel confident comparing these yield rates because the properties have similar amenities, similar rent rates, and so forth. The gross rental yield of the property you already own is 3.12%. Let’s see if the property you want to invest in yields a similar value. The property has a price tag of $10,000,000, it has 18 units, and each unit’s rent per month is $1,500.
First, we must calculate total potential income earned. Because you have 18 units, and the rent per unit per month is $1,500, you will earn $27,000 per month (18 * $1,500). To annualize that number, multiply your monthly earned rent by 12 because you will earn that rent every month. This equates to $324,000 in yearly earned income. Now we are armed with the two components of the formula, and we can plug these numbers directly into the formula to calculate gross rental yield. The calculations are as follows:
So, the property you want to invest in earns a gross rental yield of 3.24%, which is slightly higher than the property you currently own! It may be a good investment.
Net Rental Yield
Now on to the slightly more complicated rental yield formula. The premise is the same as gross rental yield, but this time we will subtract out expenses in order to get a truer metric for comparison. The expenses can include taxes, insurance, repairs, vacancy costs, or really anything that it takes to maintain the property. One thing to note is that here, debt expenses, like mortgage repayments and interest, are not usually included as expenses since they are related to the investor’s finances and not related to the property; however, you may include them as expenses if you feel it gives a better way to compare potential investments.
We need four values in order to calculate net rental yield: annual rent, property value, vacancy rate, and annual expenses. The first two values will be calculated the same as in gross rental yield. The vacancy rate is the percent of time that you expect the property to be vacant. This number can be calculated by taking the number of weeks or months you expect your property to be vacant per year, divided by the number of weeks/months in a year, or it can be average number of vacant rooms divided by the total number of potential revenue-earning rooms, for example. Divide the number of expected vacancies by the total number of units to get your expected vacancy rate. The other number we need in the formula is annual expenses. Simply add up all your expected expenses. To calculate net rental yield, subtract your annual expenses from the amount of income you will earn with the vacancy rate being considered, and divide that value by the property value.
Where:
- Annual Rent = the total amount of rental income earned in a year
- Property Value = the value of the property
- Vacancy Rate = the percent of time your property is vacant expressed as a decimal
- Annual Expenses = total annual cost of owning the property
Multiplying the annual rent by (1 – Vacancy Rate) is simply the same as taking your total annual income and subtracting the income you will lose because of vacant units in your property.
Net Yield Example
Let’s follow our example from above. You are looking at comparing the rental yields of a property you own and one you wish to own, but rather than using gross rental yield, you want to use net rental yield because the expenses of the two properties are different. The net rental yield of the property you currently own is 2.41%. Let’s take a look at how to calculate net rental yield for your potential property. Say, out of the 18 units in the building, you expect 2 of those to be empty on average at any time. This means that there are 24 months of rent (2 units * 12 months) that you will not earn out of a total number of 216 months of potential income (18 units * 12 months). This yields an 11.1% vacancy rate (24/216). Also, after careful examination of expected expenses, you assume that these costs will total $35,000. Remember, we calculated total annual income as $324,000, and the purchase price for the potential property will remain the same at $10,000,000. Alright, we are almost there, as we have all four values needed for the calculation. Now it is time to plug them into the formula. The work is shown below.
And there we have it, a net rental yield for the potential property of 2.53%, which, again, is higher than that of your existing property! This may still be a promising investment, but I’ll leave that for you to decide.