You invested equity (and probably took out a mortgage) to purchase your multi-family unit. This makes it a capital investment – which competes with other forms of investment such as bonds, equities, precious metals or foreign currencies.
As with all other capital investments, you expect a return on investment when you invest in real estate: it should yield a return – either in the form of regular dividends or from an increase in value over time, which is reflected in a capital gain when it is sold at a later date. Ideally, you should achieve both. The fact that your multi-family unit offers families with children a roof over their heads and contributes to their quality of life is something we will disregard emotionally for the time being as we consider your investment in objective terms.
Let’s assume you bought your 8-apartment multi-family unit in 2012 and paid CHF 5 million for it. At the very least, your aim is to recoup that CHF 5 million, adjusted for inflation, in a future sale. From this point of view, you can equate the value of your capital investment with the cost price (even though there is a difference between price and value from a business perspective). The main components of price, and therefore value, are:
The effective value of your property depends on who the calculation is intended for. What counts for taxes and insurance is the market value, i.e. the presumed price that the house is likely to fetch when it is sold, as estimated by experts. For mortgage lenders, on the other hand, what counts most is the capitalized income value, i.e. the net rental income that you would generate if the property were fully rented.
The current return on your investment therefore consists of the rental income plus any interest on provisions.
However, your residential building not only generates income, it also incurs costs. These may be for maintenance of the buildings and land, for administration or for insurance, for example. On top of that, there are capital costs and amortization; taxes; provisions for refurbishment; reserves for rent losses and vacancies, and many more expenses. It is important to compare revenue and costs.
The following calculations are based on the following assumptions:
Income in |
Expenses in |
Provisions in |
|
Net rental income |
211,200 |
||
Administration1 |
12,700 |
||
Maintenance (CHF 1,000 apartment/year) |
8,000 |
||
Insurance |
4,000 |
||
Reserve for vacancies and rent losses2 |
4,200 |
||
Cost of capital |
65,000 |
||
Taxes (flat rate) |
10,000 |
||
Provisions for refurbishment3 |
50,000 |
||
211,200 |
103,900 |
153,900 |
|
Profit before provisions |
107,300 |
||
Profit after provisions |
57,300 |
1 6% of net rental income/year
2 2% of net rental income/year
3 1% of the purchase price/year
Our team of advisors will be happy to help you.
No matter whether you’re talking about profit or loss, since the figure always relates to the capital employed, the rate of return allows a comparison of different capital investments. And as various types of revenue are accrued, so are different returns.
Let’s start by looking at gross and net returns. The gross return is the least meaningful because it ignores costs that reduce earnings. However, it can still help you to gain a rapid initial picture, because real estate hardly ever covers costs with a gross return of less than 2%. The net return is determined by subtracting running costs from income, i.e. the return actually generated from the invested capital. Learn more in the infobox “Net for gross?”
Net rental income × 100 / Purchase price4
211,200 × 100 / 5,035,000 = Gross return: 4.19%
4 See info box “Net for gross?”
(Net rental income – Costs) × 100 / Purchase price
107,300 × 100 / 5,035,000 = Net return: 2.13%
Rented multi-family units – also called investment properties – are one of the capital investments that you are allowed to finance from borrowed funds. The return is 100% yours, but since you didn’t have to put up 100% of the capital, there is tremendous leverage: the higher the proportion of borrowed capital, the greater the return on equity employed (for better or worse, more on this later).
Net rental income – Costs4 × 100 / Invested capital5
107,300 × 100 / 1,762,000 = Return on equity: 6.09%
4 See info box “Net for gross?”
5 2012: CHF 1.75 million, inflation-adjusted as at 2022
This is an example of the leverage effect: the return on equity is three times higher than the net return. This is not surprising, since equity is equal to one-third of the total capital.
Until a few years ago, multi-family units could be financed with a maximum of 80% of borrowed capital; since 2020, you must raise at least 25% of equity for the purchase. In addition, the proportion of borrowed capital must be reduced to a maximum of two-thirds of the purchase price within 15 years – the borrower must therefore repay at least 8.33% of the mortgage amount within this time.
But in the end, it doesn’t really matter whether you finance your capital investment with two-thirds, 75% or 80% of borrowed funds. After all, the share of borrowed capital corresponds to between twice and four times your equity – and the return on equity will be correspondingly higher.
Buildings are commodities that wear out and require regular maintenance, even when used properly. And after a few decades, total refurbishment is needed to prepare the property for another 30 to 50 years and maintain its value. The costs of such refurbishments are high; and in the case of total refurbishment with a vacancy notice, you will lose out on rental income during the construction period. It is advisable to prefinance future refurbishments through regular provisions. A good rule of thumb is to set aside 1% of the (inflation-adjusted) purchase price each year. By investing these amounts in the long term and with a low level of risk, you can even enjoy capital gains.
Until now, all returns were calculated without these provisions. 1% may sound quite low, but it is a large amount when measured against the purchase amount. These provisions also reduce the freely available net-net return, or “distribution yield”, accordingly.
(Net rental income – Costs4 – Provisions) × 100 / Invested capital5
57,300 × 100 / 1,762,000 = Net-net return/distribution yield: 3.25%
4 See info box “Net for gross?”
5 2012: CHF 1.75 million, inflation-adjusted as at 2022
In October 2020, the federal court ruled that the net return of a rental apartment may not be more than two percentage points higher than the reference interest rate. Otherwise, the rent is considered to be abusive because, according to Art. 269 of the Swiss Code of Obligations, excessive income is derived from the leased property. The reference interest rate is currently (January 2022) 1.25%; the net return may therefore not exceed 3.25%. There are still insufficient empirical values to indicate the running costs of new buildings, which is why the courts calculate the gross return of buildings that are up to 10 years old. For all other buildings, the net return applies. The methods for calculating gross and net returns used by the courts are clearly and bindingly regulated – or so you might think.
This is not actually the case: online you can find various formulas that lead to a wide variety of results. The most divergent opinions relate to the relevant reference value: which figure should you use? The purchase price, market value, tax value, insurance value or the land price plus construction and incidental purchase expenses? Should you take the actual or the inflation-adjusted purchase price – and what percentage of it? And what about refurbishment costs incurred since acquisition? It is also unclear what is relevant for calculating the gross return: rental income with or without incidental expenses, i.e. gross or net rent?
So what counts in court? An inquiry with the Zurich homeowner association reveals the following:
If our fictitious example were your property, you would actually own an investment property. This is because a capital gain of currently 3.25% net-net after taxes and provisions is a very respectable return – especially compared to similarly safe investments. However, we are not judging by quite the same standards here. After all, a borrowed capital component of 65% also means that the property is only 35% yours, or that you will only receive 35% of the proceeds when it is sold. If you had paid for the property in cash – like a pension fund would have done, for example – the return after provisions would no longer look so good:
(Net rental income – Costs – Provisions) × 100 / Purchase price
57,300 × 100 / 5,035,000 = Net-net return/distribution yield: 1.14%
Another reason why the return is so good is because conditions are currently attractive with mortgage interest rates at a low level. But what if the Swiss National Bank raises key interest rates again, as expected? And not just once, but several times in rapid succession? Then investing in multi-family units would become less attractive compared to other investments.
Lower demand and less available capital means that prices for real estate will decrease, and the rise in interest rates will lead to a value adjustment. This can quickly amount to 20% or more. Instead of representing CHF 5 million, your investment property would only be worth CHF 4 million. Assuming you had purchased your property not ten years ago but two years ago with 75% of borrowed capital, you would have amortized just under 1.1% of the 8.33% difference to 66.67% (two-thirds) within two years and increased your equity ratio from 25% to 26.11%.
You would bear the loss in value of CHF 1 million in full, and instead of the original CHF 1.25 million, your equity would only amount to CHF 250,000. However, the lender would insist that you put back in 26.11% equity. In relation to CHF 4 million, this would be CHF 1,044,000 minus the remaining CHF 250,000 = CHF 794,000. If you were unable to raise this sum, you would have to sell the property – making it not an investment property at all, but a steep loss-making transaction. According to the UBS Chief Investment Office, however, interest rates are not expected to rise sharply in the short to medium term.
Basically, there are three ways to improve your return on investment:
Approach 1 is not very practical because you cannot adjust rent at will. And without value-enhancing investments, you also have no legal means to justify a rent increase.
Reducing your costs is a viable way to go. For example, you can reduce or even completely save on administrative costs by managing your property yourself (CHF 12,700 in our example calculation). And instead of setting aside a reserve for rent losses, you can – if your financial situation allows it – bear these costs when they actually occur (CHF 4,200 in our example calculation). This alone amounts to potential savings of over CHF 16,000 per year, which increases your return on investment accordingly. In addition, if you find a more favorable mortgage or increase your equity component when refinancing, you can save on the cost of capital.
You can achieve a much greater increase in profit by setting aside fewer provisions for refurbishment. For example, earmarking just 0.5% instead of 1% per year results in CHF 25,000 more profit. However, one consequence of this is that you will have to wait longer before you can finance a refurbishment from equity. Alternatively, you can increase your financing accordingly if refurbishment work is necessary (and provided you qualify for additional financing).
At UBS key4 mortgages, you receive several attractive offers with just one request.
Would you still have bought your multi-family unit 10 years ago if you had been able to achieve a return of 2 to 3% with 10-year federal bonds at the time? Probably, because you wanted a multi-family unit that would generate a regular income and that would also provide you with a roof over your head if necessary.
You are generating an income from it – you can refer to it as a profit, not return – and it’s something that can be measured in francs and centimes, not percentages. Thinking in terms of returns and percentage points is only useful if you want to compare different investments and choose the most profitable one.