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.


Valuation Methods. Comparison

Of all the 5 methods of Real Estate valuation, the Comparable method (also known as the Comparison Method) is king.  It underpins all other forms of valuation to some degree.

I like to be able to work with a definition of a term so that I can truly understand it.  So I will attempt to define the term ‘Comparable Valuation’:

‘The establishment of a Property’s Capital or Rental value using recent, similar transactions as a guide’.

The first thing to mention about this valuation method is that it is not rocket science.  It is essentially the method that not only residential Estate Agents (Realtors) use to establish an initial property asking price, but also potential buyers.  That means that if you have ever got a particular ‘feel’ for the market in an area and felt that a house or flat is over or undervalued, you have used this method too.  This is because all it is is comparing one property value to another.  This might be oversimplifying slightly, because there are certain considerations to look into:

  1. The difference between the asking price and the eventual sale price (or asking rent compared to eventual agreed rent) is quite likely to be significant. This is down to the negotiation between vendor and purchaser (or landlord and potential tenant).  An example of this is when residential Estate Agents are very optimistic when placing an initial asking price on a property.  It’s very important when researching recent transactions that actual sale or ‘let at’ values are used.  Asking prices and rents can be ignored.
  2. The recent transactions should be as recent as possible. It’s far easier to use the comparable method when the commercial property market is active and stable.  This is because information is far easier to gather.  Sometimes it’s just not possible to find sale or let figures that have been produced in the preceding weeks or even months; however you must understand that the older the information on other transactions, the less accurate it is.  Property is hugely influenced by changes in demand and supply; this means that if (for example) an office building was sold 3 years ago for £1.35m (Approximately $2.025m) it does not necessarily follow that it would sell for more than that now.
  3. Transactional information should ideally be based upon properties that are located very closely together. In Central London and (presumably) other similar large cities, buildings should be on the same side of a particular street and preferably within a few hundred yards of each other before they can be considered closely comparable.  However, that leads us on to the final consideration:
  4. All properties are different in some way. This could be different Use (offices, industrial or retail plus sub-uses such as financial and professional services, general business or light industrial etc), Grade (the high profile, well-equipped and modern offices are known as Grade ‘A’, grades then go to B & C depending upon condition, level of amenities and pleasantness of the building in general), Size (the difference in sizes of buildings is addressed by dividing the rent or sale price of a property achieved by the area.  This produces a value per square foot or square metre) and Location (this might be the difference between (for example) a building in Central London and a building in Warrington; or even different areas in the same city, such as a building in Streatham, London and a building in St James’ Square, London).   These will all have an influence on value to some degree.  If rent is being negotiated, 2 apparently identical buildings side-by-side could have different rates negotiated.  This could simply be because a particular business tenant presents a lower risk to the landlord and was therefore able to negotiate a slightly lower rent than the neighbouring tenant.
  5. Economic conditions can affect the demand for property, and subsequently the agreed rent or price. The cost of borrowing is a big factor in property sales; likewise the general level of confidence in the macro-economy will affect investor’s appetite to acquire what amounts to a highly illiquid asset.  In economic downturns, businesses are much less likely to expand or move premises and this increases an investor’s exposure to risk.

It’s often said that Real Estate valuation is an art, not a science.  In relation to the considerations above, establishing a property value is not difficult.  However, establishing an accurate figure is where the skill comes in.  Determining an approximate rate per square foot or metre is not difficult; however it’s knowing where to adjust a figure and how to account for differences between apparently similar property transactions that sometimes produces unexpected results.

In the case of commercial tenancies, lease terms will have a substantial affect on the agreed rent:

  1. The lease Term (length of tenancy). A long term is normally of benefit to the landlord, except (for example) if he plans to redevelop the site in the mid to long-term.
  2. Break Clause. This allows one or either party to bring the lease agreement to a premature end.  In the UK, it is often placed into the lease terms in 3 or 5 year intervals.  It will be subject to around 6 months notice usually and might involve some reward if it isn’t exercised (such as a rent-free period).
  3. If the tenant has some Security of Tenure. In the UK this means that the landlord can only insist the tenant leaves the premises under certain circumstances.  All commercial leases in the UK are automatically subject to this unless both parties agree to exclude it at the beginning of the Term and this is specifically mentioned in the lease contract.
  4. The financial standing of the tenant. 3 years of company accounts are normally required for the landlord to consider.  This is because if the company has an excellent credit rating and has been established for quite some time, it will present far less of a risk to the landlord than a company that is in its infancy or has defaulted on some payments to creditors.
  5. Ease of use of the premises. If for example, a tenant is unable to access premises outside normal working hours, this can have an effect on agreed rent as it might be a significant inconvenience.  Likewise if an out-of-town office building does not have sufficient car-parking spaces for the staff, this is also likely to reflect in the agreed rent.
  6. Obligations regarding repairing and maintaining the building. If a tenant is obliged to take on responsibility for all building maintenance and repair, the rent is likely to be lower as the terms of the agreement are simply less favourable for him.  The same can be applied to insurance.  If the tenant is obliged to pay for insurance, it represents a burden for him.  Insurance payments are collected from the tenant by the landlord.  The landlord usually takes responsibility for arrangement and ensuring that insurance payments are made, as this way he knows that cover is in place.  The payments are recharged to the tenant under a separate arrangement.

An example of the Commercial use of the comparable valuation method is as follows:

To establish the rental value of Building A, three further buildings (B, C and D) can be considered for comparable evidence.

Building A is 3,000 Sq M office building.  It is established that rents in the area have increased by 7% in the last 12 months.

Building B is 2,000 sq M and is of poorer grade than Building A.  It was let around 2 months ago at £400,000 per annum (around $600,000).  This works out to £200 per sq M but this value would be below that expected for Building A as the grade is poorer.

Building C is also 2,000 sq M and is similar grade to building A.  It was let 12 months ago at £600,000 per annum (around $900,000).  This works out to be £300 per sq M for a similar quality of office but rents have increased since this was completed.

Building D is 1,000 sq M and is also a similar grade to building A.  It was let 1 month ago for £350,000 per annum (around $525,000).  This works out to be £350 per sq M and the information is quite recent.

It could be determined that Building A could be worth around £300 per sq M.  The justification for this is that it is a larger unit than C & D and although rents have increased since Building C was let, Building C would command a higher rent because smaller units are in higher demand.  If Building C was being valued now, it could be justified to value it at a slightly higher rate than Building A.

Clearly this example is very simplified.  However it demonstrates the technique, additional factors such as location and lease terms would have to be considered.



Calculation of Build Costs

When establishing a budget for a property development, the issue of build costs is hugely important.  An accurate build cost value is a vital component of the residual valuation.

Build costs are not just for the construction of new build properties.  If an existing property (for example) is to be renovated and the usage changed, or a residential property needs a lot of work to bring it back to a habitable state, the costs of work will be very similar to building from new. So to use new build costs is appropriate in the majority of cases.

Build costs are calculated using the gross internal floor area.  This is essentially the area of the internal space measured between the inside of the outside walls.  This includes all common areas such as hallways and toilets etc.

Build costs are generally available from 2 sources.  The first source is the subscription website BCIS (Building Cost Information Service), the second is SPONS (available in book format and updated every year).  Both sources are well-regarded in the construction industry as being accurate enough to use in detailed development appraisals but are expensive when you are beginning your venture (both sources are a fairly similar annual price).  When using the resources, you will find that a particular rate per M² or M³ is provided.  For example, when demolishing a building up to 50M³, a rate of £49.92 would be appropriate per M³.  The larger the building, the less expensive the work per M³ is to have carried out (economies of scale).

One of the recognised shortcomings of the residual method of development appraisal, is that the output (the land value) differs a great deal through only small changes in one of the inputs (in this case, build costs).  The larger the project, the more likely it is to happen.  For example, if 30 houses of 100 M² each are being constructed at a rate of £1,000 per M², the total build costs will be £3m.  If the build cost rate were to increase to £1010 per M², total build costs would increase to £3.03m.  So for just an increase of £10 per M², the total build costs would dramatically increase by £30,000.  Therefore it is important to get as accurate a figure as possible.  Fortunately the sources mentioned above are regarded as very accurate.

It should be mentioned however that the values provided in the sources referred to are based upon an average across regions and nationwide.  Clearly substantial economies can be achieved through shrewd research and good contacts.  It is certainly possible to reduce build costs if you know where to look and who to speak to.  This perhaps is one of the secrets and ‘art’ of making a healthy profit in property development.

It can be a time consuming process reading through the construction cost guides if you are unfamiliar with them (I don’t profess to be an expert myself).  They are extremely thorough and specific, however if you simply want to know how much it will be to build a 3 bedroomed house (at a rate per M²) then a far cheaper (free) option exists.  A regularly updated source of inclusive build costs is at:  www.homebuilding.co.uk/buildcosts.  It obviously depends on how deeply you want to go into the analysis of costs, but this alternative provides accurate information if it’s an inclusive rate you’re looking for.  It’s compiled for self-builders, not really private property developers but it offers a good indication and shows the degree of variance across regions.  If you do need to go into the deeper intricacies of building costs then I suggest purchasing either the SPONS book or taking out a BCIS subscription (incidentally, SPONS books are available ‘used’ at a discount at places such as Amazon Marketplace but obviously the accuracy suffers as they age).

At the last update on the ‘homebuilding-buildcosts’ site (Dec 2011) a large 2-storey house being built in the South-East to an excellent standard by main contractors would be in the region of £1291 per M² to build.  At the opposite end of the spectrum, a small single storey house built to a reasonable standard through a combination of DIY and sub-contractors in the North-East or Wales would be in the region of £793 per M².  These values have been put together by experts using the more detailed costs guides.

The more detailed guides (BCIS & SPONS) allow the reader to obtain far greater information.  For example, according to the 2011 version of SPONS:

  • High quality Inner London apartments would be in the region of £2350 – £2850 per M² to build.
  • Large budget student schemes with en-suite bathroom would be £1025 – £1275 per M² to build.
  • Warehouse conversion to apartments would be £1025 – £1275 per M².
  • Minor office refurbishment in Central London would be £435 – £530 per M².

Clearly some interpretation has to be applied to this information, as regional variations on prices can move beyond the ranges listed.  It should also be remembered that these prices are inclusive of builder’s profits and overheads, but not of professional fees associated with the work.

For the more specific prices:

  • For machine-excavated trench fill foundations at 600mm wide x 1 metre deep, a rate of £79.00 – £100.00 per metre.
  • For facing-brick walls, single skin and pointed both sides would be £81.00 – £105.00 per M².
  • For a cement and sand screed floor of 50mm thick would be £12.40 – £16.80 per M².

The SPONS books and the BCIS provide a huge amount of information (the SPONS book is over 1,000 pages).  You must remember though, that looking into the specific works and simply adding the costs together is risky because without experience, it’s easy to overlook some vital work component.  This can have a significant effect on the overall build costs.




Application of Discounted Cash Flow

Building upon the previous articles explaining the use of Valuation and Investment tables and how Discounted Cash Flow and Net Present Values work, we are now looking at how we can establish the true return on a property according to an assumed rate of growth and expected rents over a particular term.

This technique is known in financial circles as Internal Rate of Return (IRR), whereas property professionals refer to it as Equated Yield.

A Net Present Value appraisal allows an analysis of expected rents over the term of a lease and can produce an end figure that shows a profit or loss according to an expected rate of return.  To use the example in the article on DCF (see below), an investor pays £100,000 for the expected return of £30,000 at the end of years 1 and 2, and £40,000 at the end of years 3 and 4.  However he is borrowing the entire initial capital sum at an interest rate of 12% per annum.  Is the investment worth pursuing?

The table shows that the investor will end up with a profit of £4,585.00 after the costs of borrowing are taken into consideration.   Whether this is worth his effort or not is not relevant to us at this point, it does show however that as long as the return exceeds 12%, the remainder is profit.

So what if we have to find the actual return on an investment?   It’s all very well just ensuring that the return exceeds a certain level, but what if we need the precise figure that the investment will return?  We use the equated yield method.

It can be stated that as the NPV value gets closer to zero, the adopted yield figure (for the calculation) will be closer to the true return.  For example if the required return was placed higher at 14%, the profit would be absolutely minimal:

The NPV at this rate is clearly much closer to zero.  This signifies that after the negative and positive cashflows have been accounted for, the actual return on the investment is very close to 14%.

Calculating the actual equated yield figure is initially a process of trial and error.  This is because 2 trial rates should be used (these can actually be quite far apart) so that the true rate ends up somewhere in between them.

Again, using the example above, we know that the true rate will be very close to 14%, but for the purposes of demonstration a higher rate of 16% will be adopted and the lower rate of 12% will be re-used.

Clearly the resulting NPV figure is a negative one.  The effect of this is that the investment will make a significant loss if a return of 16% is required.  It does however, provide us with an upper rate with which to calculate the true investment return (or equated yield figure).

In order to calculate the equated yield, an equation is used:

Note:  LTR – Lower Trial Rate; HTR – Higher Trial Rate.

Therefore we can establish that the actual return on the original investment is 14.1%

When applying this technique to the context of a lease, the expected returns are incorporated and if the lease is expected to include a particular pattern of rent reviews (for example 5 yearly) the expected rate of rent increase should also be incorporated.

Budgeting for a Development Project

It is of paramount importance when planning a property development that a budget is prepared and followed.   Many TV shows feature aspiring developers that always seem to go over budget because of a combination of self-indulgent luxuries and a lack of foresight regarding potential problems.   I strongly suspect that when filming, sensible and prudent developers are omitted from the eventual screening because they don’t make for ‘involving’ viewing.

Budgeting is in no way a difficult concept to understand.  Private, novice developers and professionals alike should follow a similar process when planning projects.  It is only the scale that will differ.

When planning a development, the initial method of forming a budget is to carry out a financial appraisal.  This means that a basic plan is drawn up which sets out how much the project as a whole will cost; and how that total will be broken down into different aspects such as building/development costs, fees (estate agents, architects, surveyors, solicitors (including VAT) and Stamp Duty), and cost of land/property.  As this is only a basic plan, it does not have to be accurate down to the last penny at this stage.  However, the purpose of it is to establish if the project is financially viable for you.

My favourite method of appraising a development is the ‘residual’ method.  This is simply as follows:


Note: ‘Gross Development Value’ is the total value that you (realistically) expect to achieve when the finished property is sold on the open market.

This method allows for the required profit to be placed into the plan.  Profit is something that many novice developers almost forget about until the finished development is valued.  However profit is vital if your property venture is to succeed.   Obviously if the expected profit level is too high, the plan is less likely to work.  Likewise, if the profit is too low then it leaves you less capital to begin your next property.  On development projects at the height of the market in 2007, a realistic profit figure could have been around 30% of the Gross development value (GDV).  Currently, a profit of around 20% might be considered quite optimistic (but still possible).

The next aspect is build/development costs.  It is impossible to say what this will be in the region of, because it will depend entirely on the scope of the work, the required standard of finish and the size of the property.   Professional property developers, who are building a property from scratch will usually calculate this on an area basis and apply a rate per square foot or metre.  This method can also be applied to development properties that are not being built from scratch, but are having extensive work carried out.  This rate could be between £30 per square foot (very approximately £300 per square metre) for a very basic job, or up to around £100 per square foot for a very top-end finish.   Currently £50 per square foot (approximately £500 per sq Metre) might be a realistic figure.  So if the development property is planned to be 2,000 sq ft in area, build costs of around £100,000 will be a ‘ballpark’ figure (depending on scope and standard).

If the work you intend to carry out is not that extensive, then calculating build costs will not be appropriate.  It is more sensible to get quotes from builders for the work you want them to do.  Always make a list to give to them (keep a copy too!) so that they have a formal record of your required works.  This will form the basis of the quote that they will provide.  Simply explaining to them what you want is not clear enough; it should be set out on paper.  This will also allow you the opportunity to think about what the builders can do, and what you can do.  You might find that much of the work you have written down could be carried out by yourself, obviously this will save money.    If you obtain several quotes from builders, you will very soon form a picture of what is or isn’t a fair price for the required work.  If at all possible, always try to get a fixed price deal from the builder.  This will contribute a great deal in forming a budget that is less likely to change.  Be warned however that this fixed-price deal is certain to contain conditions.  A builder will not adhere to a fixed price if much additional work is added to the plan.  This includes changes of your plan and unforeseen problems such as the need for more extensive ground works or compatibility problems with individual build components.

Fees for involved professionals must also be included into the budget.  Solicitor’s fees are likely to be around £500-£1,000 inclusive of search fees, VAT and a small amount of additional work (phone calls & letters etc).   Obviously this will depend (again) on the scope of the work the Solicitor must carry out for you.  Complicated legal matters will certainly result in the fee increasing.

Estate agents fees should not be more than 1% of the sale price.  The estate agent might attempt to convince you that you should pay more for a ‘top-rank’ service; this is definitely not the case.  Most estate agents will acknowledge that 1% is competitive and they can still afford to provide you with an excellent service on this fee.

If the development project is a new-build property, then you might be considering the services of a Project Manager.  The fee for this is likely to be from a couple of hundred pounds for a ‘phone/email based’ service, up to £5,000 or more for a dedicated service by a Project manager who can source the best materials at the best price and even find suitable temporary accommodation for you.

All these elements can be used to provide the vital components to your project appraisal.  In these financially troubled times, if you’re looking to secure lending to help finance your venture, that lender will be far more inclined to consider your request if it is clear that an appraisal has been produced to establish the project’s financial viability.