When you buy an investment property, there are a few important things you have to think about if you want make sure your investment is a success.
Property can be a great way to get ahead with your money and create lifestyle options, but not all properties are the same so you need to know what to look out for.
But how do you tell which is a good investment, and how will you know if the property you’re looking at is really the best for you?
And when you invest, should you be looking for a property that will give you a positive income straight away, or one that might give you a better return in the long run.
The answer isn’t as straightforward as you’d expect…
When you invest in property, the three most important variables you need to consider are; the potential for growth (the increase in value over time), tax benefits, and rental return/income from the property.
I’ve recently been helping a couple of our Pivot Clients purchase their first investment property, and in going through this process I’ve realised how confusing it can be to figure out the income side of things, so wanted to write this post to help anyone else trying to figure this out.
So you can make the right decision when it comes to the income from your property investment you need to understand rental yield.
Rental yield is a measure of the income return on a property investment. This measure is so useful because it doesn’t look at the income by itself but takes into consideration the value or price of the property.
The rental yield is a very useful measure to use if you’re trying to compare properties and figure out whether a particular property is a good investment. Ask yourself, if you have a property that generates rental income of $500 per week, how do you know if that return is good, great, or poor?
For a start, you need to look at the property value – if the property is worth $300,000, the return might be great, but if the property is worth $900,000, the return could be poor. It all depends on the value of the property…
The rental yield is expressed as a percentage, and tells you the return based on the overall property value. So if a property is yielding 4% you know that if the property is worth $300,000 this means the return is $12,000 each year. If instead the property is worth $900,000, the return at the same yield of 3% will be $36,000.
By having the yield as a percentage, you can easily assess and compare the return on different properties. So if you’re looking at one property with a value of $450,000, and another with a value of $550,000, you can check what the percentage return is for each.
Once you understand the broader concept of rental yield, there are two different measures of rental yield you need to know about – the gross rental yield and the net rental yield.
The gross rental yield, is the overall rental income on the property relative to the property value.
For example, if Sam owns a property worth $500,000, and charges $450 per week in rent, the gross rental yield is as follows:
Annual rental income ÷ property value
($450 ✕ 52 =) $23,400 ÷ $500,000 = 4.68%
The net rental yield is a measure of the return on the property which includes all the ongoing property management costs, such as strata fees, council/water rates, managing agent fees, insurance costs, etc.
If we return to our example above, noting that the total running costs for Sam’s property is $4,800 each year, we calculate the net rental yield as follows:
(Annual rental income – costs) ÷ property value
($450 ✕ 52 =) $23,400 (- $4,800 =) $18,600 ÷ $500,000 = 3.72%
You can see from these examples that the difference is pretty substantial, so if you’re looking at a property you need to make sure you’re looking at the right numbers, or it’s easy to get confused and make the wrong investment decision.
Arguably in the purest sense, when you invest the net rental yield is the most important figure because this is how much you end up with in your bank account at the end of the day. This measurement will also allow you to easily compare properties of different value.
But it’s also important to note that the rental return isn’t the only important factor to consider when it comes to investing in property. What many people don’t know is that in many cases, there can be opposite (or inverse) relationship between rental yield and future growth prospects.
Typically a property where the net yield is higher will have lower growth prospects for the longer term. For example, properties in rural areas in Australia are often cheap relative to the rental income, which means they have a high yield. These properties also often grow slower that a property in a metropolitan area, say a property close to Sydney/Brisbane/Melbourne CBD.
In contrast, a property close to a CBD, say a Bondi, South Yarra, or Kelvin Grove might have a lower rental yield, but over the long term might be likely to increase in value at a greater rate than a rural property.
So what’s going to be the best sort of property investment for you? Well you might not be surprised to hear me say it depends on what you’re trying to get out of your investment and what your current situation is.
If you’re currently on a higher income/tax rate and have no need for income, you might be able to invest in a property that will give you some tax deductions, but be likely to increase more in value over time. If you’re looking to boost your income or build a property portfolio to generate income, you might be ok to invest in a higher yielding property with a lower growth profile.
You should always think about your investment goals before you jump into any investment, to make sure what you’re doing fits in with your overall plan – and to avoid making bad investment decisions which can end up holding you back with your money.
At the end of the day, if you get your property strategy right from the start you’re going to be well placed to make serious progress with your money and create lifestyle options. Make sure you think about the important issues when you’re investing!
