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Property Valuation: Common Misconceptions about Rental Yield
By Gerald Tay (guest contributor)
Net Rental Yield (NRY) is a fundamental concept in the real estate industry. Yet, it is often misunderstood and sometimes incorrectly used. This post will take a deep dive into the concept of NRY, and also clear up some common misconceptions:
Price versus Value
Definition of Net Rental Yield (NRY)
The difference between Cap rates and Required Return
Yields and Bubbles
Realised Profits vs. Paper Profits
Real Estate Price versus Value
Before moving into Property Valuation, I need you to first understand one key investment fundamental, price is not always equal to value.
Never do yourself a disservice by asking novice questions on price because you’ll only get novice answers.
For example:
You: Do you think paying $1,300per square foot is a good deal for this property?
Property Agent/Friend/Neighbour/Relative/’Expert’: I think so because it’s already at a discount and other surrounding units are transacted at $1,400 per square foot.
The Losing Investor will always speculate on price, because it’s easy. The Master Investor always invests based on value, because it’s right. This is the thrust of this series of articles: we’ll learn how to derive Property Value or Investment Value from the price we pay, and become a Master Investor.
Tip 1: “Price is what you pay, Value is what you get” – Warren Buffet.
Remember: Price ≠ Value.
Defining Net Rental Yield
What is Net Rental Yield (NRY)? I prefer the term ‘Capitalisation Rate’ (CapRate), since NRY is so misused and misunderstood by many investors.
The Cap Rate measures the efficiency of the property’s Net Operating Income to property price, where:
Net Operating Income (NOI)=Annual Rent -Annual Expenses
For example, if a property’s price is $1,000,000 and generated a NOI of $10,000, then the Cap Rate would be $10,000/$1,000,000, or 1%.
Tip 2: Property prices are inversely related to Cap Rates.
Difference between Cap Rates and Required Returns
Every investor is entitled to his/her own Required Return, but not their own Cap rate!
This is akin to saying to your car dealer, “I want to buy a new 1,600cc car and I won’t pay anything more than a $30,000 COE Premium.” However, COE premiums are $61,900 (for cars up to 1,600cc) at this post’s time of writing.
Often, while putting together large commercial property deals with my co-investors, I will inevitably hear many of them declare that they will buy nothing for less than such a Capitalization (Cap) rate.
Me: The Cap Rate of the property is 8%.
Co-investors: That’s too low. I’m expecting 12% and above.
Me: Are you referring to a 12% ROI or Cap Rate?
Co-investors: What’s the difference?
Me: A 12%Cap property has inevitably higher risks than an 8% Cap property, such as complicated management issues which will arise. With leverage on this deal, an 8% Cap property may meet our ROI of 12% or more during the entire holding period – and we get a stable tenant for a great price.
Cap rates are set by the market and tell us how much investors are paying for a given stream of income, measuring the Net Operating Income (NOI) of the property as a proportion of the purchase price.
However, the Required Return is set by you and the job of the investor is to find deals that meet or exceed his/her minimum Required Return. This can only be evaluated over a realistic holding period.
Tip 3: When calculating Cap rates, mortgage and interest should not be factored in.
Beware: Property ROI ≠ Net Yield minus Interest e.g. Net Yield: 3%, Borrowing Costs: 1%, therefore ROI =2% – this is incorrect.
Yields and Bubbles
To interpret whether bubbles exist in the property market, one should look at income and price – “bubble indicators”.
Tip 4: The analysis of yield figures provides an insight into the property market as a whole.
A bubble is then defined as a situation where the price of an asset does not reflect “fundamentals” of the market e.g. over-optimistic beliefs of investors who expect higher future prices or rentals to justify today’s high price.
At the peak of the real estate cycle in 2006 and 2007, some deals were done at very low rates. For instance, residential projects in the CCR (Core Central Regions) were sold at a Cap Rate of 1.5% based on exuberant assumptions.
Most deals at these low rates used a great deal of leverage in an attempt to lift equity returns, generating negative cashflows and refinancing difficulties.
Today, most deals are done at CapRates of 2% and lower in the OCR (Outside Central Region) residential segment. Simply put, if current property prices yield a CapRate of 2% and the appreciation return is 8%, you could be overpaying, with a potential property bubble forming.
And that’s primarily why it’s only sensible for the government to have implemented many drastic property measures in recent years.
Realised Profits Versus Paper Profits
Realized profits are Profits that have been proven by a transaction
Paper profits or paper assumptions have no transactions to prove their value, but are based onexuberant assumptions of future rental income and property value, or calculating increases in property market value even though the property has not been sold.
For example, buying off-plan (uncompleted/new launch) properties for investment are part of the gambling period – there are no proven transactions, with highly optimistic future assumptions.
To measure your Effective Capitalisation Rate or Net Rental Yield, you need to input today’s figures, not future figures.
Most marketing agents cannot tell the difference between the different rates of investment returns. But as an investor, it’s your responsibility to know!
Tip 5: Did you remember to factor Vacancy Losses into your yield?
If you hear someone say a property has a 4% yield, you need to question:
4% meaning? – Is it ROI, Internal Rate of Return (IRR), Cap Rate, Return on Equity (ROE)?
Today’s yield or Future yield?
Gross yield or Net yield?
If Net yield, what expenses are involved?
Real rental or Nominal rental?
How did you derive 4%? Ask him/her to show you on paper. Again, most of them get this wrong or try to pull wool over your eyes.
“The illiterate of the twenty-first century will not be those who cannot read and write, but those who cannot learn, unlearn and relearn.” – Alvin Toffler
Conclusion
Using only Net Rental Yield (NRY), or Cap Rate, is a convenient way to measure your investment, but it is not everything. Take some advice and use it as a way to measure how expensive a property is in relation to similar properties in the present, not whether it’s a good long-term investment.
The Capitalisation rate is a fundamental and popular concept used in real estate projects. It can be an extremely powerful analysis tool when used mutually with other yield calculations for retail investors to make surer investment decisions – if you know how to calculate it correctly.
By guest contributor Gerald Tay, who is the founder and coach at CREI Academy Group Pte Ltd, an organization dedicated to empowering retail property investors with smarter investing philosophy and strategies. He is a full-time investor with over 13 years of solid experience in building his wealth through Property Investment and is financially wealthy today. Posted courtesy of www.Propwise.sg, a Singapore property blog dedicated to helping you understand the real estate market and make better decisions. Click here to get your free Property Beginner’s and Buyer’s Guide.
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