The purchase of a house is the largest investment we typically ever make. It would sure be a good idea that it’s also a good investment. But how do you calculate the yield on a house?
Since my last post on the All You Can Eat Mortgage, my wife and I have been seriously looking into buying a house. It’s kept us super busy, but we found one!
A Lucky Purchase
We had been talking about it for several months but we didn’t have a deadline. Until we realized our lease was expiring, that we couldn’t negotiate anything with the new management and that our jobs had moved to another office 45min away.
We were on a quest to buy a house, with the main criteria being that it needs to be a good investment. We have checked dozens and dozens of properties online and made a top 3 to visit with our realtor on Saturday, 2 weeks ago. We didn’t find anything convincing, so we set another visit on Monday for the next top 3. Nothing convincing either, until we see that house that was in the neighborhood, for sale, but for some reason was not on our list.
We visit it the same evening, loved it, we had found our house.
There was good space, good light, the interior was completely remodeled and the exterior was in the process of being refreshed and repainted by the HOA. Incidentally, as we were talking outside the house, we met a lady walking her dog. She was very friendly, we started talking and after a few minutes told us she happened to be the president of the HOA. A timely and very valuable encounter.
We made a lower offer than the list price, they countered within our range and we agreed. The deal was done on Saturday, exactly 7 days after starting our search. The property was ready to move-in in less than 30 days, which was perfect for us.
Most importantly, the property had to be a good investment so I looked at ways to evaluate the Return On Investment of Real-Estate.
Find out the ROI of your Home
Without much specifics, I had a mental check-list that would qualify a property as a good investment. It helped us identify good neighborhoods, then identify several houses and eventually set criteria for the ones to visit.
Our criteria were the following:
- Asset Value : With little doubt, the property would keep its value, or appreciate, over the next 10 years.
- Rentability : It can be rented out from day 1 would our jobs decide to send us for an assignment overseas.
- Cashflow : The rent would at least cover the cost of mortgage, insurance and HOA and would ideally generate a profit,
- ROI : The return on investment should be higher than the 2% we could get on bonds.
There are 3 types of ratios that we used to evaluate the ROI of a real-estate investment.
We have used the first 2 during our search and the last one before closing the mortgage, to make us comfortable with our decision.
They each have their pros and cons and I found they are useful at different times of the house hunting process.
#1 ROI for Real-Estate : the Gross Yield
The Gross Yield is the easiest indicator to calculate because it has only 2 variables : the asset cost and the yearly rental income it can generate.
The Asset Cost is the cash cost of the asset (eg. 200k$) and the Yearly Income from the Asset represents 12 months of rent, before tax and expenses, that is what the renter would pay (eg. 1500$).
In that example, the Gross Yield would be :
Income = 1500 * 12 = 18,000$ Asset Cost = 200,000$ Gross Yield = 18,000$ / 200,000$ * 100 Gross Yield = 9%
The method is the similar to that is used to calculate the yield of stocks. For example AT&T has a yield of 5.6% because the yearly dividend is 1.88$ for a stock that costs 32.21$. However the Gross Yield for a real-estate investment isn’t accurate enough to compare it with other asset classes such as equities.
The Gross Yield was key for me to do back-of-the-enveloppe estimates of what can generate promising returns, while browsing through many many properties online.
- It’s quick and simple,
- Can be mentally calculated,
- Serves as a good first rentability estimation pass.
- It doesn’t take into account real-estate specific costs,
- It works only for a cash purchase,
- Should be used only to compare other real-estate investments.
To get an idea of how Gross Yields vary in the US, you can refer to this 2013 study by Bankrate. Yields were around 10% in Houston and 7% in NYC. Detroit was leading with 22% while San Francisco was trailing with 5% (appreciation might be a bigger factor in SF).
#2 ROI for Real-Estate : the Net Yield
While the Gross Yield is great to do a rough estimate of which neighborhood to invest in for example, the Net Yield helped us identify which properties will generate the desired return on investment.
The Net Yield is more accurate because it takes into consideration real-estate specifics costs such as real-estate taxes, maintenance and HOA, or the Direct Costs related to owning the asset.
In our above example with a property that costs 200k$ and can rent for 1500$, the Yearly Direct Costs would be real-estate taxes (3000$), yearly maintenance costs like plumbing and electrical repairs (1000$) and the HOA (2500$) if there’s any.
In that example, the Net Yield would be:
Income = 1500 * 12 = 18,000$ Direct Costs= 6,500$ Taxes = 3,000$ Repairs = 1,000$ HOA = 2,500$ Asset Cost = 200,000$ Net Yield = (18,000 - 6,500) / 200,000 * 100 Net Yield = 5.75%
The Net Yield, while slightly more complex, is also more precise and can be used to compare equities and real-estate investments. In our example, this property would generate a yield comparable to the AT&T stock (5.75% vs 5.6%).
- Gives a more realistic yield calculation,
- Can be used to compare real-estate investment (in cash) with other asset classes,
- Requires specifics costs of the property evaluated
- Works only for a cash purchase.
#3 ROI for Real-Estate: Cash-on-Cash return
You might have noticed that the main shortcoming of the Gross and Net Yield is the assumption that the purchase is made cash. For most of us, buying a house cash just isn’t an option and we take a mortgage from the bank. This has a cost and a duration that needs to be brought into the equation.
The Cash-on-Cash returns looks at the return generated by the asset based on the amount of equity invested in the asset and not its actual purchase cost.
Let’s take our previous example of a 200k$ property that rents for 1500$ / month and let’s say it has been purchased with a 4% loan over 30 years. The first year’s loan cost will be 6349$ while 2818$ will go towards equity. The 20% downpayment, or 40k$, will also go towards equity.
Income = 1500 * 12 = 18,000$ Direct Costs = 6,500$ Taxes = 3,000$ Repairs = 1,000$ HOA = 2,500$ Borrowing Costs= 6,349$ (1st year) Equity in Asset= 42,818$ (1st year) Downpayment = 20% * 200,000 = 40,000 CC Return = (18,000 - 6,500 - 6,349) / 42,818 * 100 CC Return = 12%
Since we are using a mortgage, the net income at the end of the year is lower than with a cash purchase (5,151$ vs 11,500$) but the amount invested is also much lower (42,818$ vs 200,000$), which makes for a higher return.
The first year will generate a profit of 5,151$ for an initial investment of 43k$, or 12%.
As the owner builds equity in the property, the equity amount increases, which decreases the return. After a few years, the rent might increase as well, which would increase the yield. The calculation isn’t fixed in time and will vary every year throughout the life of the mortgage but the yield will likely be the highest on the 1st year.
Once the property is paid in full, the Cash-on-Cash return becomes the Net Yield.
(18000 – 6500 – 0) / 200000 = 5.75%
Once the house is paid in full, after 30 years, the actual amount charged for rent is likely to have significantly increased. So would have the costs. The Cash-on-Cash return would need to be adjusted every year for changes in income, costs and equity.
- Gives the most accurate representation of return on investment,
- Can be used to compare leveraged real-estate investments with other asset classes,
- Requires specifics costs of the property evaluated
- Changes every year to account for inflation and rent variations.
These last 2 weeks have been insanely busy but I’ve been forced to learn a lot about real-estate and this has been fascinating! It’s definitely an asset class that I wasn’t familiar with before and I can see the appeal of investing in a tangible asset.
How about you?
Have you had a positive experience in Real-Estate investing?
If you have rental properties, what types of returns are you looking for to invest?
If you currently pay a mortgage, have you calculated what the ROI of your house would be if you rented it out?