By Kosta Kioleoglou
In the modern times around the world, it is very common for people to desire to increase their family or personal wealth by investing in several opportunities. Some of the most popular investment schemes are in the property market.
New investors usually try to understand what would be the correct criteria for them to make an investment. Although this is a very complicated issue, we will try to analyze one of the most common factors that people use for this purpose.
For anyone considering investing in commercial or residential real estate, one of the first questions you will want to ask is: what return on investment will I get from this property or, in other words, what is its yield?
Yield is an important way of measuring the future income on an investment. It is particularly important in commercial real estate, as capital growth rates are not usually as high as the residential market. So, the return you get now and in the future is a key factor in working out whether to invest. Before I continue, I believe it is important to explain how you work out yield.
Yield is calculated as a percentage, based on the property’s cost or market value, annual income and running costs. It does not take into account how much the property increases in value over time (i.e. the capital growth). When calculating yield, it’s important to know if you are calculating ‘gross yield’ or ‘net yield’. Gross yield is everything before expenses, whereas net yield takes into account running expenses such as management fees, maintenance costs, stamp duty and vacancy costs. Yield calculations are worked out by dividing the annual rental income on a property by how much it cost to buy.
For example:
Gross yield = annual rental income (weekly rental x 52) / property value x 100.
So, if you buy a retail property for Sh7, 500, 000 and rent it out for Sh65, 000 a month (Sh780, 000 annually) the annual return on your investment, or your yield, will be 10.4%. This is an example of gross yield, where the running expenses of owning a retail business have not been taken into account.
Commercial properties typically return a much higher yield than residential, generating yields upwards of 6-7% compared to yields of 4-5% in residential.
There are several factors that drive yields. 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. Macroeconomics, microeconomics and even global turbulence play a key role to the volatility of yields.
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. They are also hiding the fact that less capital growth is expected in the long run.
It is obvious that market cycles affect directly these drivers too. So, 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, this is often referred to as ‘hardening yields’. The opposite is also happening. 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’.
Most times, people think that if the yields look good then the investment is good. 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 factors, such as the likelihood of finding and retaining a good, long-term tenant, maintenance and infrastructure costs. Suitability, location of a property and all the other factors that can impact on your ability to achieve your expected yield are also key. In several cases, when investing in a different currency, for example USD to invest in a market where the currency is KES, even the foreign exchange plays a key role. It has to be considered.
Now that we know how to calculate the yield, and what it means, we need to understand it. In real life, a yield of 5% can give a positive cash flow outcome and a yield of 8% can give you a negative cash flow outcome. Surprising, isn’t it? This is because there are many other factors that affect a property’s cash flow. There is more to consider than just gross rental yield.
A lot of people believe that it is as simple as this, “the higher the rental yield, the better the investment opportunity”. In real markets investments, things are a bit more complicated. In order to understand better how property investments work, we need an example.
A property purchase price of Sh4, 000, 000 with Sh26, 000 a month as rent has a rental yield of 8% (respectively). In this instance, you have more income from rent to service the expenses of the property. Although it sounds great, this is not enough information for you to rush out and buy it. It sounds like a positively geared property but there are many other boxes that need to be ticked before rushing into a purchase.
Capital growth vs. cash flow vs. risk. In our example above, the 8% yield sounds ideal. If it were that easy, we would all be happy, everybody would be rich. However, it is much more complicated. My opinion, do not rush to any conclusions. Selecting a property for high yield alone can have some consequences. Many investors have found that high yielding properties can come at a cost of little capital growth, negative cash flow or even increased risk.
Investors, who bought a property based on the yield alone, with the area selected staying stagnant for years, achieved no capital growth. Without capital growth, their ability to grow their portfolio came to a crashing halt. So, assessing a property for potential drivers of capital growth as well as yield becomes critical for your portfolio growth.
Other investors decided to buy a cheaper property, based on affordability and the promise from the seller or the agent that it would be positively geared. They then found that the cost of holding the property was much higher than first thought. Continual repair and maintenance costs of the property eroded their anticipated cash flow. So, assessing a property for potential cash flow as well as yield becomes of prime importance.
The promise of high yields can be found in many areas especially when a market is coming out of a booming period. Reading the advertisements for properties in several areas and the high rents being achieved makes them appealing to investors. However, with high returns comes high risk. Volatility in the market is to be expected. A new investor wanting to start their portfolio may find the risks too high.
Assessing Cash flow for a property
The assessment criteria when selecting a property should be based on more than just rental yield alone. Gross rental yield is not a reliable indicator of whether a property will have a positive or negative cash flow, will have future capital growth or will be a high-risk investment. Due diligence and research is required to assess potential for growth as well as the level of risk. Another very important factor is the investment period.
In any case, when you decide to get involved with property investments, I highly recommend that you use professional advice. Same time, try to read and follow up with the market.
You need to be able to understand at least some basic terms and know basic facts about the property market. This will enable you to understand and manage your investments. Over the years, real estate has made a lot of people very rich but also many people have lost their fortunes. Investing is a very serious decision for you and your family. You need to be as ready as possible.
