What does the rental yield tell you about a property?

Rental Yield

A property’s rental yield is the amount of gross rental income that it attracts relative to its market value. In Australia, gross residential property rental yields typically fall between 2% and 5% annually.

This yield can provide insights into a property’s fundamentals and therefore anticipated investment returns.

What drives a property’s rental yield?

Two primary factors influence a property’s rental yield.

Firstly, the size and condition of the property have the largest influence on rental income. Larger properties with more bedrooms and living areas generally command higher rental incomes. A new property often fetches a premium rental, while a poorly maintained one tends to yield below-average income. Additionally, amenities like a pool can amplify rental potential, especially in warmer climates. The more a landlord has to offer, the more rent they can command.

Secondly, a property’s location plays a pivotal role in determining rental income. Location dictates the balance between rental supply and demand. Highly sought-after areas, such as prime spots in blue-chip suburbs, attract higher rents due to demand outstripping supply. Coastal locales often experience a shortage of permanent rental properties, as many owners prefer short-term arrangements (e.g., Airbnb), leading to higher yields for permanent rentals. Similarly, properties in regional locations and small towns can generate high rental yields due to a lack of available rental properties.

Furthermore, a property’s expense profile can impact rental yields. For instance, apartments with high body corporate fees often translate to higher rents to offset these expenses. Of course, higher body corporate fees often mean the property offers a lot of amenities.

In essence, a property’s rental yield is mostly shaped by its physical attributes and location.

Possible explanation # 1: Proportion of land and building value

A property’s rental yield often reflects its composition in terms of building and land values. When a property boasts a high yield, it often indicates a substantial building value, constituting more than 50% of the total value. Conversely, a lower yield suggests that the property’s value predominantly lies in its land.

This pattern emerges because renters generally pay for better or larger accommodations rather than the underlying land value. Typically, rental market preferences lean towards low-maintenance properties, ones that require minimal upkeep, such as limited garden space. Hence, the allure for renters revolves more around the quality and size of the living space rather than the land itself.

Possible explanation # 2: Low expected capital growth

In regional areas or small towns, properties often yield higher rental returns due to a scarcity of available rentals. However, these locations have abundant land supply and lower demand due to low population, causing slower land value appreciation compared to capital cities. Consequently, investors may enjoy elevated rental yields but experience slower growth in property value.

Looking at past returns, it’s improbable for an investment-grade property to yield a total gross return of more than 10% p.a. in the long term. If a property’s gross rental return sits at 6% p.a. and isn’t anticipated to change, the chances of capital growth exceeding 4% p.a. are very slim. In fact, for properties outside capital cities, the total return is likely to be less than 10% p.a., and therefore the capital growth rate will probably be less than 4% p.a.

In short, a high rental yield can be a red flag that the property is not located in an investment-grade location.

Possible explanation # 3: Alternate use

The rental value of a property might not accurately reflect the split between its building and land values, as it can be artificially enhanced.

For instance, leasing a property short-term through platforms like Airbnb can elevate its rental income. Similarly, properties capable of accommodating multiple tenants (e.g., renting the main house and granny flat separately) can also amplify their earnings.

Despite potentially being high-land-value assets, these properties experience an artificial enhancement in their rental income.

Possible explanation # 4: Market value is less than technical value

A high rental yield might signal that a property is undervalued, indicating that its inherent or technical value is more than its current market value. This tends to occur in stagnant markets that haven’t seen growth for extended periods.

For instance, the median house value in Perth has remained unchanged for 15 years. Consequently, quality investment-grade homes with high land values in Perth yield gross rental returns of 3.5% to 4.0% p.a., which is high compared to other capital cities. This high yield isn’t due to a high building value but rather reflects Perth’s intrinsic undervaluation, suggesting it’s on the brink of a growth cycle as I’ve discussed here recently.

When Perth enters a growth cycle, property values will increase, yet dollar-value rents will remain relatively steady. This scenario leads to the compression or normalisation of rental yields.

But it’s not absolute

Rental yields serve as guides rather than absolute rules. Properties and locations tend to be unique, rarely identical, and there are always exceptions that prove the rule. Consequently, relying entirely on rental yield analysis can be misleading. Instead, consider it a signal prompting further investigation and scrutiny into a property’s attributes.

How to use rental yields as a guide

I have written in the past that one of the key attributes that a property must possess to be considered investment-grade is a high land value component. Land is the component that appreciates in value most over time. Without a strong land value component (i.e., more than 50% of the property’s overall value), you cannot expect your property to double in value every 10 years, on average, over the long run.

A high rental yield can be a red flag that a property has too much building value. In this case, it is important to investigate what is contributing to the high rental yield. For example, does it have too much building value? Is it situated in a regional area? Could it be an intrinsically undervalued investment-grade property? Or, perhaps, the rental yield has been artificially inflated.

It is important to investigate this matter fully to ensure you can assess a property’s investment worthiness.