For stabilized commercial properties with predictable income streams, the rental yield can serve as a helpful valuation tool and can be useful for benchmarking opportunities against one another. Whereas, for properties which needs improvements and income is not certain, return on cost is better way to evaluate economic value.
What is the rental yield rate?
A rental yield rate is the rate of return investors expect to receive from a property during the first year of ownership, excluding the cost to improve the property and financing costs. In other words, rental yield rate is the dividend one would receive in the first year if the property were acquired with all cash. The rental yield rate is calculated by taking the Net Operating Income (NOI), which is the property revenue, minus the necessary operating expenses, and dividing it by the purchase price.
For example, if a property generates INR 64,00,000 of NOI in the first year of ownership and it sold for INR 80 million, the rental yield rate is 8% (INR 64,00,000 divided by INR 80,000,000). As per market norm, one needs to add interest at fixed deposit rate earned on security deposit received from tenant as a component of NOI.
Rental yield rates are impacted by the expected future growth of the underlying NOI, tenant’s profile, contractual length of the leases, and the liquidity available in that investment market.
Assets located in Tier 1 cities including Bangalore, Mumbai, Delhi NCR all have investors interested to purchase the limited amount of assets that exist in those markets. As a result, they are all considered extremely liquid investment markets and the amount of investor demand places upward pressure on prices, resulting in lower yield rates. These markets also tend to have strong economic growth factors that make it possible for owners to increase their rents, relative to markets with weaker fundamentals.
Conversely, in markets like Nagpur, Raipur, Lucknow, and others where liquidity and economic growth prospects are low, investors need to ensure that they receive more of their return from the yield as the chances for value appreciation are low.
The size of the transaction also plays an important role in determining yield rate. We have witnessed smaller ticket size transactions attract more investors and therefore yield rates are on lower side compared to larger sized transactions.
Different type of assets has varied yield rate. For example, office space commands lower yield rate compared to warehousing, retail, and student housing assets. But fundamentally it is the firmness of the cashflow which determines the value for core assets.
Rental Yield Limitations
For multi-tenant properties, especially opportunities where one is making several value-added improvements, the yield rate is partially irrelevant because of the instability of the underlying cash flows. For example, an office building that is 20% occupied may have a negative NOI as the revenues are insufficient to cover the operating expenses, thus resulting in a negative cap rate.
However, this could prove to be an incredible opportunity if the owner stabilized the property through reinvestment. To value these types of opportunities, we use a different method called Return on Cost.
What is Return on Cost?
Return on Cost is a forward-looking rental yield rate. It considers both the costs: A. needed to stabilize the property B. purchase cost and the future NOI once the property has been stabilized. It is calculated by dividing the purchase price by the potential NOI.
One uses return on cost to determine if one potentially generate an income stream greater than what one could achieve if purchased a stabilized asset today.
For example, if stabilized properties are trading at 8% yield rate today, it would mean that for INR 200 million, one would achieve INR 16 million of NOI. If investor acquired a value-added opportunity for INR 180 million that needs another INR 20 million for renovation, it would totally cost INR 200 million.
Post value-add business plan has been executed, in two years the property’s NOI has the potential to increase to INR 20 million. The return on cost for this property would be 10% (= INR 20 million/ INR 200 million). Investor has INR 20 million of income and if we divide that by the stabilized yield rate of 8%, the property’s value is INR 250 million.
The above methods are two of the many ways investors can use to evaluate a real estate investment. It is imperative to understand yield rate and its limitations to know how to use it when valuing real estate.
Most importantly, the yield rate should not replace the best method to value real estate: discounted cash flow analysis. Valuing real estate is complex and is both an art and a science; the best valuation methods use a combination of initial yield rates, assumptions for the yield rate upon sale to the next buyer, plus return on cost. Using yield rate computation in isolation can lead to incorrect outcomes.