How to calculate rental yield
- 13th November 2020
- Investing
Beware agents bearing attractive yields!
As any seasoned investor knows, rental yield is an important metric when evaluating a property. By presenting annual rent as a percentage of a property’s value, investors can easily compare properties and thereby assess their performance. Needless to say, given the importance attributed to this metric by investors, agents and vendors are strongly incentivised to inflate yields by making many heroic assumptions about income on the one hand and turning a blind eye to costs on the other.
“Agents and vendors are strongly incentivised to inflate yields”
When advertising the net yield of a property, agents will neglect any of the costs associated with purchasing the property or any repayments if the property is mortgaged, among other things. This often leaves investors earning a lower return than the one they were led to believe.
In the interests of transparency and our own credibility we thought it would be helpful to provide investors with the calculations we undertake when determining yield of investments on the platform.
Which yield are we talking about?
Gross yield and net yield are two terms used to appraise the viability of an investment property. Gross yield represents the annual rental income divided by the purchase price of a property. Net yield is calculated by taking the annual rental income, deducting any costs and then dividing by the purchase price of a property. The net yield calculation will give investors a much more accurate idea of how a property performs, which is why it’s vital to ascertain the true figure. For the purposes of this blog, we subscribe to Investopedia’s definition which is “Net yield is the real return to the investor”. In other words, the yield should take into account all known costs and taxes for both the purchase of the property and the net rent received.
Purchase price
It is a statement of the obvious that purchasing a property incurs costs. When calculating rental yield investors should therefore take these into consideration, not just the price of the property. As a rule of thumb, 7% should be added to the value of the property for a quick calculation. However, the following are the specific variables that need to be quantified for an accurate appraisal:
Stamp Duty Land Tax (SDLT)
Although there is currently a Stamp Duty holiday, buy-to-let investors more often than not have to pay SDLT. SDLT is not a uniform tax and varies according to factors such as the value of the property, if the purchase means you’ll own more than one property and whether the property is being purchased through a company. A good website to look at for more details is Stamp Duty Calculator. Assetz Exchange buys properties through a limited company (Ltd) and typically pays on average 3% SDLT.
Legal costs
Investors usually require a conveyancer to manage the legal aspects of purchasing a property. In our experience legal costs vary from between £700 to £1,800. However, investors should also budget for a further £400 of search fees, which are often overlooked.
Ancillary costs
At Assetz Exchange we require an independent RICS valuation and the set up of the limited company. Investors often choose to purchase a property through a company. For a single property these can be up to £500.
Contingency fund/remedial work
If the property being purchased requires repairs or certification to meet regulations then these should be factored in. Even if the property being purchased appears sound, at least one month’s rent should be set aside as a contingency and therefore included in your calculations.
Where to find the purchase costs on Assetz Exchange
Users of Assetz Exchange can see the property price and the additional costs (we refer to as FCC – fixed costs and contingency) at the top of the Property details page.
Net rental income
There are a significant number of variables that need to be considered to establish a realistic forecast of net rental income for a property. The following are the ones that we take into account:
What contract governs the tenancy?
The first thing we consider is whether the property is going to be leased to an organisation or let to a private tenant under an assured shorthold tenancy (AST). Under the lease agreements we have with organisations, all responsibilities for the property is delegated to the counterparty (the tenant). As a result, the net rental income is relatively easy to calculate as costs are borne by the organisation leasing from us. By contrast, with a traditional AST lease, landlords have more responsibilities and are liable for costs.
Management costs
Investors need to determine if they are going to manage the property themselves or use a professional agent. Most agents will charge 10% plus VAT of the gross rental income.
Service charge
If the property being purchased is part of a block of flats or it shares communal facilities with other properties then a service charge will be levied to cover the costs such as lighting, heating and general maintenance of these communal areas. Service charges can be a source of particular anxiety for investors. If the property is part of a new build then initial budgets can be optimistic and so can rise dramatically. Furthermore, mortgage lenders now pay careful attention to service charge levels when evaluating the feasibility of financing a property.
Ground rent
If an investor is purchasing a leasehold property then they will have to pay the freeholder ground rent each year. This is usually a small amount (peppercorn) but these charges have been in the spotlight over the past few years due to abuses.
Insurance
There are many different types of insurance available to landlords. As a minimum, landlords are obligated to have buildings insurance. This is sometimes included in the service charge if purchasing a leasehold property but investors should not assume this. Landlords may also want to purchase rent guarantee insurance which covers rent defaults (but not voids).
Mortgage costs
Investors will have to incorporate interest payments if they plan on using a mortgage to purchase the property. However, be careful to factor in the ancillary costs associated with the mortgage, which are often overlooked.
Taxes
Investing in buy-to-let property incurs taxes. This calculation is not straightforward and varies depending on many factors such as whether you buy the property through a company or in your own name.
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How does Assetz Exchange calculate net rental yield?
We believe it’s important to be fully transparent with investors using our platform, and the forecast net yield we show takes into account all the associated costs of owning the property.
This is best illustrated through one of the properties on our platform. Using 19-21 Derby Lane you can see that:
- The purchase price of the property is £93,538 (as at 11 Nov 2020) – a £1,500 discount to its RICS value.
- There are £8,234 of associated costs (costs and taxes associated with the purchase of the property plus a contingency balance) – a full breakdown is provided
- This results in a total cost £101,772
- The forecast annual net income is £5,846 – a full breakdown is provided
- Thus the forecast net yield is 5.74% ((£5,846 ÷ £101,772) × 100)
- Furthermore, investors can check the efficacy of the forecast net yield against the property’s financial history as monthly performance breakdowns are provided
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