Property Yield and Ratios Explained

There is one sure thing in Property Investment... Yields will be misquoted! Whilst theoretically simple, some intracacies stand in the way of enabling investors to use Yields appropriately. We hope to bust some of the myths, dust off some of the misconceptions and polish your understanding to be able to quickly assess one property deal from another property investment.

Why use Property Yields and Ratios?

Simply, to make comparison of one property investment to another, possible and useful. If one property is more expensive, or requires more refurbishment, rents for less but at a greater occupancy rate, costs more to maintain or requires the landlord to pay some bills - the blend of Yield Calculations gives a property investor the ability to quickly compare one property deal from another to gain an understanding and ultimately lead to a better property investment decision.

The Example we will keep referring to:

• A house with a Market Value of £100,000
• An interest only mortgage of £75,000 costing 5% interest pa = £3,750 interest pa or £312.50 interest per month
• £25,000 of Equity
• Internet costs of £35 per month, £420 per year, paid by the landlord
• Management Fees of 12% per month, being £72 per month or £864 pa
• Other yearly costs of £1,200, being £100 per month (Insurance, repairs, gas checks etc)
• Rent of £600 per month and therefore £7,200 per year

Gross Yield

Purpose: To measure the amount of revenue generated from the market value of an asset, ignoring the financing structure of the asset. Think of this as the same figure that your Bank will quote you when you place money with them in an account. Currently, a Current Account may generate 0.5% interest, and therefore £100,000 in the Bank would generate £500 of interest per year. The reason property investment is attractive, is that it can often beat the interest rates available in the bank, but brings with it more risk.

Calculation: (Gross Annual Rent x 100%) / Market Value of property

Example: (£7,200 x 100%) / £100,000 = 7.2%

Net Yield

Purpose: To measure the amount of revenue after tenant costs borne by the landlord. 'Tenant costs borne by the landlord' represent costs that tenants would normally be expected to pay like, council tax, electric, gas, water, ground rent, internet, phone etc. It deducts the part of the rent that simply goes towards tenant related bills, giving a 'net rent' figure. This is more detailed than the Gross Yield calculation, as it considers some specific details of the contractual setup used to rent out the property, whereas Gross Yield does not consider these elements. This gives the investor a revised % Return, and in the example below you can see that the Yield has dropped by more than 0.4%.

Calculation: ((Gross Annual Rent - Yearly Tenant costs borne by the landlord) x 100%) / Market Value of property

Example: ((£7,200 - £420) x 100%) / £100,000 = 6.78%

Interest Cover

Purpose: To measure the ratio of Net Rent to Interest Costs. It is a safety calculation, one that gives an indication about how risky a property investment may be, in terms of the proportionate cost of the finance. In the example below, the Net Rent is greater than the interest cost by a factor of 1.8. Many lenders will not lend you a Buy To Let mortgage unless the Interest Cover is 1.25 or greater, at the lender's specified rate. If you increase the amount of borrowing, or the cost of the borrowing increases, the Interest Cover ratio will fall. The 1.8 factor below tells us that if the 5% current mortgage interest rate was to increase by 1.8x, then Net Rent would just about cover the Interest Costs - An investor can therefore conclude that their break even point, before management costs and maintenance costs, would be an interest rate of 9% (5% *1.8).

Calculation: Net Annual Rent / Annual Interest costs

Example: (£7,200 - £420) / £3,750 = 1.808

Cashflow

Purpose: To know on average, how much your bank account is growing or shrinking by on a monthly basis. This is a before tax measure, and therefore you need to consider what tax you may have to pay at your own marginal tax rate. In the example below, on average, the property investor's bank account grows by £79.50 per month as this is the amount of free cash flow available after receiving the rent and paying the bills. I note here, that a single month's void, being £600 of lost rent, wipes out 9 months of free cashflow. It is a useful measure to inform an investor about how critical a void might be.

Calculation: Gross Monthly Rent - Average monthly expenses

Example: (£600 - £36 - £312.50 - £72 - £100) = £79.50 per month

Summary

If you find a property that has a fantastic Gross Yield, that is great news! But don't stop there... If you are having to borrow a lot, you may find that the monthly cashflow is poor and leaves you exposed to significant risk and needing to put your own cash in to supporting an empty property. In such a case, if interest rates rise, is your Interest Cover suffice? If any one of the above yields or ratios looks poor - Think hard, it may not be the right investment for you, unless it fits in with your property portfolio plan and the risk is offset by other property investments.

Please add any comments below if you want any other property related yields or ratios added into this blog entry, and we will gladly update the blog.