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Property Valuation: Common Misconceptionsabout Rental Yield

September 9, 2014

By Gerald Tay (guest contributor)

Net Rental Yield (NRY) is a fundamental concept in the real estate industry. Yet, it is often misunderstoodand sometimes incorrectly used. This post will take a deep dive into the concept of NRY, and also clear upsome common misconceptions:

1. Price versus Value2. Definition of Net Rental Yield (NRY)3. The difference between Cap rates and Required Return4. Yields and Bubbles5. 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, priceis 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 andother 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 investsbased on value, because it’s right. This is the thrust of this series of articles: we’ll learn how to deriveProperty 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 somisused 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 wouldbe $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 morethan 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 hearmany 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 complicatedmanagement issues which will arise. With leverage on this deal, an 8% Cap property may meet ourROI 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 exceedhis/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%, thereforeROI =2% – this is incorrect.

Yields and Bubbles

To interpret whether bubbles exist in the property market, one should look at income and price – “bubbleindicators”.

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 themarket e.g. over-optimistic beliefs of investors who expect higher future prices or rentals to justify today’shigh 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 exuberantassumptions.

Most deals at these low rates used a great deal of leverage in an attempt to lift equity returns, generatingnegative cashflows and refinancing difficulties.

Today, most deals are done at CapRates of 2% and lower in the OCR (Outside Central Region) residentialsegment. Simply put, if current property prices yield a CapRate of 2% and the appreciation return is 8%, youcould 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 propertymeasures 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 onexuberantassumptions of future rental income and property value, or calculating increases in property market value eventhough the property has not been sold.

For example, buying off-plan (uncompleted/new launch) properties for investment are part of the gamblingperiod – 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, notfuture figures.

Most marketing agents cannot tell the difference between the different rates of investment returns. But as aninvestor, 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 ortry to pull wool over your eyes.

“The illiterate of the twenty-first century will not be those who cannot read and write, but those whocannot 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 isnot everything. Take some advice and use it as a way to measure how expensive a property is in relation tosimilar 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 anextremely powerful analysis tool when used mutually with other yield calculations for retail investors to makesurer 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, anorganization dedicated to empowering retail property investors with smarter investing philosophy andstrategies. He is a full-time investor with over 13 years of solid experience in building his wealththrough Property Investment and is financially wealthy today.

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