Understanding capital growth and rental yield

There are many reasons why residential and commercial property is attractive to private and corporate investors. Continued high demand means rents and property values generally rise faster than inflation. There are also different ways to invest to suit your goals, and the risks are relatively low. However, perhaps the greatest benefit of a property investment is the ability to generate a return in two ways: a rental yield and capital growth.

Understanding the differences between capital growth and rental yield and knowing how to calculate them is key to making a successful property investment and creating a strategy that supports your financial goals.

What is capital growth?

Capital growth is the amount a property’s value increases over time expressed as a percentage of the purchase price. For example, if the value of a property you buy increases from £500,000 to £550,000, you have achieved capital growth of £50,000 or 10%.

As with most assets, property values can decrease as well as increase. In the short to mid-term, you could find the value of an investment property falls. That is known as capital depreciation. However, over the long term, property prices usually trend upwards. That makes investing for capital growth a long-term and low-risk strategy. 

How do you calculate capital growth rate?

To calculate the capital growth of a property, you subtract its purchase price from its current value, which you can determine with a property valuation. You then divide the increase in value by its original purchase price and multiply that figure by 100 to get a percentage.

Here’s an example if you buy a property for £450,000 that’s worth £550,000 five years later:

Current price (£550,000) - purchase price (£450,000) = £100,000

Increase (£100,000) / purchase price (£450,000) = 0.22

0.22 x 100 = capital growth of 22%

What capital growth can you expect on a property investment?

Capital growth differs significantly based on factors such as the type of property you buy, its location and demand. A good annual capital growth rate in the UK is around 4 to 5%. Anything over that level is considered excellent.

Generally speaking, commercial properties offer a higher capital growth rate, but they must be well-located and properly maintained. However, there’s also more risk as the commercial property market is more vulnerable to economic downturns and tends to fluctuate more dramatically.  

Predicting capital growth on a property is difficult as it relies on several unknowns. That includes the demand for that particular property type, the economic health of the area, the availability of similar properties and demographic changes in the future. Properties in prime or up-and-coming areas that are undergoing regeneration or with planned infrastructure developments tend to have a higher capital growth potential.  

Capital growth considerations

The good thing about capital growth is that the gains you make are compounded over time, so even if the rate of capital growth remains constant, the amount the value increases by rises year-on-year. As an example, if the price of your property increases by 5% each year, it will double in value in just 14 years.

On the downside, you usually need to pay capital gains tax on the profit you make when you sell an investment property. That’s something to consider when creating your investment strategy and calculating your potential return on investment. There are also no guarantees of growth. Research can help you identify areas that are primed for capital growth, but even if you choose a good property in a great location, there are still factors outside your control that can diminish your returns.

What is rental yield?

The rental yield is the income a property generates in the form of rental payments relative to its value. While some investors ‘flip’ residential and commercial property - i.e. buy it, refurbish it and sell it quickly for a profit - most investors buy property to rent it out. Commercial and residential tenants pay a monthly rent for the use of the property, which creates an income stream for the investor.

The rental yield you can expect varies significantly according to the property type and its location. Generally speaking, commercial property provides stronger rental yields than residential property. However, there is a higher risk of void periods with commercial property. They occur when the property is unoccupied and does not generate an income for the investor. 

How do you calculate rental yield?

There are two types of rental yield: gross yield and net yield.

Gross rental yield provides a general overview of the attractiveness of a property investment, while net yield gives you a clearer picture of the actual return you can expect once all your costs are accounted for. 

Gross yield

To calculate gross yield, you divide the rental income you expect the property to generate by its value or purchase price. Multiplying that figure by 100 will give you a percentage.

Here’s an example if you buy a property for £300,000 that generates £20,000 in annual rental income: 

Annual rental income (£20,000) / purchase price (£300,000) = 0.0667

Multiplying that figure by 100 gives you a gross yield of 6.67%

Net yield

Net yield gives you a more accurate idea of your return as it factors in your costs, such as mortgage payments, maintenance and insurance. In this case, you subtract those costs from the annual rental income figure before dividing it by the purchase price. 

Here we take the above example but with annual costs of £5,000:

Annual rental income (£20,000) - costs (£5,000) / purchase price (£300,000) = 0.05

Multiplying that figure by 100 gives you a net yield of 5%

What rental yield can you expect on a property investment?

Rental yield can vary significantly according to a property’s location, purchase price and level of demand. You can achieve the highest rents for commercial and residential property near city centres, but property prices are higher in those areas, which pushes the yields down.

The best yields are usually achievable in cities with strong rental demand and reasonable property prices. For example, properties in and around Manchester, Liverpool and Leeds can achieve yields of 7 or 8% or more. In areas with higher property prices, such as London and the South East, yields tend to be closer to 4 or 5%.

Rental yield considerations

One of the benefits of investing for rental yield is that you can predict your likely returns with a good degree of accuracy, which is not the case with capital growth. That allows you to make an informed investment. It also provides immediate, regular income, so investors will usually see a quick return. Generally speaking, residential rents also only go in one direction, although commercial rents experience more fluctuation.

The downside is that, like capital gains, you will pay tax on the profit you make from the rental income you receive. The tax rate payable on rental income is also higher than the tax you’ll pay on capital gains. There can also be issues if you cannot find a tenant for your property as you will still incur costs without generating a return.  

Capital growth vs. rental yield - how to prioritise the right investment strategy

The right investment strategy depends on your attitude to risk and investment goals. Rental yield offers regular income while capital growth can deliver long-term wealth creation. In truth, most investors seek to benefit from a mix of the two, but you will need to find properties that offer strong rental demand in areas with the potential for appreciation.

Achieve your investment goals

At Eddisons, we help individuals, businesses and investment funds buy and sell investment properties. Read more about how our Property Investment team can help you generate the best possible return through commercial acquisitions, browse our commercial properties for sale and get in touch to discuss your investment requirements.