We are going to go back to the basics and explain some essential property calculations, and these are, Gross yield, Net yield and Return on Investment.
Whether you are new to property investment and are interested in buying for the first time or if you are an established investor, you may not be too clear on what some of these mean and how they are calculated.
The word yield is often mentioned, but as there are two different types of yields, you need to know which one is being talked about, otherwise, you might be misled into thinking that a certain type of yield is being talked about when it is the other.
The two different types of yields are gross and net, but there is also Return on Investment (ROI) which is another important calculation.
What is Gross Yield?
You will often hear gross yield quotes, and it is probably the yield you will see the most. Gross yield is very simple to calculate. If you receive £12,000 in rental income per year and you purchased a property for £200,000 (£12,000 rent income divided by £200,000 purchase price multiply it by 100), this gives you a 6% gross yield.
It’s straightforward, and it’s easy to understand, but is it useful?
No, not really, but it can give you a quick and easy way to compare properties to one another. The calculation is very simple, but it leaves out far too much information for any practical purpose.
A lot of estate agents and developers will talk about gross yield because it can make investments look good, but so much isn’t considered, and it doesn’t take costs into account. We recommend you do not use this when making an investment decision.
What is a Net yield?
Net yield is more accurate than gross yield as it is based on the actual amount of money you will receive once costs have been deducted.
An example of this is, if you buy a property for £200,000, it might generate a rental income of £12,000, but you are not going to get to keep all of the £12,000 as there will be costs involved. Such as insurance, agents fee’s, mortgage payments, maintenance invoices, service charges and other expenses that you have to pay out for before you receive the outstanding balance.
To calculate the net yield, you take the amount of income that is left over after all your costs have been deducted and then you divide that by the purchase price and multiply that by 100.
So, for example, your property generated £12,000 gross rent, but once deductions had been made you received £8,000 and you had purchased the property for £200,000 (£8,000 divided by £200,000 multiplied by 100) gives you a 4% net yield.
Again, another simple calculation!
Although it is the same calculation, you have deducted your expenses first which makes it much more realistic. Is this calculation much more useful? Yes, and it is a good one to use because it gives you a much better reflection of what’s going on.
Let’s compare the 2 examples with the same property.
The gross yield is 6% which sounds very attractive, particularly if you’re not familiar with yields and you think ‘The bank is only offering me 2% so that 6% is a far better return!
However, the net yield shows you a more accurate picture. After your expenses, you are going to be getting 4% and compared to the banks 2%, is still a good return.
Beware if you see marketing brochures plastered with 10-15% gross yields because you might be getting 7.5%.
You will only be kidding yourself if you use the gross yield. It is far more useful using the net yield calculation as it brings in more of the information and is therefore much more effective.
As you can see, the examples show why it is much better to use net yield. Even more so if you are comparing buying a house for £200,000 versus a flat for £200,000. They might bring in the same amount of rent, but the flat might have a service charge of £1,400 a year whereas the house doesn’t.
Even if all other costs were the same, that service charge will have reduced your net income. But, by considering the net yield, it will give you a much more realistic basis on which to make a decision.
There is, however, a third calculation you can use.
You might be thinking 4% doesn’t sound too bad, but if your bank is offering 3% to keep your money locked up long term with them, you won’t be getting that much extra.
Well, you would be right but, you need to remember that you are not purchasing the property with all of your money and this is where Return of Investment comes in very useful. Return on investment is often referred to as ROI.
So, what is ROI?
Return on investment is the calculation that we recommend using, it helps you assess one property from another, and helps you assess it across different asset classes.
Here is an example.
Take the £200,000 property and it is going to cost us £55,000 with a 75% buy-to-let mortgage. £50,000 is used towards the deposit and you spend £5,000 in other costs i.e. solicitor’s fees and broker’s fees. We have rounded up the numbers to make this calculation easy to understand.
It has cost us £55,000 of our own money to buy this property and we receive £8,000 net income coming in. We now need to look work out the ROI the £8,000 net income gives us against the £55,000 we put into buying the investment.
You need to look at the £55,000 as a percentage term. So, take the £8,000 net income and divide that by £55,000, multiply it by 100 and this gives us a 14.5% ROI.
There are a couple of things that you must do and that is making sure it is all of your expenses, not just the deposit for your purchase costs and you must use the net income, not the gross income.
Your ROI is dependent on how you are financing the property, and how much of your own money you are using but it is the most direct and useful calculation that tells you what your reward is going to be for the effort and the risk that you’re taking.
So, to finish, you could say that each calculation has a purpose, the Net yield is useful, but ROI gives you the most realistic accuracy.
There you have it, that’s yields and if you have any questions or comments, please leave a comment below or directly via email – firstname.lastname@example.org
If you have any questions or you would like to go into this in more detail, we are more than happy to.