A variety of yields are often quoted by selling agents when marketing commercial properties, which can significantly distort the forecast returns for investors. So what yield figures can, or should, an investor trust to measure the worth of their assets?
Often when yields are reported, there is no description as to which kind of yield calculated is being referred to. At times, the most favourable yield option is selected to entice investors unfamiliar with the market. The investor can be blindsided, predicting returns based on smoke and mirrors.
Passing yields, and why you should be cautious
The most common yield quoted is the ‘passing’ yield, sometimes called the ‘initial’ yield. This represents the rate that is derived by dividing the net rental income by the sale price, this is usually without any adjustment for any associated expenses that may relate to the commercial premise, such as:
- Vacancy periods
- Rental fluctuations
- Rental incentives
- Non recoverable expenses, (e.g. land tax, management fees)
Uninformed investors can often get caught out by purchasing a property based on a passing yield. They then find themselves with an underperforming asset, due to the ongoing costs not initially accounted for. Alternatively, they find themselves unable to obtain finance, because the valuer does not support the proposed income.
Passing yield vs market yield
The yield that most accurately reflects the real return of an asset is a ‘market’ yield. These yields are more likely to have been evaluated by a property valuer to take into account the above factors.
For example, the below yield for 1 Smith St was advertised showing a 7% return, however upon further analysis the lease featured an incentive which runs until lease expiry, with a market rent closer to $250,000. This shows that once the current lease expiries the property will lease at $50,000 lower than passing rents.
Yields quoted in the media are not always market yields, unless specified, and cannot simply be applied to other properties to derive a value.
Investors often compare yields from similar recent sales displayed in the media to derive a value for their own property, assuming the assets are similar. Consequently, these investors may see a low yield reported in the newspaper and assume that this could be applied to their own asset. When in reality the yield is incorrect or misleading. Incorrect yield reporting may therefore distort market perception at a broader level and lead investors to believe their properties have increased in value.
For example, 2 Smith St was sold for $5 million with a passing yield of 6%. On investigation, the property featured a strong leasing covenant for 15 years with fixed 4% rental reviews and was purchased as part of a portfolio. Although similar in income to 1 Black St, the tenant covenant for the latter was much weaker due to a shorter lease term, hence a higher yield can be expected if sold on the open market.
The importance of quoting or defining yields correctly should not be underestimated. It can lead to disputes between buyers and vendors and cause sales to fall over. Market commentators will also speculate that low yields are being paid, which can further mislead investors.
The passing yield will mostly inflate the return of the property as it does not factor in all of the other contributors to the bottom line. To paint a comprehensive and more accurate picture of the real return on investment of the asset, a market yield should be used.