Successful Property Investments :About Property Rentals – Values and Yields
Property Rentals, Values and Yields;
Over the last decades, many people from different countries around the world have been getting involved in the Real Estate Investment Industry. Usually, when a market is booming almost everyone tries to get as much as possible out of the momentum leading to an interesting phenomenon of people who become real estate experts over a night. It is common then to hear people talking about trends, investment scenarios, buy to let schemes, yields, returns, ratios and hundreds of other impressing words trying to show that they know what they are talking about…. but do they really know?
Recently, I had the pleasure of being with some private investors and cracked my ribs out listening to the way they were trying to impress each other. They were talking about the buy to let opportunity in Kenya and the relation of the yield to the property values. Honestly, I was listening very carefully and learned completely new things despite my 20 years of experience in Real Estate market plus a few studies here and there. I realized how misinformed people are. One of my mentors used to say that knowledge is gold and knowledge is the key to success.
So, I will take this opportunity provided by Business Monthly Magazine, to share a few tips concerning one of the most popular property investments in the world and of course Kenya. This is, ‘the Buy to Let property scheme’, and the most important factor about it, ‘the Yield’.
Anyone considering buying an investment property will be interested in what return the property will give them – in other words, its yield. Before seriously starting to look at a property, most investors work out its yield to see if it makes their shortlist. Although some investors buy property for other reasons e.g. speculation, infrastructure potential or lifestyle reasons, most are only concerned with its current return and potential yield.
Before we get into the complexities around yields and how to work these out, it’s helpful to understand the different terms about investment yields used in the market currently.
Yield – A yield is a measurement of future income on an investment. It is generally calculated annually as a percentage, based on the asset’s (or investment’s) cost or market value. It has nothing to do with a capital gain on a property.
Gross yield – If you think about your ‘gross earnings’, then you are on the right track. A gross yield is the income on an investment prior to expenses being deducted. For property, these expenses can be quite substantial and might give a huge difference between gross and net yield.
Net yield – As you can expect from above, the net yield is the income on an investment after expenses have been deducted. The costs and expenses could include purchasing and transactions cost. These could be stamp duties, legal fees, pest and building inspections, loan start-up fees and vacancy costs, including lost rent and advertising. There might also be repairs and maintenance costs, management fees, insurance, rates and charges. Most of the time, these costs won’t be known so you will have to estimate them.
Return or total return – Also quoted as a percentage, a return includes capital gains. It is the gain or loss of the investment in a particular period (this isn’t necessarily annual as for yields). This is retrospective, so it is generally an accurate or concrete percentage.
Average yields – It is always good to know what the average yield is for the area that you are looking to invest in although every property is different. Don’t take these as gospel as to how much yield you may get on your property.
What is the difference between yield and return, one may ask..
As explained in the definitions above, a yield is only based on income, whereas a return includes capital gains. Although both might be used in the sales patter, find out the time frames of both before making any decisions on whether the property you are looking at is a good investment.
Remember, one is retrospective (return) and the other looks at the future (yield). A yield is only based on income, whereas a return includes capital gains.
How does one work out a yield?
When looking for an investment property, you will notice agents, developers and sellers commenting on yields. What you have to be aware of is that, most of them will be referring to the ‘gross’ yield and not the ‘net’ yield. Make sure you ask which one they are quoting. It is also worth knowing how to work out the gross and net yield of a property so you can calculate yourself.
Gross yield = annual rental income (monthly rental x 12) / property value x 100
For example: Property purchase – KES. 4,500,000 Monthly rent – KES. 37,500/month (KES. 37,500 x 12) = (KES. 450,000 / KES. 4.500,000) x 100 = 10% (G.Y)
Net yield = {annual rental income (monthly rental x 12) – annual expenses and costs} / property value x 100
For example: Property purchase – KES. 4,500,000 – Monthly rent – KES. 37,500 – Annual expenses – lost rent, taxes and advertising KES. 50,000 repairs budget KES. 50,000, =
KES. {(37,500X12)-50000-50000} / KES. 4,500,000 x 100 = 7,7% (NY)
What does a ‘hard’ or ‘soft’ yield mean?
Demand for property drives property prices up and this can affect the yield of your investment property. The more prices go up, the less the percentage between rents (income) to property value. When you hear people referring to yields hardening, this means the yield falls or reduces, whereas when they refer to yields softening, this means they are increasing or rising.
Rental is not the only way an investor makes money through property letting. Capital growth is equally important as the rental income growth.
When a property increases in value over time, it is known as ‘capital growth’. Capital growth, also known as capital appreciation, has been strong in recent times, but the value of property does go up as well as down. The local conditions surrounding your property also have a big effect.
What drives yield and how does the increase or decrease of property values affect the yield (Cap Rates) and Vice Versa?
What is a Cap Rate?
A cap rate is essentially the market value yield of a property. The market value (or best estimate) of a property is established by dividing the market related yield into an initial period net income of the property.
The ratio of rent to value can be a valuable guide and a requisite part of a thorough investigation of an investment opportunity. Sometimes, people confuse the increase of the Yield with the increase of the value of a property. In reality, higher rents make it less important for the property to appreciate in value to meet a certain expected return target set by the investor.
Using the equation of the yield, we can easily understand that an increase of the yield means a possible decrease of the value as the more the prices go up, the less the percentage between rents (income) to property value. However, rental yield alone, like the classic earnings-to-price ratio, is not a guarantee for a successful investment. It is necessary to look carefully “under the hood” at other considerations.
Yield, Business Confidence and Occupancy rates are the top three drivers of the commercial real estate market.
All three are affected by consumer confidence, politics and the economy. Commercial property yields are more susceptible to market conditions than residential properties as people will always need somewhere to live whereas business can and do go out of business. This risk is reflected in the higher yields that commercial property attract.
The demand for property is one of the key drivers of yield. When demand is high, the cost of buying an investment property increases. The more you pay, the less yield you get (unless rental income increases in proportion to the purchase price).
When yields are decreasing, is often referred to as ‘hardening yields’. The opposite is also true. When demand for property is down, prices fall and yields can increase. When the rent-to-value ratio increases it is referred to as ‘softening yields’.
Historically, we observe the highest yields in elastic markets where it is easy to add new housing supply or in markets where property prices have increased too much making the properties too expensive for the investors to buy.
First, this happens because it is easy to increase supply. Any significant real increase in prices results in more units being added to the market. In these elastic markets, rents will tend to rise while prices stay flat as investors turn to rents in order to make a return on investment. Many would-be home buyers prefer to rent as a non-appreciating home purchase is a less attractive investment. It is impossible for them to obtain financing with today’s tight underwriting guidelines, high interest rates and low approval ratio.
Second, where properties are too expensive, people are forced to rent because they cannot afford to buy. This increases the demand for rentals with property prices staying the same or even decreasing as the available products are not affordable. The increase in demand for rentals increases the monthly rent as well as the Yield resulting in a decreased property value. It is important to understand that this does not necessary mean that supply overcomes demand, although it could.
In contrary, supply might not meet demand but the available properties are too expensive for the average family to buy. This is the reason why we need to remember that macroeconomics have a very important role when it comes to any type of investment.
As a conclusion
Conservative investors are likely to seek out acquisitions in those markets where the current (gross) yields are significantly above bank interest rates and where current vacancies are not excessive. Such properties are not without risks but are easier to carry.
Markets where the current yields are very low are better matched with flippers who will want to turn them in as little time as possible, selling them back into the owner-occupied market without ever renting them out. These lower current yield properties do not accommodate significant financing leverage without periodic cash flow infusions and if interest rates go up, the new buyer demand from owner occupiers will soften. One must also keep in mind that eager buyers often do not qualify in today’s underwriting- mortgage and finance environment, so that alone restricts the depth of demand, isolating the target group of buyers mainly to those who can afford to pay cash .
The bias of ‘buy to let’ investors towards higher yield properties is in fact where we usually see the most demand. These investors will need to hold the properties for at least a few years or longer and be patient in off-loading inventory at paces that the market can absorb without significantly affecting current prices. Those markets where the yields are not high enough to carry nor low enough to be good flipper candidates may flounder for a bit longer as they fall through the cracks of market appetites.
It is important to note that yields are a measurement of expected return on your investment and not a guarantee. Potential investors need to take into account all the other factors, such as likelihood of finding and retaining a good, long-term tenant, maintenance and infrastructure costs, suitability and location of a property and all the other factors that can impact on the ability to achieve your expected yield.
Before investing in any type of property, I highly recommend to all investors to conduct a very good research, analyze the market in the short term as well as in the long term, determine your goals and expectations about your investment as well as your risks. It is vital for a successful investor to know all the above before investing a cent. Asking for a professional opinion is recommended as well.
At the end of the day, the more prepared you are the better chances you have for success.
By Kosta Kioleoglou REValuer,(Tegova)
Chief Strategist (CSO) for the East African Region
Director of Engineering – Property Appraisal & Valuations
Civil Engineer Msc – DBM
Taylor Scott International.
