Investing in property can be a lucrative way to generate passive income, but before you take the plunge, it's crucial to understand how to calculate the potential return on investment (ROI). Working out your return from purchasing a property to rent involves more than just knowing the rental income; it requires factoring in a variety of costs and understanding how they impact your profitability. Here’s a step-by-step guide on how to calculate your return on investment for a rental property.
Step 1: Understand the Basics of Return on Investment (ROI)
The ROI for a rental property is the amount of profit you generate from the property relative to the amount you’ve invested in it. It can be broken down into gross rental yield and net rental yield.
Gross Rental Yield is the rental income you receive before accounting for any expenses.
Net Rental Yield factors in the property’s ongoing expenses to give you a more accurate measure of your return.
Both metrics are useful, but understanding the difference is essential when assessing your overall return.
Step 2: Calculate Gross Rental Yield
The gross rental yield is the first figure you'll calculate to gauge how much income your property will generate. It is a simple formula:
Gross Rental Yield = (Annual Rent / Property Value) x 100
Let’s break it down:
Annual Rent is the amount of rent you expect to receive in a year.
Property Value is the price you paid for the property, or its market value if you're purchasing a new investment property.
Example:
If you purchase a property for $500,000 and expect to rent it out for $450 per week:
Weekly Rent = $450
Annual Rent = $450 x 52 = $23,400
Now, calculate the gross yield:
Gross Rental Yield = ($23,400 / $500,000) x 100 = 4.68%
This means you’re earning a 4.68% return on the property before expenses.
Step 3: Calculate Net Rental Yield
While gross rental yield is useful, net rental yield gives you a more realistic idea of your profitability because it takes into account your ongoing costs. These can include:
Mortgage payments
Insurance premiums
Property management fees
Maintenance costs (repairs, upkeep)
Council rates
Strata fees (if applicable)
Vacancy periods (times when the property isn’t rented out)
To calculate the net rental yield, follow this formula:
Net Rental Yield = ((Annual Rent - Annual Expenses) / Property Value) x 100
Example:
Let’s assume your expenses for the year are as follows:
Mortgage: $18,000
Insurance: $1,200
Property Management Fees: $1,500
Maintenance and Repairs: $1,000
Council Rates: $1,500
Vacancy Period (assume 2 weeks of vacancy): $900 in lost rent
Total Expenses = $18,000 + $1,200 + $1,500 + $1,000 + $1,500 + $900 = $24,100
Now calculate your net rental yield:
Net Rental Yield = (($23,400 - $24,100) / $500,000) x 100 = -1.4%
In this example, you would actually be running at a loss due to higher expenses. This emphasizes the importance of carefully considering all ongoing costs when purchasing an investment property.
Step 4: Consider Capital Growth
While rental income is a primary source of return, don’t forget to consider capital growth. This is the increase in the value of the property over time. Although capital growth is harder to predict, it plays a crucial role in your overall return.
If the property appreciates by 3% annually, for example, a $500,000 property would increase in value by $15,000 each year. Over a longer period, this growth can significantly impact your investment returns.
Example:
Property Purchase Price: $500,000
Annual Capital Growth: 3% x $500,000 = $15,000
So, while you may have a negative net rental yield in the short term, the appreciation of the property could result in a positive overall return in the long term.
Step 5: Factor in Tax Implications
Investing in rental property comes with tax responsibilities. Depending on your situation, you may be eligible for tax deductions on certain expenses, such as mortgage interest, property management fees, repairs, and depreciation. The tax benefits can reduce your overall costs and improve your return on investment.
Calculating the return on investment from a rental property involves more than just looking at rental income. By considering factors like gross and net rental yields, capital growth, and ongoing costs, you can assess whether the property is a good fit for your investment portfolio.
If you’re unsure about the numbers or want professional guidance in navigating Tasmania’s property market, it is advisable to discuss your options with your accountant or financial planner. Whether you're a seasoned investor or just starting out, having expert advice can ensure that your investment decisions align with your financial goals.
Invest wisely and enjoy the journey to profitable property ownership!