Why is the property rental yield an invaluable tool in the world of property investment? How can you interpret it to make smart decisions? Today, we're joined by Stuart Wemyss to pull back the curtain on this lucrative topic. Not only will you understand what rental yield is and how it's calculated, but we'll also dive into why they generally range between 2% and 5% in Australia.
We'll be exploring the two main factors that influence rental yields: the size and condition of the property and its location. Stuart will share valuable insights into four possible explanations for a property's rental yield, and how to use this information to determine if a property is investment grade or not. We'll be discussing the importance of understanding the proportion of land versus building value, why a high rental yield may indicate low capital growth, and how to spot if a property is undervalued. If you're interested in property investment, this is a not-to-be-missed episode!
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Speaker 0:
Hi, this is Stuart Weems, and welcome to the Investopoly podcast. My goal is to give you simple, easy to understand strategies, insights and tips to help you master the game of building wealth, and in this episode I'd like to talk about property rental yields and what they 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.
Speaker 0:
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.
Speaker 0:
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.
Speaker 0:
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.
Speaker 0:
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.
Speaker 0:
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.
Speaker 0:
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.
Speaker 0:
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.
Speaker 0:
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.
Speaker 0:
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.
Speaker 0:
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.
Speaker 0:
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.