Rental yield or money-weighted return?
Rental Yield is “easy”
It is inevitable to consider rental yield whenever looking at a real estate investment for rental. Why? Because it is very easy to calculate (or so we think). Take the rental income, divide it by your property cost, and there you have it. But most people would invariably overestimate the numerator and underestimate the denominator. Therein lies the first problem. The attractiveness of the metric is its easy calculation, but if it’s too easy it is likely to be incorrect.
Even if we are rigorous enough to take the full property cost (including all transaction costs) and the net rental income (subtracting all running costs), what if there are renovation costs incurred after a tenant has moved in? What if between the downpayment and the actual ownership transfer two or three months go by? What about periods of time without any tenant?
To be sure, we can always calculate a rental yield. But it’s not that straightforward a calculation anymore. Which means that – more often than not – we tend to approximate, to settle for a “rough” figure. In other words, a wrong number.
Is Rental Yield an informative metric?
We used an example, buying a property for 120,000 euro with an expected (gross) monthly rental income of 600 euro. This translates to a gross 6% yield. But the more we add to 120,000 (property transfer tax, notary fees, land registry fees, renovation costs, etc) and take away from 600 (community charges, taxes, agency fees, etc), the lower the yield will become. And once we have accounted for every cash flow, what will that number tell us?
It will tell us what income we are generating from our real estate investment, but can we use it to compare it to other investments? No. Does it take into consideration that, for example, our property is now worth more (or less) than what we bought it for? No.
Why is MWR better?
Conversely, MWR does both things. Cash flows (and their timing) are at the core of MWR. This means it is a metric that we can calculate for any investment, allowing for a true comparison among all your investments. It is not necessarily easier to calculate than a “true” rental yield (if you’re doing the calculation yourself), but it is a lot more useful. And it is a lot and more complete (it also takes into account a re-evaluation of the real estate investment at the end of the reference period). Keep in mind that an app like Exirio makes it very easy to calculate MWR. Just input all the cash flows and property values and the hard work is done for you.
Using Exirio, we inputted all actual cash flows relating to the 120,000 euro property purchase. This showed that a seemingly great investment (6% gross yield) may actually not be that great (MWR -2.2%). This is quite a striking discovery, although MWR is likely to increase after the first year (transaction costs and renovation fees are paid at the beginning but not incurred regularly).
In essence, rental yield is a useful metric to measure the return of a real estate investment, when we calculate in addition to MWR – not as a substitute. And if you are looking to buy a property to rent, do make sure to go beyond a rough rental yield calculation before you make that decision!
Exirio is a wealth tracking and insight app, designed to help you plan better for a life of financial freedom. Exirio was recently voted as one of the top start-ups in the United Arab Emirates by beststartup.asia.