Washington D.C. has a perennially strong economy, great livability, a hot real estate market, several universities, and a huge workforce (the political class) that has a high turnover rate. All of those factors put together seem like they’d be a recipe for a great rental market, and it’s true, the District can be an incredibly profitable market for landlords.
But that’s not always the case. District landlords can find themselves losing money if they don’t know how to properly evaluate their rental properties. That’s where rental yields come in.
Calculated correctly, rental yields can give you a solid, easy to understand evaluation of a rental property. To start, let’s quickly go over what a rental yield indicates, and how to calculate it.
What Is Rental Yield?
To put it simply, rental yield tells you your return on investment. Why is that important? Well, this ratio will tell you if you’re making money on your rental investment, and how much. However, it can be a little complicated, because there are two types of rental yields, and one of them is much more accurate than the other.
Gross Rental Yield
To calculate your gross rental yield, you simply take a property’s annual rental income and divide that by its value/price, and then multiply by 100 to convert to a percentage. Remember that the price of the property includes all the money you’ve put into it, including costs like renovations, real estate commission, and closing costs.
So, for example, if you owned a $600,000 rental property in Petworth that rents for $4,000 a month, the gross rental yield would look like this:
$48,000/$600,000 = 0.08 X 100 = 8%
That’s a great annual ROI (return on investment). But eagle-eyed readers may have already noted where gross rental yield falls short as a meaningful metric— it doesn’t take expenses into account.
Net Rental Yield
Net rental yield is a much better metric because it incorporates expenses, producing a number that’s more grounded in day-to-day reality. After all, owning a rental property isn’t just sitting back and collecting checks; there are property management fees, maintenance expenses, legal fees, inspection fees, and vacancy costs.
So how do you calculate net rental yield? Simple— you just subtract annual expenses from the annual rent before dividing it by the property’s value. So looking at that same hypothetical Petworth property from above, you get:
$48,000 – $12,000/$600,000 = 0.06 X 100 = 6%
You can see why net rental yield is so much more useful than gross rental yield. The net yield for this property is a full 25% lower than the gross yield; if the investor had made all their revenue projections based on the gross yield, they’d be in big trouble.
Another term for the net rental yield is the “cap rate,” which is what we’ll be calling it in the next section.
What’s a Good Rental Yield in Washington, D.C.?
Cap rates vary widely between property types and locations. In the District, for example, multifamily rentals, which are the most popular type of property for rental investors, have an average cap rate of 5.17% for infill properties, which are mostly in the city, compared to an average cap rate of 5.46% in the suburbs.
So for the example we used above, 6% is actually a pretty good cap rate, coming in comfortably above average. Experts say the ideal cap rate is somewhere between 4% and 12%, with long-term investors typically falling on the lower end of that spectrum, since high cap rates represent higher levels of risk.
Cap rates for multifamily properties in the District actually fell slightly in the first half of 2019, though they remain above average for the nation. The national average cap rate for infill properties was 5.11% in 2019, which is the lowest rate for any type of property.
So why, you may be asking, are infill multifamily rentals such a hot commodity? Well, the market fundamentals for them are rock solid, and point to steady cash flow. Very low vacancies, very low interest rates, and steady rent growth have made them very attractive to investors, and that shouldn’t change any time soon, especially in a market as hot as the District’s. When you compare D.C.’s average infill cap rate to other American cities, it ranks closest to Dallas and Oakland, two other cities that are absolutely booming. The upshot? Even if you haven’t invested in District property yet, it’s still a great time to get on board.
If you’re looking to invest in other types of property, there’s good news there, too. Cap rates for both CBD (5.72%) and suburban (7.63%) office properties increased in 2019, retail property of all types are high and holding steady, and cap rates for industrial property are well above the national average.
Let’s say you’re analyzing countless deals and you can’t seem to make anything work. The numbers aren’t adding up. Try finding ways to cut your expenses: Do cheaper renovations with higher ROI, find real estate brokers who offer a discount or a buyer rebate at close, or simply start looking in more affordable areas. You might also consider taking on a fixer upper in a nice area that after a little TLC will cash flow after you raise rents.
Once you understand the inputs for rental yield, you’ll have more control over your financial future.
Beyond Cap Rates: Cash on Cash Return
Even though net rental yield/cap rate is a great, accurate way to evaluate a property, there are other metrics that may yield better results, depending on your investment goals. One of the most popular of these other metrics is cash-on-cash return.
The main difference between cap rate and cash-on-cash return is that while cap rate compares your net cash flow to your investment’s value, cash-on-cash return compares your net cash flow to the amount of cash you’ve actually put into the property. Because COC return uses your actual yearly profit and the actual cost of purchase, it’s an extremely insightful metric. If you’re a short term investor, you can see why this makes a lot more sense.
Let’s illustrate it with an example. Let’s say you buy a $1 million property, and rent it for $5,000 a month, while paying standard expenses like property management, maintenance, etc. Calculating your net rental yield, or cap rate, will look like this:
$60,000 – $12,000 = $48,000/$1,000,000= 0.048, or 4.8%
That’s slightly below average, both nationally and for the District. But let’s calculate the cash-on-cash return for the same property, assuming you sell it after a year.
Let’s say you put $100,000 down, borrowed $900,000 from the bank, and paid closing fees, property management fees, and maintenance costs to the tune of $12,000.
A year later, you’ve collected $60,000 in rent, but made $25,000 in loan payments, of which only $5,000 was repayment of the actual principal. If you sell the property for $1.05 million, you’ve paid out a total of $137,000 that year; after you repay the principal debt of $895,000, your total cash inflow is $155,000 from the sale, plus $48,000 from a year of rents.
To calculate the cash-on-cash return, you take the difference between the total cash inflow ($203,000) and the total cash outflow ($137,000), and divide it by the total cash outflow:
$203,000 – $137,000 = $66,000/$137,000 = 0.48 X 100 = 48%
That’s an excellent return on investment, and one that wasn’t apparent in mere cap rate. Cash-on-cash return is a much more revealing metric if you’re a short-term investor.
The Upshot
While the District has leveled off slightly after the meteoric rise of the past decade, it’s still a great market for investment. Cap rates for CBD office properties rose in 2019, and while they dipped slightly for multifamily properties, those are still very solid investments. While the present economic uncertainty will likely impact the D.C. market, it still has rock-solid fundamentals that should carry it through any turbulence.
