What's In a Term..

Inside PropertyTM with John Maher FAPI

What’s in a Term?

Well, everything really if you want the term to have some worthwhile meaning to you. What bothers me as a property professional is the constant misuse of the term “Investment Return”, especially for residential real estate.

Measuring the Return on Investment (ROI) from residential property is not as straightforward as market commentators would have us believe. This is because there are two very different components; rental income and capital growth.

Rental income is immediate and occurs regularly, while capital growth occurs over time and is irregular. To measure the true ROI from residential property it is necessary to take into account both the rental income from the property and its capital growth.

We have all read something along the lines that “returns from residential property have fallen to just 2% or 3%.” But what does this mean?

Describing the return in this way is misleading, as it fails to describe whether it’s a gross or net return, or takes into account capital growth, which for residential property is a genuine element of investment returns.

In general terms there are three ways to measure returns from residential property:

(1) Rental Return (Yield)

This is the most basic of measures and is simply the rental income divided by the value of the property, expressed as a percentage and can be measured on either a gross or net basis.

(a) Gross Return (yield) is the gross (total) rent divided by the value of the property, expressed as a percentage. For example, if a residential property has a total income of $13,000 and a property value of $350,000, then the gross rental yield (return) would be 3.71% ($13,000/ $350,000 x 100).

(b) Net Return (yield) is the gross rent less expenses, divided by the value of the property, expressed as a percentage. For example, a gross rent of $13,000 less expenses of $2,960 made up of management fees, insurance, land and water rates gives a net rent of $10,140, which is a net yield of 2.90% ($10,140/ $350,000 x 100).

In these simple examples no allowances have been made for vacancy, interest, repairs and maintenance, land tax or depreciation.

(2) Investment Return (Yield)

Investment return more accurately describes the ROI as it takes into account both rental income and the capital growth achieved over time.

A simple method of calculating ‘investment return’ is to add the annual rental yield, expressed as a percentage, to an assumed average annual capital growth (expressed as a percentage).

If the gross rental yield is 4% and the assumed annual capital growth is 10%, then the gross Investment Return (yield) would be 14% per annum.

It is important to note that residential property does not appreciate in value at a constant uniform rate. There may be years of no growth, followed by years of exceptional growth.

However, growth over the long term can be averaged and historically residential property increases in value, on average, from between 8% to 12% per annum, depending, of course, on the type of property and its location.

(3) Internal Rate of Return

The Internal Rate of Return (IRR) is the most appropriate and accurate measure of investment performance for residential property, whether positively or negatively geared, as it takes into account income, expenses and capital growth over the life of the investment.

The IRR is the “actual return” from an investment and may be applied to any growth investment, including commercial property and stock market investments. Unfortunately, IRR is an article in itself.

This is not advice. The article is for general information purposes and to create awareness of the issue only. It is strongly recommended that readers seek proper qualified independent advice from their legal, financial and accounting advisors before taking any action.

John Maher is a registered practising valuer and a Fellow of the Australian Property Institute. John can be contacted through http://www.insideproperty.com.au.