Investing in real estate can be a lucrative endeavor, but it's crucial to understand the potential profitability of a rental property before making a purchase. One way to evaluate the profitability is by calculating the gross yield. In this article, we will explore what gross yield is, how it is calculated, and why real estate investors find it valuable.
What is Gross Yield in Real Estate?
Gross yield, also referred to as gross rental yield, is a financial metric used by investors to assess the profitability of a rental property. It is calculated by dividing the gross annual rent collected from a property by its current market value.
For example, let's consider a small single-family rental home in Oklahoma City, with an asking price of $60,000. If the monthly gross rent generated by the property is $610, the gross yield would be 12.2%.
In other words, an investor would receive a return of 12.2% by purchasing the property for $60,000, before factoring in operating expenses, financing, and other costs.
Why Real Estate Investors Use Gross Yield
It's important to note that gross yield alone does not determine the actual profitability of a rental property, as it does not consider the cost of ownership and operation. However, real estate investors still find gross yield valuable for a couple of reasons:
1. Compare Alternative Investments
Gross yield provides a quick and easy way to compare different potential investments and narrow down options. If a property has a low gross yield, it is likely to generate low cash flow and net operating income (NOI). Investors often set a minimum gross yield requirement, such as 10%, to help filter out properties that may not meet their investment criteria.
2. Calculate a Fair Market Rent
Gross yield can also be used to determine the fair market rent for a property. In situations where a property has not been rented before, analyzing the gross yield of comparable properties in the same area can help estimate the appropriate rental price. By rearranging the gross yield formula, investors can calculate the fair market rent based on the property's current market value.
For instance, if the gross yield from similar rental properties in the area is 12% and an investor paid $110,000 for a never-rented home, the fair market rent would be approximately $1,100 per month.
A Closer Look at Gross Yield in Real Estate
Calculating the gross yield is not a one-time calculation. Investors continuously monitor market rents and property values to track the change in gross yield over time. This helps ensure that the rent being charged remains competitive and maximizes potential profitability.
Let's consider a scenario where a single-family home was purchased five years ago in Tucson, Arizona. By analyzing data from Zillow and Zillow Research, we can observe the change in gross yield throughout the holding period:
| Year | Home Value | Rent | Gross Yield |
|---|---|---|---|
| 1 | $200,000 | $1,028 | 6.20% |
| 2 | $216,000 | $1,086 | 6.00% |
| 3 | $228,000 | $1,153 | 6.10% |
| 4 | $248,000 | $1,221 | 5.90% |
| 5 | $308,000 | $1,377 | 5.40% |
If fair market rents adjust back up to 6.0%, the monthly rent for this property could increase from $1,377 to $1,540, based on the current market value.
Other Financial Metrics for Measuring Real Estate Return
While gross yield is a useful tool for initial property analysis, it doesn't provide a complete picture of a rental property's profitability. Investors also consider other financial metrics such as the capitalization rate (cap rate) and cash-on-cash return.
Cap Rate
The cap rate measures the potential return on an investment based on the property's net operating income (NOI). It is calculated by dividing the NOI by the property price. Cap rate helps investors evaluate the property's performance relative to its market value.
Cash-on-Cash Return
Cash-on-cash return takes into account the property's operating expenses and the mortgage payment. It is calculated by dividing the annual before-tax cash flow by the total cash invested.
Both cap rate and cash-on-cash return provide more comprehensive insights into the potential profitability of a rental property.
Investing in real estate is a complex process that requires careful consideration of various financial metrics. By combining gross yield calculations with other key metrics, investors can gain a better understanding of the potential returns and make informed investment decisions.
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