Explaining Property Yields

When investing in property, it is important to have a good understanding of the term ‘yield’.  Contrary to popular belief, it does not mean the actual sum of money received on a particular investment.

The term Yield can be defined as:

The annual return on an investment, expressed as a percentage of the capital value.

 So for example, the annual return on a property investment is currently £12,000 a year gross.  If the property has been valued at £220,000 then the yield can be calculated by:

  • Dividing the capital value (220,000) by 100, to get the value of 1%.  It works out to 2,200 in this case.
  • Divide the annual rent figure by 1% of the capital value.  This produces a figure of 5.45.
  • Therefore, the yield on this investment can be said to be 5.45%.

This is a very straight-forward calculation that is only really carried out to enable people to compare investments across types and sub-types.  This is known as the Initial Yield figure.  The annual rent figure used in the calculation is the ‘passing rent’, meaning it is not discounted in any way by rent-free periods (a common incentive).

The next type of ‘yield’ is called an ‘All-Risks Yield’ (ARY).  This is also expressed as a percentage but even if used in connection with the very same investment calculation used above, the figure is likely to be different. It is used mainly by Commercial Property valuers to be manipulated accordingly to provide an indication of the risks involved in a particular property investment.

This is done by using it in a slightly different way to the above Initial Yield figure, which is a result of the calculation.  When establishing an ARY figure, a basic principle must be followed:

  • In a falling (Bear) market, yields rise because they represent a higher proportion of the property’s capital value (rents stay fairly static, capital values fluctuate).
  • In a rising market (Bull), yields fall because the capital value increases and the annual rent figure accounts for a lower percentage of the capital value.

Therefore, the analysis of yield figures provides an insight to the property market as a whole.  It is often far easier to consider yield values of more interest than the capital values used to calculate them.  Capital values can only really be established by looking at recent transactions of similar properties, whereas yields can be comparable across all properties.  Because of this, it is common practice to apply a yield figure as a multiplier for the annual rent, resulting in an estimate of the capital value.  An example is as follows:

A commercial office building is currently let at £50,000 per year.  If an appropriate yield figure across similar properties is 6%, then the capital value will be in the region of £833,333 ((50,000 ÷ 6) x 100).

The yield figure can be manipulated to produce a different capital value.  This is done to reflect the various risks involved in letting a property to a tenant because:

  • If the tenant is likely to default on rent payments or vacate the building leaving damage, then the value of the investment as a whole will be worth less than average.  This would produce a higher yield figure.
  • Alternatively, if the tenant is a highly regarded national company and almost guaranteed to be a ‘perfect’ occupant, the value is higher to an investor because it represents a lower risk.  This would produce a lower yield figure. Incidentally, the yield figure of a very high quality building with an exceptional tenant represents a benchmark situation, this results in a ‘Prime Yield’.

The term ‘All-Risks Yield’ is therefore used to describe a yield figure that hopes to reflect all associated risks and benefits to the investor.

Net Yield is a further expression used to describe the yield after expenses have been subtracted.  An example of this is:

A residential development of flats returns £60,000 per year for the investment company.  The capital value of the development as a whole is estimated to be £1m.  This produces an initial yield of 6%.

However, if the investment company regularly spend £15,000 per year on management costs and associated fees, this changes the yield figure.  The net return is reduced to £45,000.  Therefore the net yield is 4.5% (45,000 ÷(£1m ÷100)).

Careful analysis of yield figures to this degree is unlikely to be the practice of the novice property investor.  However, when projects get bigger and budgets increase in proportion, it is important to have an understanding of how property capital values and yields work together.

 

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