Identify The Best Investment Options using Rental Yield Analysis

This blog post was authored by Santosh Krishna, Data Scientist, Data Science Lab at Housing. 

Over the past few decades, real estate has been increasingly studied as an investment vehicle. A good investment in real estate should yield high returns over a long period of time. It’s common to hear of cases where people invested in properties worth a few thousand rupees a few decades ago and now those properties are being sold for crores. However, such investments rely on capital gain appreciation over a long period of time and they tend to be very illiquid as the holding period of such properties is very long. Illiquid assets have long waiting period for generating income.

An alternative option is to invest in rental real estate properties. The monthly rental returns contribute to wealth in addition to the capital gain appreciation of the property over a longer period. Also, for beginners in real estate investment, a very small amount (usually 15-20% down payment) is sufficient to own a rental property and then use rental returns to cover a mortgage and leverage to sell it off at a higher price, which gives high returns considering the amount invested.

For example, if a buyer wants to own a property worth Rs. 1 Crore, she’ll need a down payment of 20 lakhs and the rest of the amount can be borrowed with a home loan. If the buyer can find rental tenants for the property it can generate reliable monthly returns and pay for the monthly interest. When the buyer sells the property for Rs 1.2 Crore, considering the interest on her loan was paid by the rental returns, she gained an amount of Rs 20 lakhs. This is 100% returns on the invested amount of Rs. 20 lakhs. Consider the case where the buyer had bought the property entirely using her own money, she would have then gotten returns of only 20% on the invested amount.

Buying a property for rental income can be a promising investment option. However, the decision process for selecting a property can be a formidable task for an investor. Unlike buying a home to live in, investors who want to rent out their property need to consider factors like capital gain and rental returns before making their investment.

Capital gain is the appreciation of the property over a period of time. This is influenced by factors like nearby development projects, government infrastructure projects, etc. Such projects and their completions are highly dependent on local economics and political factors which are time variable and infeasible to estimate.

Rental returns are the monthly rents obtained on the invested property. The Return On Investment (ROI) in rental investments is calculated using Rental Yield. This post demonstrates on a data-driven and inferential analysis of residential investment options using Rental Yields. The kind of analysis demonstrated in this post can help in comparing localities in terms of their rental yield performances, which should lead to a more informed investment decision.

Understanding Rental Yield

A property’s rental yield is the percentage of the property value that you earn as annual rental income.

Gross Rental Yield = (Annual Rental Income / Cost of the Property ) * 100

If you have bought a property for Rs. 12,00,000 (12 Lakhs) and you earn a monthly rent of Rs. 10,000 then your Gross Rental Yield would be

Gross Rental Yield = (10000 * 12 / 1200000 ) * 100 = 10%

This indicates that you earn 10% of your property cost as rental income per year.

However, the investor should be aware of certain property expenses.

1) Taxes: the property taxes, income taxes that would be levied on the property

2) Maintenance Charges: covering up for the fixture, furnishing and fitting costs and their replacement costs.

3) Agent Fee: Unless the Investor looks out for tenant by himself, an agent help is required in finding a tenant.

4) Non Occupancy: It is better to be prepared that the property would be vacant for at least 1 month in an year.

All the above expenses come under the property expenses which are used in calculating net rental yield as

Net Rental Yield = ((Annual Rental Income – Property Expenses) / Cost of Property) * 100

These expenses are subjective to the city and the property type. Due to data limitations, they are excluded from our calculations of rental yields. In this analysis, we have used the Gross Rental Yield as a comparison tool for analysing localities as investment options. An investor can use this analysis to inform her decision. But she should also attempt to calculate an estimated Net Rental Yield to estimate the precise ROI for a particular property.

Rental Yield Calculation

As explained above, rental yield is calculated for a property. The calculation requires both the rental cost and the purchase cost of that property. However, a property is often listed either for a rental purpose or for a resale. Hence, we would have the information of only one value (either rent or resale) for a property. In order to estimate the other variable we identified similar properties that are listed for the alternate service, i.e., a similar resale property given we have a rental property and vice-versa.

A similar listing is identified using following features

1) Locality information

2) Building name

3) Built up area

Any two properties which match in all three attributes are considered as similar properties. If there are multiple similar listings, there would be multiple rental yields and the median value is considered as the estimated rental yield for that property. The rental yield for a locality is estimated as the median rental yield of all properties belonging to that locality.

Selecting Cities

In the recent past, the growth in rental market can be attributed to following factors:

1) Job Opportunities: With more industries and companies setting up their shops at Tier-I cities, people from different areas move to the cities and this drives up the rental market in the neighbouring areas. This trend is predominant in the IT capital Bangalore.

2) Property Prices: As resale property prices have risen to a level that makes them unaffordable for many salaried professionals, those professionals prefer to rent over purchasing a property, most commonly observed in Mumbai.

Considering the above factors, Mumbai and Bangalore are two cities which we would consider for this analysis.

Comparing Cities

Using Housing’s inventory, we estimated the average gross rental yield for each locality for both Mumbai and Bangalore. Rental yields are estimated by matching rental and resale properties in the same building and with similar flat configurations and details. We matched on the building to control as much as possible for the many latent or unseen factors that affect the valuation and desirability of a property. We calculated such yields across historical time periods from 2014-Q2 to 2015-Q3. For every quarter, we plotted the distribution of rental yields across localities using Kernel Density Estimation (KDE).

The intensity of the colour determines the recency of the time period. The darkest color correspond to the latest quarter, i.e., 2015-Q3.

Bangalore and Mumbai show a clear distinction in terms of their rental yield distributions. In Bangalore, the rental yields indicate a slight upward trend over six quarters. The distribution appears to be shifting towards higher rental yields in more recent quarters. Whereas in Mumbai rental yields have remained stagnant over the same period. Also, Bangalore’s rental yields are shooting above an average of 4 as per the recent 2015-Q3 findings which is better than Mumbai’s average of 2.5 for the same period. So the analysis suggests Bangalore precedes Mumbai as the investment destination for rental returns.

Bangalore Rental Market

Our analysis suggests Bangalore’s rental yields have been performing better than Mumbai’s. Within Bangalore, are good yields associated with certain localities or are they spread evenly across localities? There is only one way to find out. Data.

Each point in the above graph is a locality. The average per square feet rate of resale properties within a locality is mapped with its rental yield. There is a negative correlation of rental yields with the price of a locality. So for better rental yields it seems better to stay away from the costlier localities. We can take pride in opting for an investment in a more affordable locality.

Locality Suggestion

The top localities in Bangalore sorted based on rental yield are the following:

The locality Hulimavu has a highest rental yield of 6.3% followed by Electronic City with a rental yield of 5.2%.

Property Suggestion

When considering whether to make an investment it’s important to consider whether the property will meet the likely tenant’s requirement in that locality.

Investors might assume that a 3 BHK apartment priced higher than average in a high rental yield locality would get a higher rental return. However, if there are more affordable 2 BHK options then the property might go vacant for few months in an year. Or if there is an over-supply of 3 BHK in that locality with no matching demand, it makes much less sense to invest in a 3 BHK property.

To gain insight into the kinds of properties that would be more likely to match potential renters’ preferences, we estimate demand at the configuration and locality level. We estimate demand using the number of unique users interacting with Housing’s inventory in a given locality.

As Hulimavu yields the highest returns, let us study the Demand vs Supply for various bedroom types.

There appears to be an oversupply of properties across all bedroom types. Even if an investor purchases a 2BHK, at current levels of demand there would be less occupancy throughout the year which would lead to lower rental yields. The oversupply of properties across all bedroom types makes the Hulimavu locality a less favorable investment destination.

The locality Electronic City closely follows Hulimavu in terms of rental yields. A similar analysis would reveal the investment outlook for Electronic City.

Interestingly, Electronic City has higher demand values compared to Hulimavu across all bedroom configurations. Moreover, in the 2BHK component, there is a higher demand than supply. So, if someone invests in a 2BHK in Electronic City, there appears to be a higher likelihood of finding tenant, which reduces the chance of non-occupancy.

Even though Hulimavu scores better rental yields, the demand in that locality makes it a poor investment choice compared to Electronic City which yields similar rental returns with higher demand.

Find a house for rent in Bangalore

Investment Cost

From the above discussion, we arrived at a preferred location and configuration type. However, the question remains as to what is the right investment price for such a property? An investment in a 2BHK penthouse should be priced so that it finds the best demand from potential tenants. In other words, the rental pricing of that property should be aligned with tenants’ price demands.

In the above graph, the demand appears to be centered around Rs. 11,000 to Rs. 15,000 for the 2BHK type in Electronic City. Using the rental yields for this locality, the preferred investment cost should be between Rs. 30 Lakhs and Rs. 40 Lakhs.

A few other localities that have better rental yields with sufficient demand include Kada Agrahara, Kasavanahalli, Whitefield, and Marathahalli.

To do a further research on property costs across localities, use Housing’s Property Intelligence tool which provides an estimated price of a property given its configuration and location details.