There are various reasons for buying a property. On the one hand, the desire to own a home is often the main reason. On the other hand, real estate is a secure capital investment. The aim of a capital investment is always the yield, the return to be achieved with the investment. With real estate, the return can be achieved in many ways. During the use of the property, the condominium, the house or even the commercial property, a return is achieved for owner-occupation and for third-party use. Owner-occupation generates income through savings on rent, while the income from third-party use lies in the rental income. If the property is resold at a profit, a capital gain can also be realized. However, certain rules must be observed when selling real estate, particularly from a tax perspective. The speculation period applies to the sale of real estate, at least for properties not used by the owner. The three-property limit, which was developed by the Federal Fiscal Court, must also be taken into account. This rule is used to differentiate between taxable income and tax-free income from private asset management. For investors who want to generate an appropriate return with real estate as a capital investment, there are a few key points to bear in mind. The topic is multi-layered and complex, and investors should familiarize themselves with the basic rules and obtain comprehensive information.
Attention: Please note that all information is provided without guarantee and that this article does not constitute tax advice. For detailed information on your individual circumstances, please consult your tax advisor.
What does return on investment mean in real estate?
The return that the owner of a property tries to generate is the yield. This is always relevant when the house, condominium or whatever type of property is used commercially. This is usually done by using it as a rental property.
The return on investment is the profit generated by the use of the property. It is calculated annually. If the rental has not generated a profit but has instead generated losses, this is referred to as a negative return.
In order to determine the profit, the return that flows in the form of rental income must be set in relation to the capital invested. To enable an objective comparison, the return is always expressed as a percentage. If a property is purchased by an investor who wants to make a financial profit from the outset, this property is considered a yield property. It does not matter what type of property it is. Investment properties can be plots of land as well as condominiums, commercial properties, single or multi-family homes or special properties. The investor’s intention to make a profit is important for the classification.
For every investment, the investment expenditure must be compared with the rental income in order to determine the return, whereas other parameters are used for third-party use. In the case of owner-occupation, further calculations are usually neglected, as the focus here is not purely on making a profit, but on living in residential property. The return is in real terms in the form of savings on rent payments and in mental terms through the feeling of autonomy and independence.
However, third-party use is not about feel-good factors, but about carefully calculated figures. Here, the investment outlay, i.e. the purchase price including ancillary purchase costs, is compared with the expected rental income. It is important that the basic rents are used for the calculation. This is the pure rent after deduction of payments for electricity, water, heating, property management, municipal charges and so on. The basic rent is the amount that actually reaches the property owner as profit after deduction of costs. This profit is compared with the investment costs. The margin is expressed as a percentage and shows the annual return.
The difference between the acquisition costs and the income from the sale of a property is also referred to as a yield; this is a capital gain.
Buying real estate as an investment: Which property features are important?
As the return on real estate is determined by fixed factors, the profit can be calculated relatively easily. The investment outlay, which is made up of the purchase price and ancillary costs, is set in relation to the level of achievable rental income. The investor can find out about the amount of sustainable income that can be achieved by looking at the rent index, for example, which provides information about the standard local rents.
It makes sense to draw up a checklist with a cost and income side before the planned investment, for example in this way:
Real estate purchase checklist Investment properties of a property
Cost side
1 Acquisition costs (purchase price including ancillary purchase costs and, if applicable, refurbishment costs)
2 Planned useful life
3 Calculated administrative costs
4 Expected maintenance costs
5 applicable taxes
6 Possible financing costs
Benefit side
1 Sustainably achievable rental income
2 Estimated capital gain on resale
It should be noted that the yield is always dependent on the performance of the property. This in turn is determined by the general performance of the real estate market. The general rule of thumb is: the lower the construction costs and the higher the rental income, the greater the profit, i.e. the return.
Rental income alone cannot be used to assess the potential returns. If you buy a high-priced property in a good location, you can expect a high rental income. A less expensive property may require less investment, but usually generates less rental income due to its less favorable location. The ratio of investment to income remains the same, only the actual figures are different.
This in turn means that every property purchase depends on the three big “Ls”: location, location, location. A property in a good location can also be purchased with a smaller budget. Just probably not in one of Germany’s high-priced cities such as Munich or Stuttgart. However, if you rent out a well-maintained property in a good residential area of a less expensive city, you can certainly expect a reasonable return. But buying cheaply because the location is bad and then renting out expensively does not work, as rents also depend on the location.
How do you calculate a return on real estate?
It is rather naïve to simply estimate the yield “somehow”. Particularly in the case of properties used by third parties, the profitability of the rented property must be assessed by means of a careful yield calculation.
Please note: The following calculations are for example purposes only and are fictitious. All information and calculation examples are without guarantee. For an individual calculation, please consult your investment advisor.
In this valuation, a distinction is made between the net rental yield and the gross rental yield. The formulas are as follows:
1 Gross rental yield = annual gross rental income / purchase price * 100%
Example: Purchase price condominium 100,000 + ancillary purchase costs 10 % = EUR 110,000
Rental income (warm) EUR 700 per month = EUR 8,400 p.a.
Calculation: 8,400 / 110,000 = 0.763 * 100 = 7.63 % yield
2 Net rental yield = annual net rental income / purchase price incl. incidental acquisition costs * 100%
Example: Purchase price condominium 100,000 + ancillary purchase costs 10 % = EUR 110,000
Rental income (cold) EUR 500 per month = EUR 6,000 p.a.
Calculation: 6,000 / 110,000 = 0.545 * 100 = 5.45 % yield
This shows that using the net rental yield as a basis is much more meaningful, as the expenses are taken into account. This is essential for determining the real return.
If a return is to be achieved not only through rental income, but also through a capital gain, certain points must be observed. Firstly, a property not used by the owner may only be sold tax-free after the speculation period of ten years has expired. This does not apply to owner-occupied properties. There is a completely legal trick to avoid speculation tax, even if the deadline has not yet expired. In the last two years before the sale and in the year of sale, the property was used by the owner. This also includes, for example, use by the owner’s children who are entitled to child benefit.
Another pitfall lurks in the sale of real estate: the so-called 3-object limit. This states that commercial real estate trading exists if three properties are sold within five years. This has tax implications and should therefore be discussed with an experienced tax advisor before the planned sale. Properties that have been inherited are exempt from the three-property limit, as are developed properties that are sold after the speculation period has expired.
What is an average return on real estate?
The greater the difference between the investment and the rental income, the better the return. Low acquisition costs and high rental income mean a high return. The smaller the difference between costs and income, the lower the return.
It should be noted that a certain factor can be used as a basis under the keyword “average return on real estate”. A ratio in which the investment sum is 25 times the net annual rent (annual cold rent) is to be regarded as usual or average. If the factor is 20, this indicates that the acquisition costs are low. A factor of 30, however, indicates high investment sums.
Unfortunately, in some cases attempts are made to lure investors with promises of even higher yields, whereby the calculation is based on warm rents and essential factors such as ancillary purchase costs or the house fee are not taken into account on the cost side. This is highly dubious and deceives the investor into believing that a return cannot be achieved in reality.
