The gross yield of an investment is simply its gross profit (before expenses and taxes) expressed as a percentage of the investment's price. For example, an investment that costs $10,000 and produces $1,000 in gross profit would have a gross yield of 10%.
Explaining gross rental yield
Gross rental yield refers to the gross yield produced by a rental property. It's simply a function of the rent collected over the course of a year expressed as a percentage of the property's market value. A rental property with a market value of $100,000 that generates $12,000 in rental income each year would have a gross rental yield of 12%.
Gross rental yield is not reflective of the actual profits (if any) an investment property generates. It is only based on annual rental income. It doesn't take expenses such as property taxes, management fees, and other operating expenses into account. This would be the net rental yield. In fact, it is certainly possible for a property to have a strong gross rental yield and still produce poor cash flow for its owner.
For this reason, gross rental yield can be useful for a quick comparison between two investment properties or to narrow down a list of potential investments. But it isn't a great gauge of a property's profitability by itself.
In addition, there's another popular metric used to evaluate real estate investments called the gross rent multiplier, which is a close cousin of gross yield. The gross rent multiplier is a property's sale price expressed as a multiple of its monthly (or annual) rent. Investors often have a certain gross rent multiplier -- such as less than 100 times the monthly rent -- they are willing to pay for a rental property.
Before we go any further, a quick terminology note. The term "gross rental yield" is used more commonly in Australia and several other countries but isn't widely used in the United States. As a U.S. real estate investor, you may hear the term "gross yield," which means the same thing.
Why would you want to use gross rental yield?
There are a few situations where gross rental yield can be useful in real estate investing:
- Determining how much rent to charge: Let's say you just bought an investment property with no current tenants, so you want to know how much rent you should ask for. If you know what the average gross rental yield is in your particular market (a local real estate agent can help with this), you can multiply it by the property's value to determine an appropriate asking rent.
- Comparing two or more potential investment properties: Using the concept of gross rental yield can help a property investor narrow down the inventory on the market to a short list of promising opportunities. By using a certain cutoff (say, 10% or 12%) you can divide each property's expected rent by its listing price and use the gross rental yields for a quick way to find the best investment properties worth a closer look.
Calculating gross rental yield
Gross rental yield is rather easy to calculate using these three steps:
- Multiply the property's monthly rental income by 12 to determine its annual gross rental income.
- Divide the annual gross income by the property's market value.
- Multiply the result by 100 to convert it to a percentage.
As an example, let's say you have a single-family rental property that currently brings in $1,150 in monthly rent. The property was recently appraised for $120,000.
First, you would multiply the $1,150 monthly rent by 12 to find the property's annual gross income of $13,800. Next, divide this by the $120,000 market value of the property, which gives a result of 0.115. Multiplying this by 100 shows a gross rental yield of 11.5%.
One thing that can vary in the calculation method is how the property's value is determined. Some investors use an actual estimate of the current value (like an appraisal or analysis of comparable sales in the area). When trying to evaluate potential investment properties, each property's listing price or expected sale price can be used to calculate gross rental yield. And if you recently bought an investment property, use the price you paid for it as its market value.
Other important real estate profitability metrics to know
Because it only looks at gross income (annual rent) and not how much net profit the property is actually generating after its annual expenses, gross rental yield isn't a great profitability metric to use alone. For example, two properties can have the exact same gross rental yield, but if one has significantly higher property taxes or costs more to insure, the net profit they generate can be very different.
So the best way to use gross rental yield is as a ballpark estimate of a property's profit potential, or better yet, in conjunction with other metrics like these:
- Cap rate: Also known as capitalization rate, this is most commonly used with nonresidential commercial properties but can be applied to any type of real estate investment. Cap rate is calculated in a similar manner to gross rental yield as a property's net operating income (NOI) divided by its cost (or current property value). For example, a rental property worth $100,000 that generates $6,000 in annual NOI after expenses would have a cap rate of 6%.Cap rate can be a more useful comparison than gross rental yield because it considers a property's net operating income after expenses like property taxes, insurance, repairs, etc. It doesn't consider any financing costs, such as a mortgage payment, so just because a property has a high cap rate doesn't necessarily mean it will be profitable if you choose to use financing.
- Cash-on-cash return: Taking things a step further, cash-on-cash return is an investment yield metric that takes expenses as well as financing costs into account. To calculate cash-on-cash return, take a property's cash flow (the amount of annual income after paying expenses, taxes, and your mortgage payments) and divide it by your out-of-pocket costs of acquiring the property. For example, if you acquire a $100,000 investment property by putting 25% down on a mortgage with $5,000 in closing costs, you would have an out-of-pocket cost of $30,000. If the property generates $3,000 in annual net profit, your cash-on-cash return would be 10%.
Finally, none of these metrics take capital growth (the increase in a property's value over time) into account. When you invest in real estate, income is just one side of the profit potential. It's entirely possible for a property that doesn't produce much cash flow to still be an excellent investment because of long-term capital appreciation.
The bottom line
Unless your primary motivation for investing is to generate current income, consider the big picture -- not just any single profitability metric -- when investing in real estate.