A concern for investors in commercial property is how well the investment is performing or how it is expected to perform. Knowing how to gauge performance is essential which is why it’s important to understand the difference between yield and return.
Return is what an investor has earned from an investment during a certain period of time. It includes rent, profit on any other monies payable under the lease, payments for consents, and deducting non-recoverable costs and expenses. Return is retrospective, or backward-looking.
Yield is prospective, or forward-looking. Yield measures the rental income that the investment will earn, ignoring capital gain. The rental income is annualised over a certain period of time, usually the unexpired term of lease, assuming the income will continue to be received at the same rate, with an adjustment for reversionary income based upon an estimate of what the rent is likely to be if the next review were now. In most cases, the total return will not be the same as the quoted yield because of fluctuations in price. Therefore, when assessing whether the yield is attractive it is important to allow for the risk should the expected return not materialise.
The expected return may not materialise for a host of reasons, ranging from the more obvious of the tenant going broke to the less obvious but commonly experienced resistance by the tenant to the terms and conditions of the lease thereby requiring the landlord to fork out higher non-recoverable costs than might have been expected. During the management of the tenancy, often the only justification for the cost of a particular course of action is that the capital value of the investment would be enhanced, even though the return itself is lessened.
For reasons that I have delved into elsewhere, commercial property prices have generally risen over the years because of an uncoupling between the fundamental value of the property and interest rates. Because interest rates are geared to Base Rate, a UK-wide percentage, it has become the norm for investors and lenders (and valuation surveyors) to relate yield to the cost of borrowing rather than the value of the property. Property fluctuates in value not because of fundamentals but that interest rates and investment sentiment varies, depending upon the state of the market and all that that entails.
‘Yield compression’ has introduced a layer of value between the fundamental value of the property and borrowing costs. When investor sentiment is largely based upon yield compression, as nowadays, investment performance becomes distorted. In other words, when interest rates and borrowing costs are low, the price the property is likely to fetch will be higher than when interest rates and borrowing costs rise. The distortion reflects investor sentiment, regardless of the fundamental value of the property itself. Sentiment is linked to confidence which in turn is linked to the feeling that property is a good bet. When confidence is strong property becomes seemingly less risky and yields fall, and conversely when confidence is weak property seemingly more risky and yields rise. Essentially, the value of the property is itself unchanged; all that’s changed is investor perception.
It gets worse, or rather it does if you’re buying. If you’re selling then an investment market that can fool investors into thinking values are sustainable is a opportunity for too good to miss, especially for selling ex-growth propositions. At auction, the feverish route, reassured by the presence of underbidders, the successful buyer imagines the bottom-line protected: a rarely tested thought that should the proposition be re-offered for sale immediately there is sure to be someone somewhere willing to pay almost the same price.
It gets worse because yield based upon perception is likely to have disconnected from the return in reality. Since borrowing costs are the same nationwide, perception can suggest no difference between one location and another, also no real differences in specific property characteristics. Instead of assessing yield by reference to the specific proposition, yield is compared with what is generally available or achieved elsewhere. You only have to read a typical bank valuation report to note the generalities involving so-called comparable evidence and transactions. That the opinionated market rent might not be achievable, because of terms and conditions in the lease, takes second place in the world of generalities. That a similar property nearby fetched for example 5% yield seems to be of more comfort to the lender than knowing that if the property in question were for sale the factors specific to the actual property would likely result in a lower price. Valuers can get away with being economical with the facts not because of the acceptable margin for error, but that a valuation is date-specific: all that matters is that there is sufficient momentum to ensure the market doesn’t falter and enough sentiment to maintain the benchmark level of prices for a reasonable time.
Yield doesn’t matter if you’ve bought the investment and can afford to repay the loan and have no intention of selling, but it does matter in the context of total return. If because of tenancy management issues your expected return doesn’t materialise or isn’t underpinned by any increase in capital value because you overpaid to begin with, then whenever your loan is reviewed by the bank and an up-to-date valuation required, would you want to find you’re required to inject more equity just to prop up an investment that isn’t at least keeping pace with inflation?
When the expected return is marginal, because borrowing eats into equity, it is prudent to avoid any altercation with the tenant for fear of non-recoverable costs. That is why many landlords do not implement rent reviews because the cost-return couldn’t be justified. Instead, capital growth can be realised by the opportunity value in marketing an investment as reversionary: an outstanding or imminent rent review is the art of dangling a carrot to inexperienced investors for whom yield is the attraction, regardless of the total return in reality.
The Rent Review Specialist