Mainly for Students: Yields in property investment explained

The “yield” on a property, or indeed any capital investment, refers to its relationship with the income received over a given period of time. It is estimated by calculating the percentage the income stream represents as a return on the capital invested. In the case of property, consider an office block valued at £1m which is let at a current market rent of £50,000 pa. The yield is 5%, calculated as £50,000 ÷ £1m, and is often referred to as an all risks yield (ARY). Another expression is years’ purchase (YP). This refers to the number of years it would take for the annual income stream or rent to be equivalent to the purchase price of the original capital investment. Thus, it would take 20YP at £50,000 pa to purchase the £1m building. The calculations have ignored purchasers’ costs, but they will be included in most commercial property investment valuations, appraisals, comparables analysis and yield profiles, meaning yields are net of costs. This reflects property’s high transactional costs, as well as better aiding property’s comparison with other asset classes which have low or no transactional costs. The value of time Valuations apply yields to discount future cash flows, reflecting the time value of money principle. Money in your hand now is worth more than the same amount in the future. The higher the yield, the greater the discounting, the lower the YP and, in turn, the lower the value of a property, because to achieve a higher yield, investors have to pay less for their investment. Another way of seeing it is: the more safe an investment, the more buyers are willing to pay for it and, as a result, the yield is lower. Another term used in this context is present value (PV). The PV of £50,000 rent payments next year, the year after and all of the years after are discounted to the present day at a given rate of interest – yield. Yields that are applied to a valuation should be based on market transactions and then applied in an appropriately comparable way. YPs and PVs are determined from both simple and more complex formula, which are not discussed here but are embedded in valuation tables and software. Factors affecting value Factors affecting yields and values relate to risk and opportunity, including property type, location, tenant covenant strength, the timing of lease expiries or breaks and rental growth prospects. Other influences include the outlook for the economy, interest rates, lending market conditions, changing consumer and corporate trends and the returns available from other asset classes, such as equities/shares, gilts/bonds and cash. Market yields referenced in sector commentaries include prime yields, secondary yields and more sector-specific categorisations. Terminology for yields falling and rising includes yield compression and decompression, yields hardening and softening, and yields moving in or out. Yield profiles Software-based valuations usually calculate a resulting yield profile, which investors and lenders also wish to know and agents may include in marketing details. There may be slight variations in software yield terminology, as can be seen with yields more generally. A wider exploration of yield-related terminology is given below. Initial and reversionary yields The initial yield (IY) is the initial rent passing divided by capital value. The reversionary yield (RY) is calculated similarly using the rent applicable to the reversion, such as a rent review, lease renewal or reletting. For the above example of a £1m rack (full current market) rented investment valued at an ARY of 5%, the IY and RY are both 5% as the same £50,000 rent applies. The equivalent yield is also 5% (see later). For an underrented reversionary investment having a three-year term of £40,000 pa and a reversion of £50,000 pa valued at the same 5% yield to achieve a capital value of £973,000, the IY is 4.1% (£40,000 ÷ £973,000) and the RY is 5.1% (£50,000 ÷ £973,000).    Net initial yields The initial yield is usually termed net initial yield (NIY) to denote its calculation including purchasers’ costs (see box below) but may still just say initial when on such a net-of-costs basis. There may not always be a clarification of gross initial yield where costs are excluded, and other yields may occasionally add the net reference when net of costs. Also, a valuation may be on an initial or net initial yield basis when the initial rent is capitalised into perpetuity. Purchasers’ costs Standard purchasers’ costs components suffice for valuation purposes and can be adapted for other purposes. These comprise stamp duty land tax (0% up to £150,000, 2% on the next £100,000, 5% thereafter), agency fees (1%), legal fees (0.5%) and VAT on those fees (0.3%). For a £1m property, for example, this would total £57,500, so a comparable having a yield of 5% gross of costs is 4.72% net of costs, calculated as £50,000 ÷ £1m + £57,500. The corresponding precise valuation is £50,000 YP in perpetuity (YP perp) 4.72% (21.18 multiplier) = £1,057,500, less £57,500 purchasers’ costs = £1m.   Consider more than initial yields It is important not to rely only on initial yields without further information. This includes whether the property is market rented or under or overrented and the extent, as well as lease event timescales and the nature of the reversion. A low initial yield could reflect a long-outdated passing rent on an old lease being due for a substantial increase. A multilet property may have high voids, rent-free periods still running or stepped rents. Overrented properties could have seemingly attractive high initial yields, but reflect imminent lease expiry, likely tenant vacation, capital expenditure, void costs and poor relet prospects at much lower rents. Also, whereas initial yields reflect a known contracted rent, reversionary yields usually reflect an estimated rental value (ERV). Market conditions can change, comparable evidence may be limited or variable, rental valuations may not be accurate or could be purposefully optimistic, and when the future rent is eventually determined, it will reflect comparable evidence available at the time and a negotiating process. Rent reviews and statutory lease renewals also reflect lease terms, legislation and case law, whereas lettings and contracted out lease renewals will be a deal. Gross yields In another context, a gross yield may be referenced where the landlord bears costs, such as: small industrial estate units let gross of external repairs, buildings insurance and estate costs; or the residential buy-to-let market where net yields can be significantly lower than gross yields due to various costs, especially if tenants regularly move on. It is worth generally noting that management costs and taxation are not included in yield calculations. Equivalent yield The equivalent yield (EY) is the weighted average yield across all income streams. It can be used as a valuation approach, such as the 5% applied to all income streams in the above term and reversion example, because there is an insignificant risk differential across the two income streams, or because it adequately averages risk in relation to comparable evidence analysed on an EY basis. If a valuation applied 6% to a two-year term and 8% to a reversion, the resulting EY would be weighted much closer to 8%. Running yield Software may state a running yield, which is the yield based on rents at different points in time in relation to the capital value, including the IY and RY. It does, though, reflect the valuation approach, such as a single running yield of 5% following a YP perp valuation, whereas an allowance for a void could create a profile of 4.75%, 0%, 4.75%. Running yields can also be based on changing capital values. Quarterly in advance Valuations normally assume rent is received annually in arrears, despite usually being paid quarterly in advance. The software yield profile includes the equivalent yield on the arrears basis, known as nominal equivalent yield (NEY), or may just say equivalent yield, and the advance basis termed true equivalent yield (TEY). An NEY of 5% is a TEY of 5.16% as rent is assumed to be reinvested each quarter at 5%. Equated yield Whereas the above growth-implicit valuations allow for rental growth in the yields applied, including the reversionary rent, which remains in today’s values, growth-explicit valuations uplift future rents to reflect rental growth prospects. As such rents are now effectively a fixed income, they are capitalised at an equated yield typically based on gilt yields, which also represent fixed income, plus a premium for property risk. Other yields Yields applied within valuations, also known as capitalisation rates, may sometimes be denoted as term yield, reversion yield and so on. An exit yield is part of an exit value for a future sale, such as in a growth-explicit valuation or an IRR calculation (see below). The above TEY is an effective yield because it reflects reinvestment. Blended yield sometimes references an equivalent yield across multilet (including mixed use) income streams or a whole portfolio. Triple net initial yield deducts costs borne by the landlord from the rent, such as for multilet investments with voids. Property companies’ financial reporting includes variations in yield definitions and terminology including EPRA NIY and EPRA Topped-Up NIY which make adjustments to the rent. International differences will also be generally seen. Returns The above yields denote returns mainly from immediate income and future income in today’s values. Investors’ overall income returns include rental growth or decline, and capital returns comprise gains or losses. A common property sector calculation of annualised average total returns is the internal rate of return (IRR). Finance can help add to returns, but also increase losses, and IRR calculations can incorporate finance costs. Development yield, yield on cost A commercial property development may have a £10m gross development value derived from a £500,000 YP perp 5% investment valuation, £5m construction and other costs, £2m developer’s profit allowance and £3m land value. The development yield or yield on cost is £500,000 ÷ £8m (£5m + £3m) = 6.25%. To conclude What is important from this discussion, is recognising and knowing that apart from the simple notion of a yield being a return on capital, there are many more different ways it can be expressed, dependent on the financial data that is being used and what type of analysis is required. Absolute clarity of meaning is crucial to the assumptions underpinning a valuation and its validity. Austen Imber is a surveyor and former Mainly for Students editor Mainly for Students is edited by Paul Collins, a senior lecturer at Nottingham Trent University. He welcomes suggestions for the column and can be contacted at paul.collins@ntu.ac.uk