Calculating real estate rental yield with a mortgage?

Question

I'm struggling to work out how to calculate real estate rental yield in a way that makes it somewhat comparable to any other income-generating asset (e.g., given an investment of X, and a periodic payment of Y, the yield is Z%).

The sticking point for me is how to handle mortgage costs. The interest part of the payment seems pretty clearly a cost that should be deducted from the income to figure out profit, but how should one account for repayment of capital?

My initial thought was to just ignore it and use only mortgage interest when figuring out cost, but this Investopedia article (under the "Home Equity" heading) outlines one way to handle the second point by essentially treating the capital repayment as additional income. Is this a reasonable approach or are there other ways that might make a rental investment more comparable to another investment (say, the stock market)?

Answer 1

The yield should be the amount of income divided by the amount invested. So you would subtract interest paid from your income, and add the principal to the amount invested. So it's not income since if doesn't increase your wealth, but it does increase the amount of equity that you have in the house.

That means that your yield is going to decrease over time because the amount invested will increase faster that the income will increase. That is a function of leverage. Over time, your leverage decreases since you owe a smaller amount of the value of the property.

So how does that compare with the stock market? Initially you are going to see high returns (percentage wise) compared to equities because you borrowed most of the investment, so the leverage is going to multiply the returns. But leverage also increases risk. If you go without a renter for 6 months, how are you going to make the mortgage payments? That is a significant risk that you need to consider when comparing to the stock market. Your stocks won't go to zero, but you could lose your rental if you can't afford to make the mortgage payment and they foreclose.