What does the rental yield tell you about a property?

Now , for those that don't appreciate what a rental yield is , essentially it is the amount of gross income that a property will attract relative to its market value , and so it's expressed as a percentage and generally in Australia , gross rental yields , property rental yields range , but somewhere between two and 5% .

2% is probably a house in a main capital city like Melbourne or Sydney . 5% could be an apartment , for example , in Perth , but it really depends on the locality and type of property .

That kind of determines that yield , and the point of this episode is to describe how a property's rental yield can give you some insights into its fundamentals and therefore the expected returns that you might receive investing in that particular property , and so sometimes it can be a red flag , sometimes it can be a positive sign , of course .

So there's two primary factors that determine a property's rental yield . Of course , there's lots of things that can influence it , but there's really two main things , that sort of drive yield , if you like . The first one is the size and condition of the property probably has the largest influence on rental yield .

So larger properties with more bedrooms and more living area and more space generally command higher rental incomes . A new property tends to fetch a premium rental , while a poorly maintained property will probably rent for below average . And of course the amount of amenity that a property offers can also have an impact on its rental yield .

So , for example , if you had a house in Queensland and that house had a pool , you know in a warm climate a pool's a positive attribute and something that renters will potentially pay more for . So really , the more that the landlord has to offer a tenant typically , the more rental income they can command .

So that's the first thing , is really size and condition of the dwelling . The second attribute is really the property's location , as that really determines the supply and demand characteristics of that particular property .

So , for example , highly sought after areas in blue chip established suburbs , in a really good street , in a great location within that suburb , can attract premium rentals .

Coastal locations tend to attract premium rental amounts , particularly for permanent let places , and the reason for that is that most landlords that own properties in coastal locations tend to rent them on a short term basis so Airbnb to sort of maximize their income .

So in those locations you've got a real short supply of permanent rental properties and that's why they tend to yield a bit higher . Also , in regional locations or smaller towns , again that can attract higher rental yields again , just because the shortage of supply of rental properties .

Furthermore , properties expense profile can have an impact on its rental yield as well . For instance , if you've got an apartment with very high body corporate fees , often landlords will seek to compensate themselves for those additional costs .

But also those additional costs probably mean that apartment complex offers a lot of amenity as well , which again obviously adds to the rental yield . But sometimes that gross rental yield on the face of it looks attractive , but when you dig a little bit deeper into the cost profile of that particular asset it doesn't look as good .

So really , in summary , a properties rental yield is mostly guided by the dwelling in terms of size and condition and then really locality .

So what I wanted to do then now is talk about sort of four possible explanations for what might be driving a particular rental yield for a particular asset , and these are the sorts of things that might either confirm or suggest that the property is investment grade and therefore likely generate good returns , or might be a red flag to suggest that the property isn't

investment grade and therefore you need to look a bit closer . So the first possible explanation is the proportion of land versus building value .

So typically a property with a very high building value component will attract a higher rental yield , whereas we know that , as investors , we really want to invest in assets where the underlying land value represents most of the overall properties value , because we know that land appreciates at a much faster rate than buildings do and , in fact , sometimes buildings

depreciate although I I did a episode recently on that that's not always the case , but certainly land is the attribute that we really want as investors , and so if we have a high land value property , that typically means we've got less to offer in terms of accommodation , either in terms of size or even quality and finish of that particular accommodation , and , as

a result , investment grade properties tend to produce lower rental yields . You know , somewhere between two to and a half 3% at max . So if you've got a property with a high rental yield , sometimes that can be a red flag that you're spending too much money on the building value rather than the land value . Of course renters want to pay for building value .

They don't really want to pay for land value , and I often say that renters should pay for building value , investors should pay for land value . That's why there's a disconnect , I guess , there between what you should look for as an investor and what really renters will look for . Having said that , you do want to try and maximize the income .

So , even after you've purchased the property , making improvements . If it dramatically improves the rental income profile and reduces vacancy risk , then that's worthwhile also doing . The second possible explanation is that you expect low capital growth . So , again , in regional areas or small towns often offer higher rental yields for two reasons .

Firstly , there's a scarcity of supply of rental properties in small towns . For a town's got a population of 2000 people , the demand for rentals going to be relatively low and , as a result , there's not many investors that own investment properties in that locations . There's not a lot to choose from .

Secondly , those sorts of locations , because of low demand , because low population and density and so forth and the fact that there's an abundant supply of vacant land , typically those locations don't yield a lot of capital growth and so to compensate investors for owning property in those areas , the properties tend to yield a higher income level .

So it's important to note , if you look and analyze past returns in markets for investment grade properties , that it is very unlikely you're going to generate a total return that exceeds 10% per annum over long run the average long run return . So the 10% is both growth and income .

Therefore , if you're looking at a property that's yielding 6% , then it's very unlikely you're going to get more than 4% in terms of capital growth , and that's for investment grade properties .

So if that property is located in a inferior location that's not likely to grow like blue , cheap investment grade locations , then maybe in fact your growth rates probably going to be closer to 2% , but it's sort of in line with inflation , if you like . Sometimes people think , oh , I'm going to buy this property .

It's yielding 6% in terms of rental income and I'm going to get 6% or 7% in terms of capital growth . In that situation that investors anticipating they're going to earn 12% to 13% total return from a property that's in a sort of regional area or small town . Of course that doesn't make a lot of sense .

It's possible that that property could return that amount over a very short period of time . But we all know that property is a long-term asset . We want to hold it for many decades .

So the most important thing is to invest in an asset that has the propensity and fundamentals to drive a total return of circa 10% over very long periods of time , so you can benefit from that compounding and your growth rate . Therefore , a high rental yield can sometimes be a red flag that the property isn't located in an investment grade location .

The third possible explanation can be an alternate use of that property , so that the rental yield doesn't really accurately reflect what the long-term permanent tenant will pay for a particular asset . In fact , that the yield has been artificially increased , and so you can do that through a couple of ways .

Obviously , short-term , letting the property through Airbnb can elevate its income . Maybe you've got multiple tenants in the same properties . For example , if it's a dual lock , or if you've got a granny flat at the back , you're able to sort of put two tenants in there .

So it's possible that asset still is a good quality asset in terms of its locality and land value and so forth , and it's just that the rental yield is artificially elevated because of the way that you're renting out that property . And the fourth explanation could be that the market value is currently less than its technical value .

So a high rental yield could be an indicator that a particular property is undervalued . So this can occur in markets that have been stagnant for some period of time .

You know , if you go through a market where there's very little growth I did a episode on Perth , for example , a few months ago and why I think Perth is undervalued and likely to produce above average returns over the next period of time .

Perth hasn't seen much change in median house prices for about 15 years and so , consequently , an investment grade home in Perth with a really high land value component will still produce a gross rental yield of 3.5 to 4% , which is very high compared to other capital cities , almost double than what other capital cities will produce .

Now that's not because it's got a high building value or it's not a good location or so forth . It's really just because values have been quite depressed in Perth for a long period of time and the intrinsic value is most likely to be in excess of what you have to pay for that property to buy it today .

So it's market value , but sometimes it can be a hint that it is actually quite a good investment asset . So of course , rental yield serve as a guide . They're not an absolute rule . We've got to realize that properties and locations tend to be unique and you rarely can find two identical properties . And of course there's exceptions that prove every rule .

So relying on rental yield analysis alone can be misleading . But again , it's just gives you a hint on what to consider or what further investigations to make for a particular asset as a result of the rental yield .

As I've said many times in this podcast , to generate good compounding annual returns from investing in property , you need to invest in a property that has a high land value component , that is located in an area that produces a lot of scarcity , so that is , there's more buyers than there are sellers for that particular asset and an area that has proven performance .

So it's got the runs on the board that demonstrate over the last four decades it's produced an average growth rate of 8% or whatever it might be , so it's proven its performance . The problem with buying a high land value type assets is that they tend to generate very low rental yields . As such , when you come across a property with a high rental yield .

Sometimes it can be a bit of a red flag , and it's important then to understand what is contributing to that higher rental yield . Is it too much building value ? Is it situated in a non-investment grade location ? Is it intrinsically undervalued but still an investment grade property ? Or maybe the rental yields have been artificially inflated ?

Either way , it's really important that you investigate further and investigate its investment worthiness and don't get dazzled by really high rental yields , thinking or believing that , hey , this is a great asset because I'm booking that rental income .

Income is great , of course , but we don't want it to come at the cost of accepting a much lower capital growth rate , because in 20 to 30 years time , that company annual growth rate in dollar terms will produce substantially more return than what income will .

Notwithstanding , we know that income is taxed each year and capital growth is not until we sell the asset and again , which adds to the compounding nature of that particular return . Okay , that's it for me for this week , until next week . Bye for now .