Understanding how much profit a commercial property will bring you is a crucial part of any purchasing decision. Here we simplify what calculations you must do to work out your commercial property rental yields so you can make an informed choice when deciding what to invest in. We also explain some key terms that are useful for any commercial property investor to be aware of.
What Is Rental Yield?
There are two types of rental yield: net yield and gross yield.
Net yield is the income or return on investment (ROI) before interest rates, maintenance costs and periods when your property may stand empty is deducted; gross yield is the return on an investment before expenses and costs are deducted.
Rental yield is a method of calculating the ROI on your commercial property using how much rental income the property is likely to generate over the actual cost of buying the property.
By using it as a barometer, you can compare different properties before you buy in order to see how much return you are likely to make.
Calculating Rental Yield
Gross yield
This is calculated by dividing a property’s annual rental income by the property value in the following way: gross yield = annual rent ÷ property value x 100
So, let’s say the annual rent you expect to make on a property is £10, 704 (12 x £892 pcm, which was the UK average as of January 2017).
That figure is then divided by £216,750 (the average cost of a house in the UK as of September 2016) x 100, so the gross yield will be 4.9%.
Net yield
The net yield will give you a figure for the ROI after you have deducted your expenses. It can be calculated like this:net yield = (annual rent – operational costs) ÷ property value.
Let’s use annual rent at the same value as above at £10,704.
That figure is then subtracted by operational costs (purchase price, transaction costs, letting fees, maintenance and repair costs, mortgage interest and insurance etc) = £8,359 (average as of April 2015). This is then divided by property value (£216,750) and multiplied by 100, so the net yield will be 1%.
The higher the percentage, the better, and remember these calculations are based on the UK average – there will be clear variances depending on location. According to experts, any figure above 7% (net yield) is a healthy ROI.
All Risks Yield
If you are investing in commercial property, it’s useful to be aware of what is known as an “all risks yield”, as this form of yield is the amount that Chartered surveyors, property valuers and valuation professionals will use to showcase the risks associated with certain investments.
In order to calculate an all risks yield figure, you should be aware of the impact of a buoyant or falling property market.
In a buoyant property market property yields are likely to drop. This happens because the overall capital value of property increases with market demand whilst the annual rent is likely to remain static (at least until a rent review is completed) at a lower percentage of the total capital value. In a falling property market however, yields are likely to increase.
Property Yields Versus Capital Values
Property investors often query why more importance is placed on property yields compared to overall capital values. The reason for this is simply that capital values on property investments can only really be created by reviewing recent, comparable transactions of similar properties in similar locations. Property yield however, is easily compared across a platform of properties.
Because of this, it is common practice to apply a percentage yield figure as a multiplier against a property’s annual rental income as this will help to build an estimate of the capital value of the property.
Calculating Property And Capital Values Using Rental Income
This example helps explain the concept further. The calculation you need is this: capital value = (annual rental income / yield) x 100
Let’s say a commercial property is being rented out, for say £150,000 annually, and an approximate yield across nearly matching properties is identified at around 6%. This would mean that the capital value = (£150,000 / 6) x 100, which is £2.5M.
Covenant Strength And Its Effect On Property Yield
Property yield figures can also be “worked” to show alternative capital values that more precisely reflect the investment risk. Why is this important? Simply because the investor risk associated with renting a property can be measured more realistically by doing this.
If for instance a tenant is known to have a good reputation and is financially reliable, then this will mean that they will present a lower level of risk to the property owner. The value of the tenanted property will therefore be higher to another investor because of the reduced risk of tenant default on the rent payments.
Lease strength of this nature is usually referred to as “covenant strength” and is a term used in the to signify the quality of a commercial tenant.
How Prideview Can Help
We can provide advice on any aspect of acquiring a commercial property and guidance if your current property is not delivering on its ROI potential. Our team of experts can also offer professional, current advice on getting better value from your mortgage as well as rental management services.
