Cost Analysis – ROI
Whether you’re purchasing your first rental property, or adding to an extensive portfolio, your first step should always be to calculate your potential property’s ROI. As a rule of thumb, the most effective way to analyse a rental property’s ROI is to calculate its rental yield.
ROI as rental yield
In order to calculate rental yield, you must divide your property’s rental income by the initial cost of buying the property. This is usually expressed as a percentage.
This is done by taking the total amount of rent and subtracting all running costs (mortgage payments, insurance, repairs and maintenance, etc.), then dividing your answer by the total amount you invested to purchase the property (this should include all fees; including taxes, legal fees, survey fees, etc.). Remember, the higher the yield, the better.
What is a good return yield percentage?
In my experience, a good rental yield for BTL property is 4-5% or more. Any property with yields below this level could risk not bringing in enough income to cover running costs, such as ongoing maintenance, mortgage payments and those unforeseen, expensive problems that inevitably crop up when investing in a property.
Areas with high levels of rental demand or capital growth can be very tempting. Additionally, below-market-value properties can often seem like a good deal. However, if the rental return is only, say 3%, then month-by-month your income is unlikely to even cover the mortgage payments.
Points of consideration
While calculating the yield of a rental property is relatively straight forward, there are a few points to consider which can affect your calculations:
Void periods are periods in which your property is not being rented out. Ignoring these periods is a common mistake, however, it is one that can easily throw off your calculations.
It is highly unlikely that your property will be occupied throughout all 12 months of the year, so when calculating your rental property’s yield, keep in mind that there will inevitably be times in which your flat sits empty.
Whether you’re in between tenants, are involved in heavy repairs, or at the very beginning of your investment, these down times must be calculated and prepared for. One way to accomplish this is to “stress-test” your property, by using 11 months’ worth of rental income when calculating your rental yield.
When calculating your rental yield, it is important that you use the total figures in order to get the most accurate results. When using the total investment amount, it should include ALL your costs, which may include the following:
Cost of property
Cost of refurbishments and repairs
Running costs during void periods (e.g. council tax, insurance, etc.)
Costs of furniture
Make independent yield calculations
Oftentimes when agents, or developers speak of yields, they can often sound incredibly appealing, and you should see this as a red flag.
This is because many agents who are motivated to sell you their property often make their calculations based on basic costs of the property only, essentially ignoring all the costs associated with buying the property (as per the list mentioned above). Without these added expenses, the yield will clearly be much higher, which makes the deal seem sweeter than it actually is.
As a responsible and detail-oriented property investor, you must make sure you perform your independent yield calculations to ensure the numbers that you see are what you’ll actually be taking home.