Revealed: Where to find healthy returns on rental properties

Expert crunches the numbers on the best property deals.
Expert crunches the numbers on the best property deals. Photo credit: Getty.

As with any investment, gains from property don't happen overnight. However, unlike cash-based investments such as term deposits, property returns can be volatile and carry significant risk.   

For people planning to buy a property and rent it out, with the goal to build passive income for retirement, it's important to know the basics.

Newshub spoke to Ed McKnight, an economist at Opes Partners on what a 'yield' is and how to calculate it, which regions might unearth returns above 5 percent and the top spots worth checking out in Auckland.

What's in a 'yield'?

The value of a potential rental property is often referred to as the 'yield', which is the amount of annual income (rent), relative to the purchase price.

People may hear the terms 'gross yield' and 'net yield' bantered about interchangeably - the difference is that 'gross yield' is just income, whereas net yield includes operating expenses.

'Gross yield'

Gross yield is calculated based on the annual rent, divided by the purchase price.

A home which rents for $650 per week ($33,800 of income per year), for which the purchase price is $640,000 would have a yield of 5.3 percent (33,800/640,000).

"[If] you hear the term 'yield' in property circles, you can usually assume it is gross yield. This is because it is quick to calculate and easy to compare," McKnight said.

"But because it doesn't include the true costs of holding the investment, it's a vanity metric." 

Gross yield may be useful when comparing similar homes within the same city, as a ballpark indication of potential profitability.

"It's still [a] useful [tool] to calculate and compare, but first-time investors also need to know its limitations," he added.

'Net yield'

As rates and other expenses can differ according to region, the net yield can provide a more accurate profit estimate when comparing properties in different locations.

"Net yield includes operating expenses, [e.g.] rental income, less rates, insurance, body corporate fees, etc, divided by the purchase price. 

"It doesn't include the cost of the mortgage."

Calculating total property return 

Although the 'net yield' includes expenses, when comparing property investment to other forms of investment, the rental yield and capital growth of the property should be factored in.

While property investors typically calculate profitability in different ways, a standard calculation takes into account net yield, plus the capital growth increase, less the mortgage interest rate.

"[For example], a net rental yield of 3 percent (in Auckland), plus a capital growth rate of 5 percent, less a 3.5 percent interest rate (assumes 100 percent lending), would [equate to] a 4.5 percent total return per year on the property's value," McKnight said.

While capital growth is an estimate which can be compared and weighted according to the region investors are looking at, McKnight suggests 5 percent as a useful ballpark.

"Over the last 18 years, only a handful of suburbs didn't grow by 5 percent year-on-year," he said.

Where to find healthy yields 

For people wanting to invest in property long-term, McKnight said the best places to unearth a decent yield are those where there's a big difference between the rental and residential property markets.

"[The] Manawatu-Wanganui [region] tends to [deliver] good yields because house prices are relatively cheap, and there is a high proportion of people who rent," he said.

Further south in the capital, rents are higher than in Auckland, while the median house price is lower.

"The [October] median rent of a 3 bedroom house in Wellington is $650 per week, and [as] the median house price [for] the Wellington region is $640,000, this is a 5.28 percent yield," McKnight said."

Auckland's [average yield] sits at 3.86 percent, as the median rent for a 3-bedroom home is $630 per week (cheaper than in Wellington), while the median house price is $848,000," he added.

For investors wanting more bang for their buck, another option is to look at different types of properties, such as those catering to niche markets.

"In Hamilton, we are seeing yields of around 10 percent for properties close to the hospital and university, and are rented [on a] room-by-room [basis]."

Niche properties, such as those catering to students, with a separate ensuite and kitchenette for each room may provide a much higher return, but it's important to weigh this up against potential risks, such as marketability for re-sale.

"Every property comes with risks and benefits.  

"My advice [to a first-time investor] would be to take a portfolio approach and spread the risk [by acquiring] standard properties," McKnight said.

Top spots in Auckland

Auckland house prices tend to attract high capital growth, making it more suited to capital growth rather than yield. 

However, opportunities for capital gain cannot be ignored and an investor is wise to consider gains from both angles.

"Many investors will suggest only buying for yield [i.e.] cashflow, [whereas] the real benefits of property investment come from capital gain," McKnight said.  

Over the last 18 years, McKnight said that based on data from January 2000 to August 2018, the median house price of the average Auckland suburb grew by 7.66 percent per year. 

"In essence, the average house in the average Auckland suburb grew in value by $748,600: that's $40,096.41 per year." 

"While it's true that [capital gain] is harder to control than yield, if [investors] don't focus on [it], then [they're] missing opportunities to get more of it," McKnight added. 

Top-performing areas within Auckland to rent out and buy for capital gain

Although the yields are likely to be lower than in other regions, people looking for rental properties within Auckland could look north-east of the Manukau Harbour.

"Based on [my] data for Auckland, Mangere and surrounding suburbs are the only areas where the median house price is less than $700,000, and [the] capital growth rate [is] above 8 percent."

Crunching the numbers on performance data, people in the market for higher-priced homes, who are looking to invest solely for long-term capital growth might consider the merits of Point Chevalier.

"Point Chevalier grew [by] 9.45 percent on average over the last 18 years. 

"The rental yield will be very poor and the entry price high, but it is the fastest-growing suburb in Auckland," McKnight said.

Areas that have been rezoned to allow for higher density housing and up-and-coming areas could provide opportunities for the more experienced investor to develop or do-up.

"[If looking at higher density housing], be aware that this moves from property investment to development and carries higher risks, taxes...and returns.

"Gentrifying areas where much of the housing stock needs love [is another option].  

"This is another reason why I'm a fan of Mangere: the new Waterview tunnel has made it a better option for commuters [and] my pick is that this area will begin to [improve]," McKnight said.

While property provides the potential for healthy future gains, understanding the basics, such as how to calculate a yield and factor in the true cost of investment will help novice investors separate the wheat from the chaff.

Areas to consider include the Manawatu-Wanganui region and Wellington, while niche investments, such as student accommodation may provide higher returns in areas such as Hamilton.  

Although Auckland is generally out-of-sight for much other than capital growth, there may be opportunities in areas where the standard of living is improving over time.