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What is Gross Yield in Real Estate & How Do Investors Use It?

CEO Khai Intela
Gross yield in real estate is a metric that investors use to gauge the potential profitability of a rental property. By analyzing the gross yield of a property, investors can also determine the change in...

Gross yield in real estate is a metric that investors use to gauge the potential profitability of a rental property. By analyzing the gross yield of a property, investors can also determine the change in fair market rent, which helps them maintain strong profits. In this article, we will delve into the concept of gross yield and explore why it is crucial for real estate investors.

What is Gross Yield in Real Estate?

Gross yield, also known as gross rental yield, measures the total gross rent collected from a property in comparison to its market value or purchase price. The formula for calculating gross yield is as follows:

Gross Yield = Gross Annual Rent / Current Market Value

For example, suppose a small single-family rental home in Oklahoma City with an asking price of $60,000 generates a monthly gross rent of $610. In this case, the gross yield would be 12.2%:

$610 monthly rent x 12 months = $7,320 gross annual rent

$7,320 gross annual rent / $60,000 property price = 0.122 or 12.2%

In other words, by purchasing the rental property for $60,000, an investor would receive a return of 12.2% before factoring in operating expenses, contributions to a capital expense account, mortgage payments, and taxes.

Why Real Estate Investors Use Gross Yield

It's important to note that gross yield alone does not indicate potential profitability because it does not consider the cost of owning and operating a rental property. A property with an attractive gross yield may still have negative cash flow due to expenses.

However, real estate investors calculate gross yield for a few valid reasons:

1. Compare Alternative Investments

Gross yield provides a quick and easy way to compare potential investments and narrow down options. If a property does not generate a satisfactory gross yield, the cash flow and net operating income may also be low. By dividing a home's gross rental income by the asking price, investors can quickly determine whether a potential investment falls within their buy box.

2. Calculate a Fair Market Rent

The gross yield formula can also be utilized to determine the fair market rent for a home that has never been rented before. By analyzing the gross yield of comparable properties, investors can calculate the fair market rent by rearranging the formula:

Gross Annual Rent = Current Market Value x Gross Yield

For instance, if similar rental properties in the same area have a gross yield of 12% and an investor paid $110,000 for a home, the fair market rent would be approximately $1,100 per month:

$110,000 current market value x 12% = $13,200 gross annual rent

$13,200 gross annual rent / 12 months = $1,100

financial spreadsheet report

A Closer Look at Gross Yield in Real Estate

Before purchasing a rental property, investors calculate the gross yield to determine its viability. However, this calculation is not a one-off endeavor. Investors continually monitor average market rents and property values to track changes in gross yield over the holding period. This helps ensure the property is charging the right rent and generating maximum potential profit.

To illustrate, let's consider a scenario where a single-family home was purchased five years ago in Tucson, Arizona. By utilizing data from Zillow and Zillow Research, we can track the change in gross yield over the past five years:

Year Home Value Rent Gross Yield
1 $200,000 $1,028 6.20%
2 $216,000 $1,086 6.00%
3 $228,000 $1,153 6.10%
4 $248,000 $1,221 5.90%
5 $308,000 $1,377 5.40%

Gross yields averaged around 6.0% per year until the last year when it dropped to 5.4%. If fair market rents adjust back up to 6.0%, the potential rent increase would be from $1,377 per month to $1,540:

Gross Annual Rent = Current Market Value x Gross Yield

$308,000 current market value x 6% = $18,480 gross annual rent or $1,540 gross monthly rent

Before increasing the rent, investors run comparable rent analyses to determine the fair market rent for similar homes in the same area. This ensures that gross rents remain competitive and the property generates maximum potential profit.

Other Financial Metrics for Measuring Real Estate Return

Although gross yield is a quick and easy calculation used to evaluate potential investments and determine fair market rent, it does not provide a complete picture of a property's profit potential. Operating expenses are not factored into the gross yield equation. As a result, investors often turn to additional financial metrics to assess profitability before making a purchase.

Cap Rate

Cap rate, also known as capitalization rate, measures the potential return on an investment based on the property's net operating income (NOI). NOI is calculated by subtracting normal operating expenses (excluding the mortgage payment) from the gross rental income. To determine the cap rate, divide the NOI by the property price:

Cap Rate = NOI / Property Price

For instance, let's consider three examples:

Gross Annual Rent Price Gross Yield NOI Cap Rate
Home #1 $13,000 $120,000 10.80% $7,200
Home #2 $16,000 $140,000 11.40% $7,000
Home #3 $13,000 $130,000 10.00% $9,100

Initially, Home #2 appears to be the best choice based on the gross annual rent and gross yield. However, because operating expenses are higher, it actually has the lowest cap rate among the three options.

Cash-on-Cash Return

Many real estate investors finance the purchase of a rental property, making cash-on-cash return another important financial metric. Cash-on-cash return takes into account operating expenses and the mortgage payment. It is calculated by dividing the annual before-tax cash flow by the total cash invested:

Cash-on-Cash Return = Annual Before-Tax Cash Flow / Total Cash Invested

For example, if an investor purchased a $100,000 rental property with a 25% down payment of $25,000 and the annual before-tax cash flow is $3,500, the cash-on-cash return would be 14%:

$3,500 annual before-tax cash flow / $25,000 total cash invested = 0.14 or 14%

calculator and computer mouse

An Easier Way to Calculate Potential Returns

Calculating the potential return of a rental property manually can be time-consuming and prone to errors. To simplify this process, Roofstock offers a simple spreadsheet that allows investors to view the potential financial performance of a property. By entering relevant information, investors can forecast key return on investment (ROI) metrics, including cash flow, cash-on-cash return, net operating income, and cap rate.

By combining financial metrics like these with gross yield calculations, real estate investors can gain a comprehensive understanding of a property's potential instead of relying on just one or two measures of return.