You expect two things from your investment property: capital growth and cash flow.
When we talk about cash flow, we would inevitably mention “rental yields”. Many investors believe the higher yield, the better, as that means more rental income into your pocket.
Healthy rental yields are great. However, cashflow is not all about yields. Today we’re going to explain why.
What is rental yield?
Rental yield is the ratio of the total rental income you receive over a year to the market value of a property.
There are two types of rental yields: gross rental yield and net rental yield. The above definition is for gross rental yield, while the net figure excludes your annual expenses (insurance, maintenance, property management fees, etc.).
Why is rental yield important for investors?
Understanding rental yield is important for property investors as it helps determine if the investment is financially feasible, and sustainable in terms of portfolio building.
Let’s do a quick calculation to get abetter picture of how the rental yield influences your cash flow.
We are going to buy a $500k house with:
· 80% LVR loan
· Principal & Interest with4.5% interest rate
· 35% of gross rental income to be spent on holding costs
· Average 2 weeks vacant period per year
· Rental price and expenses growing by 3% per year
What will the cash flow be like in the coming 30 years if the initial rental yield is 5% (rent=$480/w), 4%(rent=$385/w), and 3% (rent=$290/w)?
· With a rental yield of 5%, you just need to pay $176 each week to own the property. Keep in mind this is P&I, so on IO you may still be positively geared in the eyes of the Govt.
· If the rental yield is down by 1%, holding costs rise as per the examples above
· The initial weekly repayment almost doubles if the rental yield is 3%, and you receive nearly $400 less than the 5% yield scenario at the end of the term.
Apparently, a healthy yield is crucial to your investment journey due to these varying cashflows.
However, it’s not all about yields.
Because once you have bought the house, the house price denominator will be fixed in the yield calculation, and the change in the numerator, i.e., the rental income growth, becomes more important.
Say you bought a $500k house, the initial rental weekly rent was $450, rental yield = 4.68%. In one year, its market value has grown to $550k, and weekly rent has grown to $500. Its rental yield for someone who’s going to buy it now would be around 4.7% ($500/w*50wks/$550,000=4.7%), but for you, the rental yield is 5.2%($500/w*50wks/$500,000=5.2%).
So besides the initial rental yield, rental growth is also key to your investment success. In our opinion, the next 12-36months will demonstrate a drastic improvement in “yield on purchase” for many who now own or soon buy an investment property.
Speaking of rental growth, you must have noticed one thing: rental growth rates differ from market to market.
How did Australia’s SA3s perform in rental growth in the past two years? The below chart shows the number of SA3s falling in each rental growth range.
I bet you would prefer buying in the 98 SA3s with over 20% growth to the rest if they had similar yield levels.
Then let’s look at some specific regions. The below tables list 3 groups of regions with different initial rental yield. The 2022 “real” yield refers to the yield calculated based on the purchase price in 2020.
In the 3 groups based by price points, we featured 2x regions within each group. In all 3x scenarios we were able to find a lower initial yield that has now achieved a higher “real” yield on purchase price after 2 years of strong rental growth.
Examples like the above demonstrate why we don’t just look at yields, but, more importantly, the potential of rental growth alongside yield.
How do we identify the potential?
We look at rental market pressure.
There are many indicators with which you can examine the rental market pressure. One of them is the vacancy rates.
The vacancy rate is the percentage of available rental properties in all properties in a market. It demonstrates the demand and supply relationship:
· A vacancy rate of 2% is considered the equilibrium point at which the market balances between renters’ demand and landlords’ supply.
· A vacancy rate below 2% signifies high pressure, where the supply is not enough to meet the increased demand; As a result, the rental prices tend to increase here, and increase with greater ferocity the lower this vacancy rate becomes.
Many regions where rents have surged have been experiencing extremely low vacancy rates of <0.5% for the past 2 years or even longer.
Besides vacancy rate, the growth trend of rental price vs. sales price, the trend of for-lease listings, rental DOM, 1 year vs 3-5-7-10 year rental trends, rental affordability to income and more is analysed to truly uncover rental market pressure.
At Investorkit buyers’ agency, we value the right rental yields. However, we hunt markets demonstrating high rental pressure so that your investment enjoys a better return in the longer run. Would you like to achieve your investment goals faster without getting lured by the common investment trap of high yields in isolation? Work with InvestorKit! Click here and request your 45-min FREE no-obligation consultation today!