You’ve probably heard this before – if a property’s rental yield sufficiently exceeds the interest rate, then it is likely a good investment.
On the surface, this seems to make sense. After all, when you buy an investment property with the aim of collecting rental income, don’t you want to see how your rate of return (rental yield) stacks up against your cost of capital (mortgage interest rate)?
There is definitely a lot of basis to this formula, and the underlying reasoning is sound. However, there is also the danger that some may misconstrue this formula as being the only thing that matters when gauging whether a particular property would be a good investment or not. But it is just one of many factors to consider.
This article is about those other factors – six of them, in fact.
Factor #1: You Must Look at Net – Not Gross – Rental Yield
If you are a salaried worker making $10,000 a month, do you see the full $10,000 hitting your bank account at the end of each month? No. The same goes for rental income. Your gross rental income – which is used to calculate your gross rental yield – must go toward expenses other than your mortgage interest costs.
In Singapore, property tax and maintenance are the two big ongoing expenses to account for. Make sure you deduct those from your estimated gross rental income to arrive at your net rental income. Only from there can you calculate your net rental yield and compare it to your mortgage interest rate.
This is much closer to a true apples-to-apples comparison, but it is still not the full picture. Remember, you are legally obligated to service your mortgage payments, but no tenant is legally obligated to rent your unit. This brings us to the second factor, which is…
Factor #2: Rentability is Just As Important as Rental Yield (If Not More)
Unlike rental yields, there is no simple number that can be calculated to measure rentability. It is purely a subjective metric, but one that is just as – if not more – important as rental yields.
Rentability, in a nutshell, is how easily you will be able to rent out a particular unit. Here’s a question to ask yourself. If you bought a certain unit, how long do you think it would take for you to find a tenant (without having to offer discounts over the market price)?
There is also a trap to be wary of here: You see, in many instances, a property’s rentability may be inversely proportional to its rental yield. So, for example, a property could have either high rentability and low rental yields, or low rentability and high rental yields.
An example of the first case could be a property in area with surging demand. Because demand is high, so is its rentability. But this demand also means expensive prices. And the higher the purchase price, the lower the rental yield (remember that purchase price is the denominator when calculating rental yields).
For the second scenario, an example would be a property where the lease period is closer to expiry (e.g. less than 30 years remaining). This lowers the purchase price, and since tenants are not concerned about lease periods, there is no direct effect on rental income. However, many properties with expiring lease periods may have negative qualities associated with age – such as being run-down – making it difficult to attract quality tenants. Thus, rental yield remains high, but rentability is low.
Of course, as we said, this does not apply to all (or even most) properties. But it does apply to enough properties that we must caution you against falling into the “rentability trap”.
Factor #3: Interest Rates are Not Static
As governments look to resuscitate the economy via massive injections of liquidity, global interest rates have been brought to all-time lows – and look to stay that way for the next several years. This has been reflected in our mortgage rates.
But just because interest rates are highly likely to remain low for the foreseeable future does not mean they will stay that way for the long term. Once they (eventually) rise, that net rental yield may suddenly no longer look as attractive by comparison. Remember that in floating-rate home loans, the interest rate can change every three, or even one, month. By contrast, you can only raise the rent yearly (with no guarantees the tenant would agree).
So, just because net rental yields may look healthy today when compared to rock-bottom home loan rates, don’t assume this equation will hold in the long term. When analysing the difference between the two, you should build in a buffer for future interest rate increases. Otherwise, you might risk your returns on your investment turning negative almost overnight.
Factor #4: Don’t Forget Liquidity
In an investment context, liquidity is the ease by which a particular asset can be converted into cash. For example, blue-chip stocks would be considered fairly liquid, as you could both buy and sell them on the same day (and at the market price) if you wanted to.
That is not the case for property, which is one of the most illiquid types of investments there are. This is not a bad thing in and of itself, but it is something that must be accounted for. For instance, if mortgage rates rose and the ROI on your property turned negative, you would not be able to sell it immediately. If you wanted a quick sale, you would likely have to offer significant discounts over the market price.
How do you factor this in? Well, just like rising interest rates, the safest way is to give yourself a buffer to reduce the chances of your ROI turning negative. And from the more personal side of things, it is also important you conserve your cash flow so you don’t find yourself in the situation of having to liquidate your property to service other obligations.
Factor #5: Capital Appreciation Also Contributes to Returns
On the more positive side of things, it is also important to remember that returns on your property investment have two components. Rental income is one, capital appreciation is the other. Too often, investors ignore capital appreciation, perhaps because it is not immediately accessible (does not contribute to current cashflow) and is more uncertain.
That is true. But this doesn’t mean you should disregard it altogether. What it does mean is that, when scouting out potential investment properties, to also look at the development’s transaction history to see if there has been a general upward trend. Remember, property investment is a long-term game. Yes, rental income may provide immediate cash flow, but in the long-term, capital appreciation is what can really add to your total returns.
Factor #6: Your Rental Unit Could Serve as a “Backup”
Here’s a key difference between a property investment and other types of investments. You can actually live in your investment property (but you can’t sleep in your stock portfolio).
What this means is that, if things should unfortunately go sour, your rental unit could actually serve as your “backup”. As we mentioned in our previous article, article, ‘What Happens To Your Mortgage If You Lose Your Job?’, you might have to move into a smaller home.
Your rental unit could be that home. Sure, that should not be your primary, or even secondary, consideration when assessing a potential investment property. But it might be worth asking yourself – would I be okay staying here if I had to?
The Ultimate Question: What is Right for Your Unique Situation?
All investments carry some level of risk, and property is no different. Further, the level of risk also varies depending on the investor’s personal situation. What might be a risky bet for one might be a safe investment for another.
So, it would be irresponsible for us to claim that there is a single metric or equation that can tell you whether a certain property is a good investment for you or not. There are too many variables in play (and we hope this article has shed light on some of them).
But what we can do is offer you personalised advice through one of our Home Finance Advisors. If you prefer to do more independent research first, our comprehensive home financing guides should also help you on your journey.
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This article was written by Ian Lee, an ex-banker turned financial writer who hopes to use his financial background and writing skills to help raise people’s financial literacy levels – a necessity in our modern world.