In our previous article on property investment basics, we covered one component of Return on Investment, i.e. Capital Gains. In this article, we will look at the other component – rental yield.
PART 2 : RENTAL YIELD
Some investors’ will rent out their properties as their investment strategy is to reap the long-term cashflow. Others will rent out their properties to offset the costs of holding the property while they wait to realise their Capital Gains. Whichever the case may be, you need to know if a property’s rental yield will be able to fulfil your investment strategy.
Calculating rental yield can be quite tricky as there are many more variables to deal with than calculating capital gains. These include rental fluctuations, maintenance cost changes, times when the property lies vacant, property taxes, repairs and refurbishments, and others. Some of these are unforeseeable, so calculating rental yield is not an exact science.
However, you still need to do the math in order to get a fair indication of what your returns will be.
How to calculate rental yield
Let’s say you purchase an apartment for RM300,000 (assume this price includes all costs related to the purchase – fees, stamp duties, repairs, furnishings, etc). You rent it out for RM1,500 per month, giving you RM18,000 rental income per year. Thus, theGross Rental Yield
is calculated as:
(RM18,000 / RM300,000) x 100 = 6% per annum
Assuming your total expenses per year to maintain your property comes up to of RM3,600 (management fees, property taxes, etc), the Net Rental Yield will be calculated as:
(RM18,000 – RM3,600) / RM300,000 x 100 = 4.8% per annum
However, this calculation does not take into account the other unforeseen costs that may be incurred in a year such as repairs, new taxes, revision of rates and other costs, etc.
It is also based on the assumption that you bought the property with cash out of your own pocket. Since most investors finance their property purchases, a major factor has not been taken into consideration. So, this method gives you a quick indication of rental yields, but it doesn’t give you a very accurate picture of your property’s financial performance.
As such, many investors prefer to look at the cash-on-cash rental yield to get a better picture. This calculation method considers the total cash received per annum minus the total cash paid out per annum over the actual cash invested.
How to calculate Cash-on-Cash Rental Yield
Total Annual Income - Total Annual Cost = Total Cash Returns per annum
Total Cash Returns / Total Cash Investment = Cash-on-Cash Rental Yield
Using the same property example, let’s assume you take a RM200,000 loan for 30 years at 6% per annum. That means your capital outlay is RM100,000 (let’s assume this includes all the financing costs, for easy calculation). Your monthly repayments come up to just about RM1,200, or RM14,400 per annum.
Your Cash-on-Cash Yield will be:
Total Annual Income of RM18,000 minus Total Annual Cost of (RM3,600 + RM14,400) = RM0 cash return over cash out.
RM0 divided by your cash investment of RM100,000 gives you a Cash-on-Cash Rental Yield of 0%. (Unless your property lies vacant – then your yield goes down some more.)
What? 0% returns for a capital outlay of RM100,000? That doesn’t seem very attractive!
Well, the good news is, this is not the whole story with property investments. Remember, property is neither a liquid nor short term investment. So you need to approach it with the correct frame of mind.
Have a firm investment strategy
First, if your strategy is to sell for capital gain, even with 0% cash-on-cash yield, you’re actually getting a pretty good deal. This is because all the costs of holding the property are taken care of until the time you decide to sell. By then, you stand to make quite a bit of money, as we had calculated in our previous article.
Secondly, if your strategy is to generate cashflow, remember that it’s normal practice for landlords to raise the rent every few years! So you can increase your cashflow over time, while your holding costs remain quite stable.
For example, assume you increase your rental to RM1,800 from the fifth year onwards. Your cash-on-cash yield would now be:
Total Annual Income of RM21,600 minus Total Annual Cost of (RM3,600 + RM14,400) = RM3,600 cash return over cash out.
RM3,600 divided by your cash investment of RM100,000 gives you a Cash-on-Cash Rental Yield of 3.6% per annum.
(Please note that all these are broad figures used to illustrate a point. Exact figures may be different from case to case.)
If your strategy is to hold on to your rental property for a long time, the yield will likely continue to go up and you will see a huge jump when the loan is finally paid off.
There are some other factors to consider as well
Paying down the loan – This reduces your loan tenure, allowing you to eliminate a major cost factor in your cash-on-cash calculations. This also frees up more funds to invest in other properties.
Inflation – When inflation goes up, it can also mean more renters, as fewer people can afford to buy homes. More renters means increased demand for rental properties, so rents may go up as well.
Capital appreciation - As your property’s value increases, you can sell it to reinvest in higher value properties. Or you could leverage on the property’s increased value to obtain another loan (refinancing - http://www.mortgagecalculator.org/helpful-advice/what-is-a-refinancing.php) to fund another investment.
Some common mistakes that people make in property investment are over-leveraging themselves, buying on market euphoria, and not knowing when to cut their losses and when to grit their teeth and ride out the bad times. This is usually due to insufficient knowledge or having the wrong mindset.
Remember, real estate investment has its own unique characteristics and it pays very well to approach it with the right knowledge, strategies and expectations.
These are just some of the major points to consider when embarking on your journey as a property investor. As you gain experience, you will also gain more skills and knowledge which will help you make sharper investment decisions.