CALCULATING RETURN OF INVESTMENT (ROI) ON A RENTAL PROPERTY

How do you calculate your investment returns?

The process of calculating property investment returns can be very complicated indeed. On commercial property investors will go to great lengths to use techniques which discount future cash flows from individual investments to work out the potential returns and in turn their value.

For residential property owners life doesn’t need to be so complicated. The focus for calculating potential returns on property should be on the two main factors.

Firstly the income such as rent, and secondly, the capital appreciation resulting from the potential rise in property's price. An investors total returns are the sum of both.

Returns from a rental property

Buying a residential investment property is not just like buying a straight forward investment. An investor is actually perceived as running a business, and therefore needs to include any associated costs of running that business in their calculations.

The standard costs are categorised as: mortgage (if any), maintenance, building administration, property management, property taxes, vacancy period, and cleaning. Rent and other costs are likely to change over the investment period and this needs to be factored into the calculation of a landlords investment returns.

The main revenue source is obviously the rental income, so when calculating their net returns a property owner needs to include net income (after expenses) and add this to capital appreciation. This needs to be done for the entirety of the investment period.

Buying & selling costs

Buying a residential investment property will mean that an owner incurs certain set up costs for bringing the investment into being. These costs include the initial costs involved in the purchase of the investment property such as the legal fees. Finally, there is the cost of exiting the investment when selling the property in Panama around 10% of the closing price (5% taxes, 5% broker commission). All these need to be factored into the overall calculation of a property investors returns.

Accounting for the long-term

One further complication to a property investor trying to calculate their likely returns is trying to account for the effect of inflate on and the likely growth rate in house prices generally. Therefore in calculating a residential investment’s long term returns a landlord will need to be able to predict both of these.

The return on capital

These calculations of returns all relate to the asset value of the investment property and the rental profit after expenses. However, this is not a true measure of the real returns made by a property investor. This is because unlike a deposit in an investment fund or government bonds a property owner is likely to have borrowed a significant proportion of their investment capital in the form of a mortgage. This means that they are likely to only have put in a proportion of the total capital into the investment. For example on a $300,000 property they may have put down a 30% deposit or $90,000 into the investment. What this means is that any investment calculations needs to measure what the returns are on that $90,000 and any other additional capital costs not just the $300,000 in order to enable a potential property investor to measure whether the returns are good and likely to be better than investing that money in alternatives such as investment funds or government bonds.

What returns should you be aiming from a property investment?

To some extent the investment returns required will depend on each individual circumstances. For some investors anything above that available on government bonds deposit account would be OK. This type of return generally is not that high as it reflects the fact that it is a low risk investment. Property investment is not risk free and given that an individual is investing a considerable amount of time, effort and capital it is reasonable to expect a return above this.

A property developer would look to receive a return of about 20 - 25% on capital invested. However, carrying out a development is far more risky than an investment. In addition, a development particularly a large one is likely to take place over several years; in which case the annualised returns could easily be halved to say 10%.

If we use these figures as a guide I would say that a long term real return of between 6-10% is OK although not excellent. An investor has to appreciate that buying a property investment is not passive in the same way as holding government bonds is and running a rental business does involve small amounts of work to keep it on track. Therefore the returns that a property owner should expect from their investment should reflect this. A landlord should be aiming for at least a high single figure and preferably a double figure return on their capital. Anything above 20% is excellent.

The difficulty with predicting property investment returns

Long-term predictions are notoriously difficult. Predicting things like the interest rate, the levels of inflation further out than a couple of years into the future was impossible up until recently. Hopefully the Panamanian housing market will continue to benefit from this stable investment environment and enable all your property investments to continue to prosper.

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Rental yields

Dear reader,

Thank you for stopping by our company website, it will be a pleasure to assist and educate you about the property numbers you must know with a series of articles called “Panama Link Investment guide”.

Today I want to speak about Rental Yields so you will have a better understanding of what you need to consider before buying an investment property. After reading this article you will be able to check by yourself your return of investment (ROI). Since some agents might promise you returns that are not going to happen it is a good idea to check them by your own. You will then realize if a broker tells you the true or not and when it is time to walk out the door.

Please write us if you have any question and enjoy the reading. We look forward to hearing from you!

Stefano Bertoli

What are rental yields and why are so important?

Rental yields are probably the most important investment metric used by property owners investing in residential property. It is an indication of the level of return on an investment. You do not want to invest your money in a product without knowing the potential profit – do you?

How to calculate a gross rental yield

The rental yield is calculated by measuring the yearly gross value of rent income as a percentage of the underlying capital value of the buy-to-let investment.

Example: A 2 bedrooms apartment in San Francisco (a popular neighbourhood in Panama) valued at $200,000, generating an annual rent of $18,000 would therefore have a gross rental yield of 9%. This gross rental yield is a useful starting point in calculating your potential return of investment (ROI) and helps give a property owner a quick and easy metric by which to measure it against alternative property or other form investments.

However, gross rental yields don’t tell us the full story. Any landlord will tell you that, unfortunately, they don’t get to keep all the rent. Therefore a more accurate figure of the true cash return from the rental property is given by its net rental yield.

The net rental yield strips away the associated costs of generating the rental income. This might include any management charges, such as: letting agent fees, property management, service charges, repair costs, insurance charges and mortgage.

How to calculate a net rental yield

An examination of this property in San Francisco shows that the expenses come in at around 20% of the total rent (10% Property Management, 10% maintenance and vacancy costs). Therefore applying this figure to my previous example would mean that the gross rent of $18,000 becomes a net rent of $14,400 (I did not consider property and income taxes as there are exemptions and each individual has different financial and tax payments situations). This results in the gross rental yield falling from 9% to 7.2% which still remains a very good profit!!!

What is a good rental yield?

In my opinion the types of rental yield that a landlord should be looking for will depend on the type of investment property they are looking at, and where they are looking to buy. As a  rule of thumb and in the current economy and house market environments (2015) I would say a property owner in Panama should be looking for a gross yield of about 8-10%.

The general rule with single lets, is the larger the property the lower the relative gross yield. Conversely, a studio flat in Panama City is likely to potentially draw in a higher yield. Panama City will have the higher yields as will prime property location anywhere in the country.

A good example is to compare San Francisco (a neighbourhood in Panama City) with Coronado (a beach location) where rental price - property costs are similar to San Francisco and rental price in Coronado can be even higher. The bad things about beach locations is that even if properties can generate higher yields if rented for a full year you need to consider that apartments can stay vacant for a longer time and it is more difficult to find a tenant willing to stay for a period of at least 6 months when compared to the city.

If a landlord is looking a purely income and prepared to look purely for a cash cow (steady return of profits), it should be entirely possible to obtain a gross yield above 8%. With rents once again rising and property prices looking as if they may perform a bit lower for some time (2015), landlords need to switch focus to rental yields and not property price increases.

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