Written by Peter O'Malley
Many would-be investors are caught out when they purchase an investment property.
The reason being the yield is simply miscalculated in many cases, leaving the new investor having to find additional finances in order to cover the mortgage repayments.
The stated return in the agent’s advertisement seemed a plausible 6% pa. With interest rates at around x%, the investment seems to stack up. But does it really? It all depends on what basis the yield is based on. The gross yield, or the net yield?
The quoted gross return of 6% can be whittled down to as little as 3% when expenses are factored in. Whilst the investor takes 6% pa, after expenses they are only keeping 3%, leaving an unexpected gap in between income and repayments.
Capital Growth or Income?
Research shows that the majority of residential real estate investors buy an investment property with “potential capital growth” being the main investment criteria. Income is largely overlooked with the main focus being on annual capital growth.
It is close to speculation when an asset is purchased and the income stream is overlooked in favour of a focus (hope) on potential capital growth. But this is what many investors do, without realising it. Speculating on capital growth coupled with a property love affair is one of the reasons that many economists have concerns about the Australian real estate market.
Yield often comes in behind capital growth for investors. Importantly, the net yield is usually overlooked in favour of the often-quoted gross yield.
But if the net yield is strong, you will have a solid investment, one, which is almost certainly going to give you what all investors are chasing, capital growth.
Over the long term, capital growth is influenced by a strong net yield, not the other way around.
Capital growth is an investor’s reward for owning the property over the longer term. The very best investments produce an income that covers all expenses, including mortgage repayments.
Real estate agents will almost always quote the gross yield as it pumps up the yield. As an investor, you need to focus on the net income that you will receive. The tenant is not going to pay those exorbitant strata fees and neither will the agent who sold you the property.
Annual Income divided by Purchase Price x 100 = Gross Yield %
Annual Income minus All Expenses divided by Purchase Price x 100 = Net Yield %
What drives down the Gross Yield?
When investing in a property, it is imperative that you are aware of the costs that will erode your return. Some of these costs are obvious and some are easily overlooked.
Costs that need to be factored in up front include vacancy (allow for 2 vacant weeks p.a), agent’s management and leasing fees, strata, water and council rates, property maintenance, land tax if applicable and landlord insurance. These are all expenses that you would not have if you did not own the property. Therefore, the income that you hold after these expenses have been paid is the real rate of return.
Taxation and negative gearing is another huge consideration for investors. Expenses can be offset against income, lessening the blow. However, the accountant Austin Donnelly summed it up best when he said, “You are better off sharing a profit with the tax department than keeping a loss to yourself.”
The expenses that a landlord must cover can almost halve the income the property generates.
How does the investment look now? You can also apply this zero based thinking to your existing investment properties. Are you getting a good return on your equity?
Many people would get a superior return by selling the property and depositing the proceeds into an interest bearing bank account.
Chris Williams of Harris Partners said, “We have seen an increasing number of investors sell their property and simply put the cash into a term deposit. Particularly since the GFC, some landlords feel as though there is a greater risk than upside to their equity being in the real estate market. The net return they are getting on their equity does not stack up.”
Chris added, “This trend has been most notable amongst baby-boomers who have seen fantastic capital growth due to being long term real estate holders. There seems to be a desire to cash in and avoid any potential double dip GFC. Being long-term real estate investors, many baby-boomers are without any or have minimal superannuation. To get $25,000 after expenses on a property with $1 million equity does not stack up for many boomers now.”
Investors moving out of property and into cash is also one of the reasons rental prices are likely to continue rising. Even though some investors are coming into the market, more investors are selling out, shrinking the overall rental pool. This comes at a time when demand is rising due to a housing shortage and population pressure.
In time, the rising rental market is what could dramatically improve the net yield of residential real estate, inspiring a new wave of investors in to the market.