How to calculate return on investment in the rental property market
Posted by Rebekah Hutton on Fri, Aug 2019
Many people are turning to the rental market to create an investment portfolio to establish an ongoing income stream and diversify their investments. When entering the rental market, it’s important to learn how to evaluate whether a rental property will be a beneficial investment compared to its cost. This is known as the return on investment (ROI) and when it comes to the rental property market, there are several ways you can evaluate this to decide if the property will be of financial gain.
The holy grail when it comes to ROI for investors is a high yield property in an area with large capital gains (i.e. A home with good rental income in an area that will continue to raise the home’s value). Establishing a steady rental return and low maintenance and management costs will also improve your return on investment numbers.
So, how do you know if a rental property will make a good return on investment?
Do your homework
Firstly, it’s important to do some groundwork when it comes to buying a rental property. Understanding the demographics of the area, the type of clientele the property will attract, the expected growth of the area, expected maintenance and management costs is essential. This will give you an insight into the potential value of the property, rental returns and expenses that you as the landlord may have to fork out.
Visiting the area, speaking to locals and your real estate professionals will give you a good insight into the expected value of the property and the type of clientele it may attract.
There are two main ways rental investments can create financial return.
Firstly, the property can rise in value (known as appreciation) and secondly it can create an ongoing income stream or cash flow from rental returns.
There are some basic formulas you can use when first weighing up whether a particular property is worth the investment based on a percentage of the property value.
Gross rental yield
calculates the expected annual return as a percentage of the purchase price or value of a property.
Gross rental yield = [annual rental income (weekly rental income x 52) / property value] x 100
This formula can be a quick first-line calculation when weighing up different properties as potential investments, however it does have several limitations due to not considering property expenses, renovations, maintenance costs, council rates and stamp duty. For example, a $600,000 rental property being rented out for $450 a week has a gross rental yield of 3.9%.
When comparing properties to purchase for investment, looking at which has a higher gross rental yield allows us to easily see which is more likely to have a more positive cash flow.
For a more comprehensive calculation taking into consideration expenses and multiple income factors, you can use the following net rental yield formula below:
Net rental yield:
[(annual rental income – annual expenses) / total property cost] x 100
This is where the net rental yield calculation can give you a better insight into your potential ROI after considering all potential expenses related to the property – some of which you may have to estimate. Generally speaking, good net rental yields in metropolitan areas can attract an annual 3-5% gain and some regional areas are upwards of 5% annually.
Many investors will look for areas with high rental yields to increase their ROI, however it shouldn’t be the only factor impacting your decision-making process. Other factors to consider are the property’s appreciation value, capital gains, tax deductions and growth of the property area.
If you’re interested in purchasing a property for investment purposes give a Hodges agent a call today.