Rental yield is a common figure thrown around in the UAE real estate investment market. While this metric is useful to quickly compare the profitability of different properties, it has various pitfalls. Savvy property investors know this; hence they don’t focus on yield but rather on other rates of return. If you cater to investor clients, it’s important to talk the talk and have clients understand that you are competent and well informed about the financial implications of investing in property.
In this article, we look at what rental yield is, why it can be an inaccurate representation of property gains and other metrics which can be used to analyse property investments more accurately.
What Is Rental Yield?
Rental yield shows the profit potential for investment properties by measuring the gap between the income you can generate from the property and the purchase cost. This is done by dividing the annual rent by the property’s price.
Let’s look at an example:
A 7.4% rental yield sounds like a great figure to quote, and in the UAE, agents throw rental yield around. However, there can be a huge error in relying solely on rental yield.
Let’s establish why rental yield is an inaccurate gauge of a properties return:
Does not account for expenses
Buying property comes with various additional costs such as maintenance, service charges, repairs, insurance, etc. It is important to consider these expenses when analysing investment deals as they can have a significant impact on return.
Does not account for vacant periods
While every investor wants their property to be occupied for 100% of the year, this is highly unlikely. The duration of the property’s vacant period depends on its location and demand in the area. During these vacant periods, you will not be earning rent hence, reducing your income and return. Accounting for vacancies when analysing the property will give you a more accurate vision of what to expect.
Excludes the benefit of taking a mortgage
When purchasing a property, most investors use a payment plan or a mortgage. With these tools, they make consistent monthly payments over several years to fund their investment. By using a mortgage, they can leverage their debt and earn higher rates of return as opposed to making a full cash purchase. This is due to principal reduction which decreases the total amount owed on the loan by using your rental income to pay for your mortgage.
Investors are looking for a rental income-generating business. They know about costs, and they critically analyse a property before even considering a purchase.
Focus on Rates of Return
At this point, you may be asking yourself, “What are rates of return?”.
These are calculations which compare your potential gains on an investment property with the amount you’ve invested in the property. Property rates of return are usually expressed as a percentage and are essential to calculate for any investor client as they help determine whether the property is a worthwhile investment opportunity. In this article, we will focus on three rates of return including return on investment (ROI), Capitalisation Rate and Cash on cash return.
How To Determine Rates Of Return
Well, there are a few calculations we can look at and experienced investors know them all. Before we do that, let’s familiarise ourselves with the below investment terminologies:
- Net Operating Income (NOI): Used to determine the revenue and profitability of an investment property by looking at gross annual rent and subtracting all operating expenses.
- Principal reduction:The concept of your tenant buying your property for you over time by paying off your mortgage using rental income.
- Cash flow: The amount of profit you bring in each month after collecting income, paying all expenses, and setting aside reserves for future repairs.
Let’s take a look at how we can calculate different rates of return using the example below:
Your favourite Aunt is considering buying a property in Town Square. You offer to help her understand the property’s rates of return and whether she should invest in the townhouse. Here are the property details:
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|
Cost of the property
|
AED 1.7M
|
|---|---|
| Down payment |
AED 1.7M
AED 425,000
|
| Loan amount |
AED 1.7M
AED 1,275,000
|
| Mortgage interest rate |
AED 1.7M
4%
|
| Amortization period |
AED 1.7M
25 years
|
| Annual rent |
AED 1.7M
AED 125,000
|
| Monthly P&I |
AED 1.7M
AED 6,730
|
| Total first-year interest |
AED 1.7M
AED 50,448
|
| Vacancy period (2 weeks) |
AED 1.7M
AED 5,208
|
| Annual Service charges |
AED 1.7M
AED 6,632
|
| Annual Insurance |
AED 1.7M
AED 1,650
|
Step 1: Determine Income And Operating Expenses
The first step in analysing an investment property is understanding its expected vacancy period and total operating expenses. Expenses can include service charges, property management fees, insurance, advertising costs, repairs, etc.
Other expenses could include property management fees, utilities (for short-term rentals), repairs, advertising costs, etc.
Step 2 – Financial Benefits Of The Investment
The next step is to look at cash flow and principal reduction. These are the benefits you receive from an investment property. Cash Flow shows your monthly profit after subtracting expenses and debt payments. Principal reduction shows how much of the loan is paid down by the tenant. The principal reduction also represents the increase in wealth buildup the investor receives from a tenant paying off their mortgage.
In this example, we see that the cash flow is much lower than the annual rent; this is the figure that investors who mortgaged a property want to look at.
Step 3 – Rates Of Return
Now that we have completed the property’s preliminary analysis, we can compute the rates of return by looking at a couple of different methodologies.
Return on Investment (without appreciation)
Here we look at the impact a mortgage provides, and we see a much better ROI than rental yield. Return on investment looks at the profit generated from a rental property by factoring in all income and costs. ROI can be computed with and without appreciation, we recommend using the without appreciation approach to arrive at an accurate percentage. Appreciation is unpredictable, investment properties should deliver a profitable return even without appreciation. If the property appreciates, think of this as an additional bonus.
Capitalisation rate
This rate of return is useful for both cash and mortgage properties. The Capitalisation rate is especially useful to quickly compare different properties however, it should not be used as the sole indicator of strength because it does not consider debt leverage, time value of money or future cash flows.
Pro Tip – Always make sure your capitalisation rate is higher than the interest on your client’s mortgage. This shows that the property investment is stronger than the loan.
Cash on cash return
This last rate of return used by many investors is the cash-on-cash return which looks at income earned on cash invested. This is an annual measure of the investor’s earnings on a property in comparison to the amount the investor spent to purchase it. It’s useful for understanding cash flow and is an easy way to measure profitability however, it does not look at wealth build-up through principal reduction.
Let’s recap:
- The rental yield on this property is 7.4%
- The return on Investment (ROI) is 14.4%
- The capitalisation rate is 6.6%
- And cash on cash is 7.2%
In the beginning of this article we went through why rental yield is not a good indicator of property return. Hopefully after understanding these three different rates of returns, it is even more clear why rental yield is not a compelling metric for property investors. It does not factor debt service, cost of ownership or vacancies hence, investors don’t want to work with. In this example, we see that rental yield and cash on cash are very close however, this isn’t always the case.
Understanding the different calculations and the reasons behind the calculations are important so that you can explain the rationale behind these numbers to your clients.
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