Rental Yield is the return generated from rental income, as a percentage of a property’s overall value. At the suburb level, it is averaged out across all of the properties rented in that suburb. A strong rental yield means higher income and is often the basis for ‘cashflow positive’ investments, making it a popular statistic to cite when selecting a location to invest in. So how should we use this statistic to help us?
There are some broad themes in rental yield which apply quite consistently across the Australian property market. Firstly, rental yields will be weaker in the most expensive suburbs of a city, and stronger in the cheaper parts of the city. Secondly, rental yields will be weaker for detached houses, and stronger for townhouses and apartments.
This can be explained if we understand the economics of rental return. The rental return that a property will generate will be shaped by three main factors:
The location of the property – this will include consideration such as access to employment, transport, services, lifestyle and amenity. This will be an immediate judgment of the location’s quality, rather than a long-term assessment of the location’s potential.
The amenity of the property itself - Tenants will assess a property based on its internal and external space, design, condition and features, but again in an immediate sense rather than in its future potential. Tenants will not take into account the land or building’s future use.
The availability of properties which offer similar locational and functional benefits – the more similar properties available to the tenant, the less they will pay.
One of the keys here is that tenants will not pay for future potential, while buyers will. In the best suburbs of a city, land values will be higher because of the superior location, and also because land has the potential to be put to a more profitable use in the future. This might simply mean an extension of an existing house, or the conversion of an old house into a block of units. Such improvements will be more profitable in the best suburbs of a city than in the worst suburbs, and buyers and sellers of property within these suburbs will recognize this in terms of property value. Tenants don’t care about this, however, and will only pay for immediate location and property benefits.
In the same vein, how effectively a block of land is utilised will have a large impact on rental yields. For example, a large block of land in a valuable location which only has an old, small house on it is a very poor utilization of the land, and would return a very low rental yield. Only one tenant is utilising the benefits of the location, and are not doing it in very salubrious circumstances. However, if the owner demolished the house and build 4 townhouses, 4 tenants can make use of the location, and would enjoy the benefit of a new property to live in, albeit with a smaller backyard than the original tenant. The owner would significantly increase the income from the property, and only have to pay for the construction of the new townhouses, and so his/her yield would increase substantially.
There is also the effect of demographics on rental yields. Those with significant wealth are less inclined to rent as a permanent lifestyle arrangement, because it does not offer as much security, flexibility or prestige as owning. As people grow richer, they can afford to prioritise these needs, even if it does not seem economically rational to do so, As a result, demand from tenants is weaker in richer areas, while the demand from owners is stronger, which both work to reduce yield. Conversely, in poorer areas, the cost of renting versus owning is a much more coldly rational equation, and in many cases people in these areas cannot afford to own property, which increases the demand for rental accommodation and pushes up rental yields, while reducing the growth in asset values. This is exacerbated by investor activity. Investors will generally pay a premium to invest in the best cities (i.e major capital cities) and the best suburbs of those cities, and will be prepared to sacrifice yield for safety and hopefully higher capital growth.
By definition, yields are tied to asset values, so it an increase or decrease of rental yield is not always as good or as bad as it seems. A increase in asset values but stagnation in rents will lead to a decrease in yield, but would be welcomed by property owners in the area. On the flip side, an increase in yield that came due to a fall in property values, would be equally unwelcome.
So what does this mean to you as an investor? In South-East Queensland, we see these similar trends in action, with many different nuances specific to areas and property type. When evaluating the rental yields for specific suburbs in South-East Queensland, you’ll need to understand the nature of each suburb and how this effects yield.
The most expensive suburbs in Brisbane, such as Ascot, Fig Tree Pocket, New Farm, Teneriffe, Bulimba, Hawthorne, Mermaid Beach and Sunshine Beach all have yields below 3% for houses, however, it is possible to find townhouses or units, which make much better utilization of the land, with rental yields from 4.5%+ upwards.
Suburbs such as Stafford Heights and Salisbury within 10km of Brisbane’s CBD have poor yields relative to neighbouring areas, due to a high proportion of old housing stock. However, the land values are very similar, as these suburbs offer similar amenity and potential as their neighbours.
Most of Brisbane’s outer suburbs have the highest rental yield, but due to future supply/demand have a high probability of achieving the poorest growth.
The recent oversupply of the Brisbane apartment market offer a number of lessons in this regard. Medium and high-density apartments should achieve higher rental yields, as they offer high locational benefits as well as the most efficient use of land. However, developers misjudged the level and type of demand, building too many apartments in certain areas, such as the West End, Woolloongabba, Newstead/Bowen Hills, and Chermside, and too many 1 & 2 bedroom apartments pitched to investors rather than larger apartments suited to downsizing owner-occupier demographic. This has led to high vacancies and falling rents, as owners have been unable to find tenants and have been forced to discount heavily. Yields have fallen less, however, due to a corresponding drop in asset values. While higher-density apartments are an efficient use of land, the apartments have not been cheap to construct, due to high planning and labour costs. This has proven to be substantial overcapitalization, and has made the reduction of rental income due to poor market research and design even more damaging. Investors have been lumped with expensive assets that have fallen in value, have little scarcity or land value, and are returning yields no better than many townhouses or units that have much greater prospects of capital growth.
Overall, rental yields need to be kept in the context of the location and property type you are investing in. Just because a suburb has a low rental yield, you can still find properties within it that will produce a higher yield, which due to their location will make a strong investment. Conversely, if the pursuit of yield leads you to a marginal location, or an overcapitalization of built value, then you should probably look elsewhere. There will be little future scarcity for your type of investment, and little capital and rental growth.