Investing in real estate can be a lucrative venture, but it's essential to understand the key concepts that drive profitability. Two of these concepts are rental yields and positive gearing. In this blog post, we'll break down these terms and provide examples to help you grasp how they can impact your investment strategy.
What is Rental Yield?
Rental yield is a measure of how much cash (or rental income) your property generates each year, as a percentage of the property's value. There are two types of rental yields: gross rental yield and net rental yield.
Gross Rental Yield: This is calculated by taking the annual rental income of the property and dividing it by the property's current market value, then multiplying by 100 to get a percentage.
Net Rental Yield: This takes into account your operating expenses, giving you a more accurate profitability measure. It's calculated by subtracting annual expenses from the annual rental income, dividing by the property's value, and then multiplying by 100.
Example of Gross Rental Yield
Imagine you've bought a property for $500,000, and you rent it out for $500 per week. The annual rental income is $500 * 52 = $26,000.
Gross Rental Yield = ($26,000 / $500,000) * 100 = 5.2%
This means the property's gross rental yield is 5.2%.
Example of Net Rental Yield
Let's say the same property has annual operating expenses of $6,000 (including maintenance, management fees, etc.).
Net Rental Income = $26,000 (annual rent) - $6,000 (expenses) = $20,000
Net Rental Yield = ($20,000 / $500,000) * 100 = 4%
So, the net rental yield is 4%, providing a more accurate picture of your investment's profitability after expenses.
What is Positive Gearing?
Positive gearing occurs when the income from your investment property exceeds the expenses associated with owning it. This means the property generates a profit before taxes.
Example of Positive Gearing
Continuing with our example property:
Annual rent received: $26,000
Annual expenses (including interest on the mortgage, maintenance, management fees, etc.): $18,000
The property's income exceeds its expenses by $8,000 ($26,000 - $18,000), meaning it is positively geared. This additional income can be a significant advantage, as it provides cash flow that can be used to cover the mortgage, invest further, or as additional income for the owner. The biggest obvious benefit here is that you earn extra income and your investment doesn't leave you out of pocket. The downside is that any extra income you earn is taxable and you can't claim tax deductions.
What is Negative Gearing?
Negative gearing is the opposite. It occurs when the cost of owning a property (including interest on the loan, maintenance, and management fees) exceeds the income it generates. Despite resulting in a loss, negative gearing can be a strategic approach for investors, particularly in markets where capital growth is expected to outpace these losses over time. This strategy relies on the property's value increasing enough to cover the losses incurred during the period it was negatively geared.
Example of Negative Gearing
Imagine you've purchased a property for $600,000, and it generates $25,000 in rental income annually. However, your annual expenses (loan interest, maintenance, council rates, and management fees) total $32,000.
Annual Rental Income: $25,000
Annual Expenses: $32,000
Annual Loss: $7,000
This property is negatively geared by $7,000, meaning you're making a loss each year. However, if the property's value increases to $650,000 within a year, selling the property would not only cover your losses but also potentially yield a significant profit.
Tax Implications of Negative Gearing
In many countries, the losses from negative gearing can be deducted from your overall taxable income, providing a tax benefit. This deduction can make negative gearing an attractive option for investors, especially those in higher tax brackets. The strategy is betting on the property’s long-term capital growth to offset the short-term rental income losses.
Understanding rental yields and positive gearing is crucial for anyone looking to invest in the property market. By calculating these figures, investors can make informed decisions about which properties are likely to offer the best return on investment. Remember, a higher rental yield and a positively geared property can signify a profitable investment, but they are just part of the picture. Consider other factors such as property location, capital growth potential, and market conditions when making your investment decisions.
If you're looking to invest in property, be sure to speak to your financial advisor about which option best suites you.
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