In Pakistan, when investing in property, renting a property is quite profitable investment. It is because the property you buy remains as your hard asset, which can experience any increase in value over time. At the same time, rather than keeping the property vacant, it can be rented out, providing a stable source of cash flow, further adding to the value of the property. From every end its a win-win situation.
But how can we determine if the property we are investing in will be profitable for renting or not? Investors for this use a metric called Rental Yield, which provides an estimate of the profit a rental property can generate.
This article will take you through the details of rental yield, and at the end of the article, you will be able to calculate the rental yield of your property.
What is Rental Yield?
“The term rental yield refers to the annual rental income produced by a rental property and is displayed as a percentage of the total property value.”
In simple terms, rental yield is a measure of how much profit a property is generating over a period of one year in comparison to its market value. This gives an estimate only and is not always exactly accurate. In reality, many factors can arise that can alter this percentage later on.
Why is Rental Yield Important?
Rental yield calculation is essential in the cost-benefit analysis of a rental property to determine whether the process is profitable enough. Some main reasons it is considered important are:
- Rental yields ensure to make better investment decisions by comparing different properties in the market on the basis of their rental profitability.
- Knowledge about rental yields facilitates better negotiation and dealing with property transactions or renting.
- This percentage allows to maintain a practical expectation of what to expect as profit.
- It helps generate a standard or threshold against which the profit variation can be measured.
- Information of this metric allows for better planning of investment strategies.
Effect of Property Type on Rental Yields
The type of property greatly influences rental yields:
Apartments: Apartments require less initial cost due to budget-friendliness and shared maintenance costs so they may experience high rental demand. One would expect it to provide a high rental yield but regular monthly charges should be considered in the calculation.
House: Houses require more initial cost as they are expensive and have high repair and maintenance costs causing them to produce lower rental yields. But houses have a more stable rental income flow, meaning they can provide a rental yield for a longer time period.
Commercial properties: Commercial properties need very heavy investments at the start but are capable of generating high rental yields due to demand and location.
Effect of Location on Rental Yield
The location of the property also influences its rental yield. The demand and market prices vary with each location affecting the overall profit. City centers and busy commercial areas often have lower rental yields since property prices are higher and rents are comparatively lower. While in suburban areas property is more affordable but rents can be high providing higher rental yields. But demand is contrasting to rental yield in each area which makes gaining a tenant tough.
Types of Rental Yields
Rental yields are classified into two types, which are:
- Gross Rental Yield
- Net Rental Yield
This classification is mainly based on the inclusion of maintenance costs to the total estimate.
Gross Rental Yield
Gross Rental Yield is the rental yield calculated by the rental income and property value, with no involvement of any other extra costs on the property. It is a simple metric to identify the overall rental yield. The formula of gross rental yield is:
Gross Rental Yield: (Annual Rental Income / Property Value) x 100
Example:
Let's suppose you have a property of 50,00,000 rupees value and your monthly rent is 18000 rupees. Your annual rent would be 18000 x 12 = 216,000. Your GRY would be (216,000 / 50,00,000) x 100 = 4.32%.
Net Rental Yield
Net Rental Yield is the rental yield that provides a profit estimate on the basis of rental income, maintenance and other property costs, along with property value. It may provide a lower percentage than gross rental yield, but is more accurate.
The extra costs may be:
- Federal and provincial taxes
- Property management charges
- Repair and maintenance costs
- Mortgage costs
- Insurance charges
The formula to calculate net rental yield is:
Net Rental Yield: [(Annual Rental Income - Expenses) / Property Value] x 100
Example:
Let's suppose you have a property of 50,00,000 rupees value and your monthly rent is 18000 rupees. Your annual rent would be 18000 x 12 = 216,000. Your other expenses on the property such as insurance, maintenance, etc., are all about 4000 monthly and 48000 annually. The NRY would be 216,000-48000 = (168,000 / 50,00,000) x 100 = 3.36%
| Aspect | Gross Rental Yield | Net Rental Yield |
|---|---|---|
| Definition | Rental return before expenses | Rental return after deducting expenses |
| Formula | (Annual Rent ÷ Property Value) × 100 | (Annual Rent − Expenses ÷ Property Value) × 100 |
| Expenses Included | Not included | Included |
| Accuracy | Less accurate | More accurate |
| Profit Reflection | Overestimates returns | Shows real profit |
| Purpose | Quick comparison of properties | Detailed investment analysis |
| Investor Use | Initial screening | Final decision-making |
What makes it a good Rental Yield?
The appropriate rental yield varies for each area. It is because of different factors such as location, demand, property type, and demographics. For US markets, a rental yield of 7% or more is suitable and is considered a profitable investment. For the local Pakistani market, a 7-8% yield is also efficient.
Rental yield is an effective metric to estimate investment profit. Based on a simple calculation, it provides a means to make better decisions through a standard on which properties can be compared and an expectation of profit can be maintained.