9 Oct 2020 / Blog > Knowledge

Real estate as a capital investment? The four most important key figures.

When buying a property there are key figures which should be considered before making a decision. In this article, we explain the four most important key figures, which you can use to decide whether a property is suitable as a capital investment or not, step-by-step using examples.

Flat: Our example flat is located in the university city of Dresden. Numerous medium-sized and large companies have now settled here and ensure a stable job market. Vacancies are therefore rare in the right residential areas. The flat is located on the fourth floor of an apartment building built in 1928 and is 100 m² in size. It has three rooms, a balcony, a bathroom and a guest toilet. Its purchase price is 200,000 euros after the purchase price negotiations. The condominium is well connected to public transport and centrally located.

Example of a flat No. 1

Example of a flat No. 1

Example of a flat No. 2

Example of a flat No. 2

1) Purchase price factor & gross rental return

The gross rental yield is a good way of quickly calculating whether the investment in this flat is basically worthwhile without having to go deeper into it. The gross rental yield describes the ratio between the net rent earned in one year (annual net rent) and the purchase price of the property. The higher the rental yield, the better, because the more yield one receives with the invested capital or for the purchase price. For our flat we assume an annual net cold rent of 12,000 euros. The annual net cold rent includes all rental amounts of one year which the tenant transfers to the landlord minus operating costs such as property management or costs for heating and water.

Example:

Annual net cold rent

Annual net cold rent

The gross rental yield is thus 6 percent.

The purchase price factor is often mentioned. This factor ultimately describes how many years the flat would have to be rented out in order to be refinanced by the annual net cold rent. The higher the factor, the worse for the investor, because the more expensive the flat is in relation to the rent and the slower it refinances itself.

Example:

Purchase price factor

Purchase price factor

The purchase price factor is 16.66. This means that the property must generate 16.66 annual net cold rents in order to refinance them. It is important to note that small changes in the purchase price factor can lead to large changes in the profitability of the flat. This should not be forgotten when considering the purchase price factor.

However, both the gross rental yield and the purchase price factor can only be initial indications when considering a property. They do not include any further costs. A purchase price factor of 16.66 as calculated in this example is already a very good value. In many larger cities such as Hamburg or Berlin, however, it is currently well over 30.

2) Net rental retun

The net rental yield takes into account, instead of just the basic rent, some additional costs that cannot be passed on to the tenant, the so-called "non-apportionable costs". These are, for example, administrative and operating costs, the creation of a reserve for maintenance or loss of rent. In contrast to these are the apportionable costs, these can be apportioned to the tenant and are e.g. sewage charges, heating or hot water.

The net rental yield describes the ratio between the cold rent earned in one year less the non-apportionable costs and the purchase price, which in the invoice also includes the ancillary purchase costs (property tax, broker and notary). For this reason, the net rental yield is more accurate than the gross rental yield, but it is also somewhat more complex to calculate and lower than the gross rental yield. For our flat we assume non-apportionable costs of 2,400 euros per year as well as a one-off incidental purchase cost of 20,000 euros.

Calculation:

Net rental return

Net rental return

The net rental return for our example flat is therefore 4.36 percent.

Like the gross rental return, the net rental return only describes a snapshot and does not include the financing or the taxes to be paid. A closer look at the monthly cash flow therefore offers a more detailed analysis, as it is precisely the tax that can have a considerable influence on the result.

The cash flow can be calculated within a few minutes. The aim of the cash flow calculation is to calculate the amount of money that is left over or has to be paid in arrears each month when a property is let. In the end, a property brings in rental income on the one hand, but on the other hand there are costs, the formation of reserves and interest on loans. When calculating the cash flow, these costs are compared.

3) Cash flow before taxes

In order to calculate the monthly cash flow before taxes, one starts with the monthly basic rent. The calculation of the basic rent can be based on the previous rent, similar flats and the rent index of a city. Sometimes, however, special features such as a rent cap, as is currently applicable in Berlin, have to be taken into account. All costs that are regularly incurred and cannot be apportioned to the tenant (non-apportionable costs) are gradually deducted from this basic rent. As briefly outlined above, these are on the one hand the operating costs, e.g. costs for property management, the formation of reserves for maintenance or loss of rent. Not to be forgotten is the respective instalment to the bank, which on the one hand consists of the interest and on the other hand of the repayment of the loan. The repayment of the loan is ultimately assets that are built up. Nevertheless, the money must be transferred to the bank and is first tied up there. If, at the end of this calculation, the cash flow is positive, then the flat will pay for itself through the rental income. As before, we assume a monthly basic rent of 1000 Euros for the flat. Furthermore, the bank rate and operating costs must be determined.

Bank rate:

The monthly rate to the bank is influenced by the amount of financing. What amount is ultimately borrowed by the bank, what is the interest rate on it and what is the monthly repayment of the loan? For our example we assume that we finance 100 percent of the purchase price with a bank loan and finance the ancillary purchase costs from equity. Incidental purchase costs are, for example, the land transfer tax, costs for registration in the land register, the broker's commission or the notary's fee. The ancillary purchase costs amount on average to around 5 to 15 percent of the purchase price and are rarely financed by banks. In our example, assuming that the ancillary purchase costs amount to 10 percent, this would be 20,000 euros. For the sake of simplicity, we assume an interest rate of 2 percent per month. We also assume 2 percent per month for the repayment. Based on this, we pay 334 euros in interest and 334 euros in redemption. Added up, this results in a monthly bank rate of 668 euros.

Operating costs:

Operating costs comprise the apportionable and non-apportionable costs discussed above. Only the latter are included in the calculation. The amount of this part is stated in the statements, which can be obtained directly from the seller or the agent of the property. It is very difficult to estimate a generally applicable amount that one has to bear as the owner of a property on a flat-rate basis. Depending on the property, the amount can vary considerably.

For our calculation example, we estimate 90 Euros non-apportionable costs as we assume that the property management costs 40 Euros per month and we have 50 Euros for other costs. In addition, as the owner of a property you should build up a reserve. This reserve is intended to provide for any loss of rent or repair work that may be required in the property. A common amount that is estimated for the maintenance reserve of a flat per month is about 10 euros per square metre per year and 3 percent of the rental income to provide for possible loss of rent. This results in an amount of approximately 114 euros for a 100 square metre flat. This results in operating costs of 204 euros.

If these parameters are taken into account, the cash flow before taxes is obtained.

Calculation:

Cold rent 1000 Euro - Bank rate 668 Euro - Operating costs 204 Euro = Cash flow before taxes 128 Euro

This means that the rental income in this example is sufficient so that after deducting the bank rate and operating costs, there is still 128 euros left. This means that a positive monthly cash flow is generated. However, this is 128 euros before taxes. It should also be taken into account that the bank rate includes 334 euros in repayments, which can be described as asset accumulation.

Exclusively by calculating the cash flow, it is not possible to say whether there is really anything left at the end of the month. One must also include the taxes to be paid. For this reason, the calculation of the cash flow after taxes is important.

Cash flow after taxes

The calculation of the cash flow after tax is necessary because at the end of the year rental income has to be considered and taxed in the tax return. Although some expenses may be offset, rental income is taxable in principle. It is difficult to make flat-rate assumptions in the calculation, as the amount of tax depends on various factors. Both the age of a property, the resulting depreciation and the owner's tax category can influence the tax burden. It is therefore important to calculate the taxes for each individual case in order to understand what amount is left at the end after all costs have been paid, including the amount to be paid to the tax office.

In our example, from the point of view of the tax office, the first thing we are talking about is rental income of 1000 Euros per month. This has to be taxed. However, some costs may be offset against this amount. This reduces the taxable amount. These costs also include, for example, the interest paid of 334 euros. However, the repayment of the bank instalment cannot be offset. Similarly, operating costs may not be deducted in full, as part of the operating costs is simply money transferred to another account and not spent directly, or reserves are formed as a result. Only when costs for repairs are incurred may the costs be claimed. However, the costs of the housekeeping allowance, which are borne and paid directly by the tenant, can be deducted directly. In our case this is 90 Euros for property management and other costs.

On top of this there is the depreciation of the flat or the building in which it is located. The depreciation can also be deducted from the rental income. However, the depreciation only applies to the building and not to the ground on which the building is located. For the sake of simplicity, we will assume for the purposes of the example calculation that 50 per cent of the purchase price is for the building and 50 per cent for the floor. The exact value may vary according to the size of the building, type of building, age of the building, etc. The tax offices have a more detailed tool for the calculation, which can be used to calculate the exact building share of the purchase price. Depending on how old the building is, the amount of the depreciation rate per year is calculated. For the example calculation we assume 2 percent, which may be written off for 50 percent of the building. For our example this is about 167 Euro per month.

Calculation:

Rent 1000 Euro - Interest 334 Euro - Apportionable costs 90 Euro - Monthly depreciation 167 Euro = Taxable amount 409 Euro

The bottom line is that the tax office sees 1000 euros in rental income and 591 euros in costs. That leaves 409 euros to be taxed. If we assume that we as real estate owners receive an annual salary of about 40,000 euros, we have to pay about 38 percent tax on the additional income we generate with the rent. This results in approx. 156 € costs per month which are caused by the tax. With these costs, our monthly surplus of 128 Euro before becomes a deficit of 28 Euro per month. This means that even if a property generates a surplus before tax, this does not necessarily mean a surplus after tax. This must be taken into account when evaluating a property.

Conclusion

In this example, at the end of our calculation there is more monthly expenditure than income for the property. However, this does not necessarily mean that the property is unsuitable as an investment. It ultimately depends on the aim of the investment. If you would like to improve your current income directly after purchasing a flat, our example flat is not suitable. However, if you see the flat as a long-term investment, the flat can become a very good investment over the financing period. Since rents are constantly rising due to inflation and the property can also increase in value, the calculation may look different after a few years.

As soon as the flat is paid off, we are allowed to keep a large part of the rent ourselves, as the installment to the bank is then completely waived. We will then own a flat which has cost us 200.000 Euros. In addition, you can probably also be happy about an increase in value of the property, which was deliberately not taken into account in this example calculation.

The bottom line is that we have invested 10,000 Euros in this property and after paying off the bank loan, we earn money for which we no longer have to work. The so-called passive income.

*Disclaimer

This blog article does not constitute legal, tax or financial advice. If readers of this blog article adopt the contents or follow any advice, they act on their own responsibility. Despite careful and extensive research of the contents as well as verification of the calculations, we cannot assume any legal responsibility and no liability for the correctness. We therefore recommend that you make your own calculations and, if necessary, seek the advice of a legal, tax or financial advisor.*

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