What is Rental Yield?
The Rental Yield is a real estate metric that compares the rental income generated by a property to its fair market value, expressed as a percentage.
How to Calculate Rental Yield?
To calculate a property’s rental yield, a real estate investor needs three inputs:
- Rental Income → The rental income is the profits generated by a property per year that belong to the owner from renting out the property (or units) to tenants.
- Operating Costs → The total costs incurred by the property owner as part of operating the property, which includes costs such as property management fees and repair costs.
- Property Value → The property value refers to the current market value of the property, i.e. the fair value as of the present date.
The rental yield of a property – calculated post-operating expenses – can be broken into the following steps:
- Annual Rental Income → Calculate the annual rental income of the property from all tenants
- Operating Expenses → Calculate the sum of all fees and expenses incurred from operating the property
- Annual Rental Income ÷ Operating Expenses → Divide the property’s annual rental income by the sum of all operating expenses
- Percentage Form Conversion → Convert the resulting figure into a percentage by multiplying by 100
Gross Rental Yield vs. Net Rental Yield: What is the Difference?
There are two different types of rental yield metrics: 1) the gross rental yield and 2) the net rental yield.
- Gross Rental Yield → The gross rental yield is the rental income of a property relative to its property value, without consideration toward operating expenses such as property management fees, repairs or vacancies. While more convenient and less time-consuming to calculate, the gross rental yield is more of a quick and dirty method to estimate a property’s potential profitability rather than to provide a comprehensive picture of the property’s profit potential on a more granular level.
- Net Rental Yield → In contrast, the net rental yield is virtually identical to the gross rental yield, except for accounting for the property expenses incurred as part of running the day-to-day operations. The net rental yield, compared to the gross rental yield, offers a more accurate measure of a property’s true profitability. The trade-off, however, is that the metric requires more detailed financial data points (and estimates) to calculate.
Rental Yield Formula
The rental yield formula compares a property’s rental income to its property value.
The formula to calculate the net rental yield – the more practical measure of profitability in the real estate market – is as follows.
Rental income must be expressed on an annual basis, whereas the property value is the property’s current market value.
The rental yield is expressed as a percentage for investors to better understand the income to expect relative to their property investment, including the real property’s profitability relative to comparable properties.
Like most real estate metrics, the rental yield cannot be used as a standalone measure to guide financial decisions.
However, the underlying pricing that drives the rental income, as well as factors such as location, vacancy rates and trends, are all taken into account by the rental yield.
Net Rental Yield Calculation Example
Suppose a rental property was to generate $25,000 in rent for the year, and the current market value is $400,000.
After dividing the annual rental income by the current market value of the property, the rental yield is 6.25%
- Rental Yield = $25,000 ÷ $400,000 = 6.25%
The rental yield can also be calculated using the property cost rather than the property value.
The latter reflects the current fair value of the property, whereas the former is the fixed property purchase price on the date of initial purchase.
But while there is a mismatch in the timing of the metric if the purchase cost were to be used, the metric can still provide some useful insights on the property investment.
What is a Good Rental Yield?
Similar to most standardized metrics, what constitutes a “good” rental yield is subjective and is based on the circumstances around comparable properties.
Comparable properties must be located near the target property, with a virtually identical risk/return profile, which is predicated on the property type and characteristics.
- Location: The standard rental yield can vary across a wide range based on the location. The rental yield on properties located in high-demand, low-supply markets would exceed that of a low-demand, high-supply market, i.e. “seller’s market”.
- Property Type: Likewise, the property type is also a critical factor to accurately interpret the rental yield. For instance, a multi-family property should be expected to have a higher rental yield than a single-family home in most cases, assuming the location and factors that impact the pricing per square footage are similar.
By obtaining a better understanding of a rental property’s current and pro forma profitability, a real estate investor can make more informed decisions where the odds of a more favorable outcome improve.
Generally speaking, a higher rental yield implies more profits and a better return on investment (ROI) in the property – all else being equal.
So, to reiterate, the rental yield that property owners should target depends on several factors such as location, property type and the current state of the market with regard to competition (supply vs. demand).
To provide a rough guideline and starting point, a rental yield between 5% to 8% is a decent starting point for most properties before delving into the other factors that must be considered.
For example, if the rental yield on a property is 8% and the purchase price is $200,000, we can rearrange the formula to determine the investor would expect to receive $16,000 in rental income per year, not inclusive of operating expenses or fees.
- Gross Rental Income, Per-Year = 8.0% ÷ $200,000 = $16,000
What Factors Determine Rental Yield?
There are numerous factors – both internal (e.g. state of property conditions, current tenant) and external variables (e.g. market trends, interest rates) – that can impact the rental yield on a property either directly or indirectly, as in the case of the current interest rate environment.
However, the factors that tend to have the greatest impact on the yield are the following:
- Rental Pricing Rate: The higher the pricing of the rental property, the higher the rental yield will be. The drawback, however, is the necessity to ensure pricing is competitive with other properties located in the same area. Otherwise, the property might remain vacant for an extended period, resulting in no rental income for the property owner.
- Property Value: The lower the property value, as of the current date, the higher the rental yield. But at the risk of stating the obvious, there is usually a valid reason for properties to be sold on the market at lower price points. For example, the property in question could be located in an unsafe area with rising crime rates (and thus has low demand).
- Operating Expenses: More operating expenses arising from running the property results in a lower rental yield. The most common examples of operating expenses are maintenance costs, repair costs, property taxes and property management fees.
- Vacancy Rate (or Occupancy Rate): The rental properties that remain vacant for a prolonged period – i.e. at an occupancy rate of zero – exhibit lower rental yields. Therefore, property owners strive to reduce vacancies by ensuring that the property is priced near the market rate and is well-maintained, among various other factors that influence the decisions of potential tenants.
Rental Yield Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Gross Rental Yield Calculation Example
Suppose you’re tasked with calculating the rental yield on a commercial property with a current market value of $4 million and five units available for rent.
The rental building property, based on the existing leasing agreements and historical tenant data with regard to past defaults or collection (credit) issues, is projected to generate $240k in rental income in 2023.
The $240k in annual rental income was determined by multiplying the number of occupied units by the monthly rent – which we assumed to be $4k per tenant – followed by multiplying the $20k in monthly rental income by the annualization factor (12x).
- Property Value = $4 million
- Number of Occupied Units = 5 Units
- Rent per Month = $4,000
- Monthly Rental Income = 5 Units × $4,000 = $20,000
- Annualization Factor = 12x
- Annual Rental Income, gross = $20,000 × 12 = $240,000
As part of operating the property, the owner expects to incur a total of $60,000 in expenses, inclusive of property management fees, repairs, and vacancies. By subtracting the total operating expenses from the annual rental income, the net rental income is $180k.
- Annual Rental Income, net = $240,000 – $60,000 = $180,000
Given those assumptions, we can quickly determine the gross rental yield by dividing the annual rental income on a gross basis by the property value, which comes out to 6.0%.
- Gross Rental Yield (%) = $240,000 ÷ $4,000,000 = 6.0%
2. Net Rental Yield Calculation Example
Since the return on a property investment should consider the associated expenses, our next step is to determine the net rental yield by dividing the annual rental income, net of total operating expenses, by the property value.
- Net Rental Yield (%) = ($240,000 – $60,000) ÷ $4,000,000 = 4.5%
The net rental yield is 4.5%, which we arrived at by dividing the annual rental income, net ($180k) by the property value ($4 million).
In comparison, the percent differential between the gross and net rental yield is 2.5%.
- % Differential, Gross vs. Net Rental Yield = 6.0% – 4.5% = 2.5%
In conclusion, the rental yield on the commercial property is implied to be 6.0% and 4.5% on a gross and net basis, respectively.