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How to calculate property yields properly

by Nikki Dale -

As a buy to let property investor or a landlord the short list of fundamental investment criteria when purchasing a property is largely the same.

Rental yield is on that short list, as it determines whether a property is a good investment.

Property yield, in other words, your annual rental income or your annual rental return, and the yield describes this yearly annual income from rental as a percentage of the property purchase price.

For property investors or landlords buying a property, – especially with the aid of a mortgage – being thorough with the annual yield calculations can determine whether mortgage payments are viable or not.

Understanding rental yield

In a personal due diligence check list, that all landlords and property investors should use for every investment, this has got to be in the top three.

There is in fact two yields that can be looked at.

Gross yield is a very simple post-it-note sum – this gives you the top overall gross annual rental income percentage and with this it’s easy to compare one property with another one.

Next step is the deeper dive into rental yield and this is focusing on the rental profit. Essentially, what is left in the rental income pot after all annual fees and costs have been deducted.  This is when you can really see if the property will be a wise investment.  Sometimes you find after the mortgage repayment, letting fee and service charge and ground rent (if all applicable) there is not a lot of income left to cover other things like maintenance and repairs.

However, it’s fair to say that high net rental isn’t the make or break of a decision, as many property investors and landlords buy properties based on area growth and are happy as long as on a annual basis, the property investment washes its own face.

How to calculate rental yield

Gross yield

To calculate gross yield, take the monthly rental income generated by a property x 12 months, divide this total by its purchase price and times by 100.

Annual rental income:  £9,600 (£800 x 12)

Purchase price: £150,000

Gross yield = 6.4%

Great we have a gross yield.  However, what really tells you whether the investment is viable and will bring in a good yearly income is calculating the net rental return or net yield of a particular property.

Net yield

To calculate net yield, take the gross annual rental income, minus the annual costs and fees, which leaves the profit generated by the property, divide this profit figure by its purchase price and times by 100.

Annual costs to be deducted from the gross yield could include mortgage repayments (if bought with the aid of a mortgage) ground rent, service charge, letting fee, management fee, insurances – these would be the fixed annual costs*.  There are other costs like repairs and maintenance and some years these costs will be more than other years.

Annual rental income:  £9,600

Annual costs: £1,500

Annual rental profit: £8,100

Purchase price: £150,000

Net yield = 5.4%

Should rental yield be the No. #1 factor to property investment?

Whilst yield is super important, it’s not the only deciding factor.  Many investors and landlords will (should) look at the bigger picture, meaning they will look at ROI along with a five or 10-year forecast which includes a sensible estimation of annual compounded rent increase year-on-year.

The bigger picture should include growth, especially in a high-demand, regeneration area.  Capital appreciation over time is a huge factor and while nobody knows the future there are plenty of logical aspects property investors and landlords can look at to predict growth in rents and in property appreciation.

ROI based on a 10-Year yield forecast   

With a forecast of the future, especially over 10-years, I think it’s always best to be conservative, we don’t know what ups and downs the property market will experience over the next 10-year period.  Nonetheless, it’s an interesting exercise to do as indicates how your investment of capital is working for you and shows you some predicted ROI.

ROI is the profit per annum (or over a period), divided by the property price.

Different regions, cities and towns will have different rental growth, this depends on a number of factors, we know demand creates fantastic year-on-year increases. But what creates that demand in an area? Regeneration, creation of jobs, big companies and corporations relocating their headquarters, universities, infrastructure, commuter areas.

Calculating annual compounded rent increases

For a 10-year forecast you can estimate the compounded rental income increases.  So, if you take the area where your property is and reports have been seeing a 2%, 3% or even 5% p.a. rental increase over the last few years, or maybe a higher rental rise has been strongly predicted, apply this percentage as your compounded year-on-year percentage.

You can also conservatively apply a similar or same percent to the estimated increase of annual costs – it’s sensible to assume if rental increases, so will the annual fees and costs.

The table below gives an expansion of the rental yields we’ve looked at above but over 10 years.

The formula yields £11,989.08 (7.99%) by year 10, which is compounding the start rent of £9,600 (6.4%) by 2.5% year-on-year starting at the end of year one.

Also, in below chart and for example purposes, the annual costs have also increased in the same way and by the same percentage.

The formula shows the annual costs at £1,873.29 by year 10, which is compounding the start annual fee of £1,500 by 2.5% year-on-year starting at the end of year one. This will be case by case and maybe there won’t be any increased annual costs till year 3 or 4, but it’s a realistic viewpoint there’ll be some increases along the way.

The net yield is then simply worked out as before, Gross rental income minus the annual costs.

Purchase price: £150,000

Years Gross Yield Gross Rental Income Fixed Annual Costs* Net Yield Net Rental Income
1 6.4% £9,600.00 £1,500.00 5.40% £8,100.00
2 6.56% £9,840.00 £1,537.50 5.54% £8,302.50
3 6.72% £10,086.00 £1,575.94 5.67% £8,510.06
4 6.89% £10,338.15 £1,615.34 5.82% £8,733.81
5 7.06% £10,596.60 £1,655.72 5.96% £8,940.88
6 7.24% £10,861.52 £1,697.11 6.11% £9,164.41
7 7.42% £11,133.06 £1,739.54 6.26% £9,393.52
8 7.61% £11,411.38 £1,783.03 6.42% £9,628.35
9 7.80% £11,696.67 £1,827.60 6.58% £9,869.06
10 7.99% £11,989.08 £1,873.29 6.74% £10,115.79
Total £107,552 £16,805.07   £90,758.38

 

Net Income after 10 years = £90,758.38 

Estimated ROI by year 10 = 60.51%

Read More: How does PBSA fixed assured rental income work


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