We then look at the same property with the mortgage included and using the actual cash invested. This gives us a cash-on-cash rental yield.
Net Rental Yield
Here’s an example if you’re renting a property for $2,400 a month and it’s unoccupied 5 percent of the year. The take-out for a vacancy for annual cash in is $27,360. Now calculate these costs:
Annual insurance cost: $1,200Annual taxes: $1,400Annual repairs budget: $600Rent management fee: 6 percent
These expenses total annual cash out of $4,842. An income of $27,360 minus the cost of $4,842 works out to $22,518 in rental income after expenses. Now let’s say that it cost you $300,000 to purchase the property. $22,518 divided by the property value of $300,000 equals a rental yield of 7.5 percent.
Net Yield vs. Gross Yield
There’s obviously a significant distinction between these two terms. By itself, “yield” simply indicates the rent generated by property over the course of the year and the percentage it represents of the purchase price. Yields generally tend to be higher in less expensive areas. Gross yield does not consider expenses—what it costs you to keep that property up and running, including the interest you might be paying on loans and mortgages. You’re left with a rate of return or “net yield” when you subtract these expenses.
Cash-on-Cash Rental Yield
We’ll use the same presumptions here: Monthly rent is $2,400 and the property is unoccupied 5 percent of the year. The take-out for a vacancy for annual cash in remains at $27,360. Now we’ll say that you put $60,000 in cash into the detail, so you borrowed $240,000. The calculation would work like this:
Payment of monthly principal and interest: $1,556.64Annual insurance cost: $1,200Annual taxes: $1,400Annual repairs budget: $600Rent management fee: 6 percent
These expenses total annual Cash Out of $23,521.28. An income of $27,360 minus costs of $23,521 equals $3,839 cash return over cash out, and $3,839 divided by a cash investment of $60,000 equals a cash-on-cash rental yield of 6.4 percent.
Why It Matters
Net rental yield doesn’t exist in a vacuum, but it can go a long way toward telling you whether investing in a certain property is a wise—or not so wise—move. In simplest terms, it tells you whether you’re paying too much for a property, so much so that you’d find a better rate of return elsewhere.
Risk vs. Reward
Few would argue that the stock market can be quite risky in the short term. The blips often correct and get back on track over time, but you can lose money easily if you can’t wait it out. A little bit of bad news or a bad earnings report can take a stock down hard for a while. A properly selected rental home will provide monthly positive cash flow and be relatively insulated from bad economic news. Your tenant still needs a place to live even if the stock market just took a dive. You should also be building equity over the long haul through value appreciation and paying down the mortgage. This equity can be tapped for other investments.
Return on Investment
Bonds are less risky than stocks, but the tradeoff is low yields. Bond interest for the safer municipal and government bonds is lower than that for corporate bonds, but those aren’t really that great, either. It’s hard to get excited about this type of investing, especially if you’re retired and on a fixed income. The monthly cash flow of a good rental home can easily provide double the returns of bonds, especially with the tax advantages that you don’t get with other asset types. You can also use leverage with mortgages. Instead of taking $150,000 out of bonds to buy a house for cash, you could take out around $30,000 for a down payment and stay diversified with a better return on your investment.
