Yield – Gross vs Nett | What is the real rate of return?

Many first-time 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 4 or 5% pa. With mortgage rates at around 3.5%, the prospective investment property seems to stack up. But does it really? It all depends on what basis the yield is based on. The gross yield, or the nett yield?

The quoted gross return of 4% can be whittled down to as little as 1.5% once expenses are factored in. Whilst the investor may take 4% pa in revenue from the tenant, after running expenses they are only keeping 1.5%, before paying the mortgage. The investor is left with an unexpected gap between income and mortgage repayments. The landlord finds themselves having to ‘top up’ the mortgage on the property every month.

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 in favour of capital growth.

It is close to speculation when an asset is purchased with the income stream completely overlooked in favour of ‘potential capital growth’. Many investors unintentionally do so though. Capital growth is an investor’s reward for owning the property over the longer term. A good rental return in the interim is crucial to the overall success of the investment.

Now that the property market has stopped rising at the frenetic pace it did in 2021, investors are becoming more circumspect. The rental income matters because that is what will underpin the investment over the first 3 – 5 years. The good news for investors is rents are now rising for the first time in quite a few years.

Furthermore, a rising rental market at the end of a property boom is absolutely crucial to ensuring a soft landing. Over the next few years, expect more investors to enter the market as prices fall and rents rise.

During the boom last year, the opposite was occurring – landlords were selling out with owner occupiers being the buyer profile in 80% of cases. This sustained trend during COVID has seen the overall rental supply tighten, particularly in housing stock.

Real estate agents will often quote the weekly rent and/or the gross yield. As an investor, you need to focus on the nett income you will receive. The tenant is not going to pay those exorbitant strata fees and neither will the agent who sold you the property.

Establishing the nett income figure

Costs that need to be factored in up front include vacancy (allow for 2 weeks vacancy p.a), agent’s management and leasing fees, strata, water and council rates, property maintenance, land tax if applicable and landlord insurance. Therefore, the income that you hold after these expenses have been paid is the real rate of return.

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?

by Peter O’Malley