For any given rental property, there is a single statistic that, in the end, is the defining factor of that property’s success: its rental yield. The rental yield of a property is calculated with a fairly simple equation:
Yield = (Annual Income-Annual Expenses)/(Cost of Property + Rehab)
Note that cost of property doesn’t include your mortgage payments — those are part of annual expenses. The cost of property does, however, include absolutely everything you will have to pay for before you can start renting the property out, including down payment, closing fees, costs of all renovations, costs of advertising… everything.
How to Invest in Real Estate While Working a Full-Time Job
Many investors think that they need to quit their job to get started in real estate. Not true! Many investors successfully build large portfolios over the years while enjoying the stability of their full-time job. If that’s something you are interested in, then this investor’s story of how he built a real estate business while keeping his 9-5 might be helpful.
Here’s an Example
So let’s say you purchase a house for $120,000, but you only put $30,000 down. A typical 30-year mortgage at 4% would have you paying $420/month for the other $90k (this is NOT a rate quote APR, mortgage police!). Then you hire a property management company to handle the details for you, and they charge 10% of your monthly rent amount. You set your rent at a quite reasonable $1,000/month, so the property management company takes $100/month to take care of the house. You pay an additional $280/month for various forms of insurance, a rainy-day fund in case of emergencies, and basic maintenance costs.
So now you know that your annual rent is $12,000, and your monthly expenses are:
– $100 (property management)
+ $280 (maintenance and insurance)
x 12 (to arrive at annual expenses)
So, you have $12,000 in predicted income minus $9,600 in predicted expenses, giving you a total of $2,400 for the top number of your equation. Since you paid only $30,000 down on your home but you also paid $3,000 in closing costs and $17,000 to renovate the kitchen, bathroom, it’s a total of $50,000 put in.
So your final rental yield is $2,400/$50,000, which divided out gives us a yield of 4.8%.
The Bigger Picture
Knowing the rough yield for a potential investment property is a must! However, it can also be very useful to find out data on historical yields in the neighborhood around your property. Here’s why:
- A neighborhood that has yields of below about 4% tend to be mostly stable, with tenants that stick around. You can expect a longer average tenancy in a neighborhood like this — but of course, that low yield means a longer wait until you start profiting and less profit per year once you do clear that hurdle.
- A neighborhood that has yields of above about 12% can be very difficult to keep tenants in. That high of a yield often means a very elastic housing supply, which means new options pop up frequently and people move more often — especially out of a rental and into an owned home. It can be hard to keep a rental home filled for a long time in such a neighborhood, which can make it meaningfully harder to actually get the yield predicted (because, of course, achieving the predicted yield means having a tenant for all 12 months).
- A neighborhood in the middle — 5%-11% — is generally the best investment in terms of actually maximizing your return.
But keep in mind that we’re now talking about two different numbers — the average yield of the neighborhood is not at all the same as the predicted yield of your property. In the most ideal circumstances, you can match a property with a ridiculous predicted yield (like 16%-20%) with a neighborhood that has a low-but-still-safe average yield (like 7%).
That won’t happen. If such a place exists, someone has already purchased it, guaranteed. But it’s the dream, the goal to which it is possible to aspire. This isn’t the last detail I’m going to share with you about yields, so for more of the ins and outs, be sure to check back next time!
What questions and comments do you have about yields and evaluating properties?
Let’s discuss below!