Before embarking on any property investment, it is crucial for any would-be investor to consider various yield calculations. These metrics allow for comparisons to be made across different opportunities and enable buyers to better understand - and therefore mitigate - the risks. They also help to ensure that a given property has a robust investment case from day one, increasing the likelihood of maximising returns in the long-term. Investors should also be careful to consider a wide range of metrics, rather than relying on any single calculation, before proceeding with any investment.
5 KEY PROPERTY INVESTMENT CALCULATIONS
1. Gross Yield
The most basic metric is the gross yield, often referred to simply as “yield”. It is calculated as follows:
Gross Yield = Annual Rental Income / Purchase Price
For example:
Property Price = £100,000
Annual Rental Income = £9,000
Gross Yield = (£9,000 / £100,000) x 100
Gross Yield = 9%
Some investors include purchase costs such as stamp duty within the above calculation, but for simplicity, most choose instead to address this in their ROI calculations (see below).
Gross yield has its limitations - it really does not tell the full story as to how an investment is likely to perform. This is primarily because the investor's costs are not baked into the calculation. The limitations of this metric are magnified in the case of investment types that provide higher rental incomes and involve higher costs, such as HMOs and short-term rentals.
The gross yield also disregards the differences between property types – leasehold properties, for example, will typically include a service charge and potentially ground rent, while freehold properties won’t, and older properties typically demand higher maintenance costs compared to new-builds.
Notwithstanding these limitations, gross yield can be a useful starting point to quickly and easily compare across different investments – particularly if they are of the same type (e.g. long-term rental v long-term rental, or HMO v HMO), and to give an initial indication, or threshold, for how a property is likely to perform.
2. Net Yield
Net yield is a more accurate, and therefore more useful, metric than the gross yield. It is calculated as follows:
Net Yield = (Annual Rental Income – Annual Rental Costs) / Purchase Price
The formula could also be expressed as Annual Profit / Purchase Price.
For example:
Property Price = £100,000
Annual Rental Income = £9,000
Annual Rental Costs (e.g. letting agent fees, etc.) = £2,000
Annual Mortgage Costs = £3,000
Total Annual Costs = £5,000
Net Yield = ((£9,000 - £5,000) / £100,000) x 100
Net Yield = (£4,000 / £100,000) x 100
Net Yield = 4%
Typical costs
Net yield is a better metric by which to measure the viability of a given investment, as it is more easily compared with, for example, the return the investor may expect to earn by placing the cash in a bank account (though such comparisons should also factor in that, as a general rule, UK properties have also tended to attract capital appreciation over time).
The net yield metric also helps to focus the investor’s mind on the costs inherent in running different types of property. For example, short-term holiday lets generally have higher gross yields but also attract additional running costs, including regular payments to cleaners, utility bills and higher management fees.
However, the key factor ignored by net yield is the amount of cash an investor actually has tied up in a deal, and where an investor has acquired a property using debt, it therefore doesn't give a 'true' reflection of the return on cash being earned. For this, we need to use a different calculation - the ROI.
3. ROI (Return on Investment)
The ROI metric can be used to holistically quantify how hard the investor’s cash investment is working, and for the majority of investors, is likely to be the most useful calculation. Calculating the ROI is also a helpful way to demonstrate the power of leverage in property investments, and how it has the potential to supercharge returns. We will address the potential benefits - and risks - of using leverage in greater detail in a subsequent blog post.
It is calculated as follows:
ROI = Annual Rental Profit / Cash Invested
For example:
No leverage (cash only deal):
Property Price = £100,000
Acquisition Costs (Stamp Duty, legal fees, surveys, etc) = £5,000
Cash Invested = £105,000
Annual Rental Income = £9,000
Annual Costs (e.g. letting agency fees, etc.) = £2,000
ROI = ((Annual Rental Income – Annual Costs) / Cash Invested) x 100
ROI = ((£9,000 - £2,000) / £105,000) x 100
ROI = (£7,000/£105,000) x 100
ROI = 0.667 x 100
ROI = 6.67%
With leverage (interest-only mortgage):
Property Price = £100,000
Acquisition Costs (Stamp Duty, legal fees, surveys + mortgage fees) = £7,000
Total Mortgage = £75,000
Cash Invested = £32,000
Annual Rental Income = £9,000.
Annual Rental Costs (e.g. letting agent fees, etc.) = £2,000
Annual Mortgage Costs = £3,000
Total Annual Costs = £5,000
ROI = ((£9,000 – £5,000) / Cash Invested) x 100
ROI = (£4,000 / £32,000) x 100
ROI = 0.125 x 100
ROI = 12.5%
Here we can see that though the annual return is lower where leverage is used (£4,000, as opposed to £7,000 in the case of the cash-only deal), the ROI is much higher in the second example, as £4,000 represents a higher percentage of the actual cash invested in the deal.
As was the case with net yield, the ROI demonstrates how hard an investor’s cash investment is working for them, and can be directly contrasted with investing the same amount of money (in this case £32,000) in other investments, such as a high interest bank account or other securities such as bonds.
4. Payback period
The ROI calculation above can also be used to calculate how long it would take for a property to repay the initial investment of cash. Our example below also demonstrates how the use of leverage can shorten the payback period for an investment. It is calculated as follows:
Payback period = (1/ROI) x 100
For example:
No leverage (cash only deal)
Payback period = (1/6) x 100
Payback period = 0.167 x 100
Payback period = 16.7 years
With leverage (interest-only mortgage)
Payback period = (1/12.5) x 100
Payback period = 0.08 x 100
Payback period = 8 Years
5. Cap Rate
Last but by no means, least, we have the cap rate - a metric popular with US real estate investors and institutional investors in particular. The cap rate indicates the rate of return that can be expected on a real estate investment property if it is owned outright - ignoring the effects of leverage and thereby allowing objective comparisons to be made. It is helpful for completing a quick cash flow analysis of comparable properties, and allows real estate investors to quickly assess the one-year rate of return of an investment property. There are alternative cap rate calculations, but a widely used formula is:
Cap Rate = (Annual Rental Income – Annual Rental Costs) / Current Market Value
It can also be expressed as Net Operating Income / Current Market Value. It is typical to include all costs used in our net rental yield calculation, other than mortgage costs, in calculating the Net Operating Income.
For example:
Market Value on Day 1 = £100,000
Annual Rental Income = £9,000.
Annual Rental Costs (excluding mortgage costs) = £2,000
Cap Rate = ((£9,000 – £2,000) / £100,000) x 100
Cap Rate = (£7,000 / £100,000) x 100
Cap Rate = 7%
Where the ROI metric may be affected by the differences in financing costs between different buyers, the cap rate focusses solely on the profitability of the property. In other words, different investors, due to their personal circumstances, may find that financing is more or less expensive, which impacts ROI. The cap rate eradicates this variability.
Additionally, since property prices fluctuate over time, using the current market price is a more accurate representation of the rate of return a property is generating than the the ROI / net yield, which uses the fixed value original purchase price (and can becomes less realistic over time).
While the cap rate can be useful for quickly comparing the relative value of similar investments in the market, it should not be used as the sole indicator of an investment’s strength precisely because it does not take into account leverage. Nor does it factor in the time value of money, among other factors.
Time Value of Money
Summary
Every investor is different and each is likely to have different approaches, not only in the types of properties in which they look to invest but also their due diligence methodology, including the manner in which they calculate their expected returns. However, it would be advisable for all investors to use some, if not all, of the metrics set out in this article when exploring a potential investment. They should also consider the potential benefits (and risks) of introducing leverage into an investment - a topic we will cover in greater detail in a subsequent blog post.
About Oxstone
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