The term ‘yield’ is used in articles related to both residential and commercial property and there is an implication that the meaning is the same in both instances, but in fact it is not. So what is the difference between the use of this term when it is applied to residential property as opposed to when it is applied to commercial property?
If a four-bedroom house is rented and returns $45,000 per annum, and the house is worth $450,000, it achieves a 10 per cent (gross) yield. Usually that is compared the mortgage interest rate on the property, which may be six per cent, and the rates and insurances costs, from which a net yield is derived. We are talking about income here, so the greater the yield the higher the income. A 12 per cent yield would mean $54,000 in rental income.
Commercial property is different. An office block of 1,000 square metres that receives rental income of $300 per square metre per annum provides an annual rental income of $300,000.
The yield (assumed) of seven per cent, is used to determine value based upon rental income divided by the yield as a percentage – i.e. $300,000/0.07 = $4.285 million.
That is the price (value) the building would expected to achieve if sold with a tenant paying that level of rent.
As a denominator, the lower the yield, the higher the value; if the yield was five per cent, the value would be $6 million.
A small shift in yield can make a lot of difference.
In summary, applied to the residential market, yield is a measure of income. Applied to the commercial market, it is a measure of value.
Determining the yield is part art, part science. It is ultimately, a subjective assessment by a valuer based upon both local knowledge and a few factors.
Taking the building as new, the strength of the attraction to a purchaser lies in the strength of the occupier as a business and its ability to continue to pay the rent for the duration of the lease.
The length of the lease is a major component; if the tenant is signed up for 10 years, that is significantly better than three years and if it was a government tenant or a major national company, government agency or national retailer, that rental income is almost guaranteed and as an income stream can be used as collateral for securing debt.
The tenant’s management strength, its history and profitability are all valid considerations. The better they are, the lower the yield and the higher the value.
This information though won’t be available from private companies, but it is for listed companies. Other measures such as Dun and Bradstreet financial ratings can also be relevant.
Comparables are also relevant, and indices published by reputable companies may also be useful.
Unlike residential developments, where profit is realised once only upon sale, commercial rents keep on giving and can be very profitable over time.
However, capital outlay is usually much greater and obtaining a tenant can take tim. Currently, with a LVR of 60 per cent or possibly lower, it’s highly unlikely funding will be forthcoming unless the building or a substantial part thereof, is pre-let.
If you are embarking on commercial development for the first time, make sure you have the knowledge to do so and manage the risks that may occur. Whether it’s acquisition or development, the commercial world is a very different ball game to residential investment.