Get your head around rental yield with our no-nonsense guide.
If you're thinking about becoming a landlord with a buy-to-let property, it's important to understand what rental yield means.
This handy guide will explain what rental yield is, how you can calculate it, what constitutes a good rental yield – and how you can drive it up as far as possible.
What is rental yield?
Rental yield is a measure of the return on a property investment. There are many factors that can affect rental yield, including property prices and regional disparities, capital appreciation, interest rates, demand growth and a fluctuating housing market.
What is a good rental yield?
As a benchmark, a rental yield of 7% or more is considered 'very good'.
How to calculate rental yield
Gross rental yield
You can calculate gross rental yield by dividing a year's total rent by the purchase price of the property and multiplying by 100.
For example, if you bought a buy-to-let property for £400,000 and receive £1,500 a month in rent, to give an annual rental income of £18,000 (12 x £1,500), the gross rental yield is:
(18,000 / 400,000) x 100 = 4.5 or 4.5%.
However, while gross rental yield might be a simple calculation, it doesn't take into account any costs, such as mortgage repayments, insurance or upkeep of the property – and these need to be considered to judge whether letting the buy-to-let property is providing a good return.
Net rental yield
Net rental yield is often a better measure to use than gross rental yield because it takes into accounts the cost of owning the property, including any outstanding mortgage repayments.
Net rental yield is calculated by taking the annual rental income minus costs associated with owning the buy-to-let property. Then, depending on which definition of net rental yield you wish to use, it can be divided by either:
a) the property value
b) the initial capital outlay on the property (ie. the full amount less what has been borrowed through a mortgage)
Let's take example (a) first:
If you bought a £190,000 property with a £140,000 buy-to-let mortgage at a fixed interest rate of 3.44%, your interest repayments will be £401.33 monthly or £4,816 annually.
If you set the monthly rent at £800, the annual rent collected will be £9,600.
Typical annual costs for insurance (£360), essential repairs (£900) and void periods (£800) add up to £2,060.
This means the net rental income will be £2,724 (£9,600 - (£4,816 + £2,060)), with the net rental yield being (2,724 / 190,000) x 100 = 1.43 or 1.43%.
Now let's look at example (b):
The first part is the same. You buy a £190,000 property with a £140,000 buy-to-let mortgage and annual repayments of £4,816. You also collect £9,600 in annual rent, but other costs each year tot up to £2,060.
The net rental income will be £2,724, but instead of dividing this figure by the property value, we instead divide it by your capital outlay. ie. £50,000.
This returns a net rental yield of (2,724 / 50,000) x 100 = 5.45 or 5.45%
The examples demonstrate how the true returns of buy-to-let are whittled away when you take into account the overall costs.
Which net rental yield calculation should I use?
The answer to this question depends on your purpose for knowing.
For example, if you are trying to decide which city to purchase a buy-to-let property in, then net rental yield that looks at the property value allows you to compare like for like. For example, how much profit will you make from a £200,000 home in each location given the likely rent and costs.
However, if you are an investor looking to compare whether buy-to-let would be a better option than say, stocks and shares, example (b) that looks at your actual capital outlay is the one to use.
With this example, it's also worth noting that as you pay down the buy-to-let mortgage and can potentially remortgage on to a cheaper deal (ie. lowering your costs), then your rental yield would increase.
However, this needs to be balanced against your accrual of more equity in the property. The larger chunk of the home you own outright, the more your yield will drop for the set rental income (ie. because each pound is not working as hard).
How to maximise rental yield
Rental yields vary depending on factors such as the current mortgage interest rates, taxes and reliefs available, and fluctuations in the property market. But there are steps you can take to maximise your rental yield.
1. Increase the rent
If the rent you have set is lower than the market rate, you may be able to increase it. However, you will need to ensure that this is permitted within the Assured Shorthold Tenancy Agreement.
You should also not underestimate the worth of reliable long-term tenants who take care of your buy-to-let property. The loss of income incurred by just one vacant month could take two years to recoup through a rent rise.
2. Decrease the rent
It sounds like a contradiction in terms, but if the rent is too high versus the property or the area, lowering the rent can ensure you don't miss out on rental income due to void periods.
3. Utilise your tax reliefs
You pay tax on rental income but you can offset several unavoidable costs against your bill. These include buildings and contents insurance, council tax and utility bills (if you pay them on behalf of the tenant) and essential maintenance.
However, since April 2017, a new buy-to-let tax system has been gradually phased in.
It means that from April 2020, you will not be able to deduct your mortgage interest payments from your rental income when calculating what tax you owe. Instead, all of your rental income will be taxed, and you'll qualify for a 20% tax credit for your mortgage interest.
In the meantime, from April 2019, you can offset 25% of your mortgage interest payments against rental income, with 75% of the payments qualifying for a 20% tax credit.
4. Update the property
Expectations among the kind of tenants you want are higher than ever, so follow suit by putting in a decent kitchen and bathroom. You'll also be able to charge more rent.
5. Be pet friendly
There are millions of pet owners in Britain, but only certain rental homes permit them. If you establish your buy-to-let property as pet friendly, tenants may be willing to pay more.
6. Lower your overheads
This can mean anything from remortgaging to a better deal and sourcing cheaper plumbers or electricians.
My property is making a loss – what can I do?
While thorough research should help ensure your property investment is a success, like any investment there are risks. If your buy-to-let property is vacant for any period, then it will quickly wipe out any potential gains.
If you find yourself unable to fund the mortgage, call your lender immediately, as it may be able to offer a solution such as a temporary payment holiday or to extend the term of the mortgage, thus reducing monthly payments.
If you are forced to sell and the price of your buy-to-let property is now less than your outstanding mortgage, you will be in a state of negative equity. Read more about this in our guide.
Remember, you will still need to give contractual notice to your tenant. Debt charities such as StepChange will offer free and impartial advice.