How to calculate the value of an investment property?

An investment property may be a nice home or an impressive apartment, but it is also a business. You have made a significant financial investment so that the asset returns some of its costs in income. This is what all assets do, in some way, but when you buy an investment property you don’t have the convenience of a term deposit or a fixed interest account, which quote you a rate of return. Even companies on the ASX can show you the indicative dividend yield from their stock.

But what do you do with property? How can you predict what the property will return you? When you buy an investment property there are three essential measurements of its performance: the rental yield, the capital growth, and the gross yield (rental + growth).

The rental yield is usually discussed as a percentage of the purchase price, and thereafter the valuation price. Typically, in Australian capital cities, the rental yield is around 4 – 5 per cent, so a $400,000 apartment should yield $16,000 – $20,000 per year. In the regional centres, yields can be higher, 5 – 7 per cent, so that a $300,000 property yields $15,000 $21,000 per year in rent. Very expensive, high-end properties, usually have low yields. A $2 million property might only earn 2.5 – 3.5 per cent yield, or $50,000 – $70,000 per year.

Investors will look at the rental yield closely because they want to know how much of the mortgage repayments can be met by rental income. But they also need capital growth – the rising value of the property itself. The point of investing is to build wealth and capital growth is often seen as the engine room for wealth creation. In normal circumstances this growth should be around 5 per cent, falling to 1-2 per cent in soft years and rising as high as 10 per cent. Buying a property in an up-and-coming area gives owners a solid capital growth performance.

The third measurement is gross yield which is rental yield and capital growth taken together. When you hold an investment property for at least 10 years, you should be able to plot its total return to you: let’s say 10 per cent on average.

The gross yield on your property is an important metric because it will tell you the overall return on your investment. It’s counterproductive to go after a high rental return if you are being left behind in terms of capital growth; if part of your plans include refinancing a property and releasing equity, capital growth is important.

Most investment property strategies are a trade-off: a property might be low cost and therefore relatively high rental yield, but it might be in a place with low capital growth. You might pay extra for the property and experience lower rental yield (because yield is a percentage of the purchase price) but the property excels in capital growth. The main point of doing gross yield calculations is to ensure that your investment is worthwhile over the term you intend to own it.