Yielding useful information

It might seem that the yield rate is a clear-cut way of determining the return on an investment. It is a measurement that is widely used for comparison and in analyses. However, the devil is, as usual, in the detail. Companies that appraise properties point out that one yield does not equal another. Knowing just its value might mean very little. And different projects should definitely not be compared based on ?dry' numbers taken out of context.
So many properties, so many yields
It turns out that yields almost vary as much as projects do. So it is worth taking an interest in what sort of yield is being discussed to avoid making decisions based on inaccurate data. The various yield rates include running yields, equivalent yields, initial yields, redemption yields... to name but a few. There is also the net yield and gross yield. So which one should an investor or analyst refer to when they quote the yield for a given property? "The idea is to calculate the sort of financial surplus a building generates," explains Luiza Berg, management board member and financial director of Gant Development. "Yields on apartments, offices and properties should definitely not be put side by side, nor should a general market yield be compared to an actual project. You need to find out how the yield was calculated and only then compare it to other data," adds Ms Berg.
The trap of subjectivism
"On the Polish market, in the case of new and leased commercial properties with a relatively stable cash flow, transaction conditions are set on the basis of the current rate of return, the so-called initial yield [editor's note: based on the current annual rent rate]," explains Wojciech Doliński, director of Comparables.pl. There is only one exception: "In some cases investors also use average rates of return calculated on the projected ten-year cash flow," he adds. Where do these differences come from? "Experts follow their own judgement and professional experience," explains Luiza Berg. "The method of yield calculation should of course be provided, but the truth is that this is a rare occurrence. If the yield is high, few people wonder where it derives from. If it is low there is more inclination to clarify how it was calculated," notes Luiza Berg. She goes on to add that the valuation differs in the case of residential properties and commercial ones. What counts in residential projects are the discounted cash flows and the internal discount rate. The average weighted cost of obtaining capital is calculated. This is the yield used by developers in internal calculations. But these are sometimes published in the results of public companies and for analysts' needs because they reflect market conditions and the cost of capital. "Most residential developers have a market-oriented approach. Yield calculation must be consistent; there are certain restrictions in this respect. Office properties are evaluated differently. Here yield rates depend on the commercialisation level and the rent rate," says Ms Berg.
The funds' and experts' views
Investment funds use expressions such as yield on present income or running yields to sum up returns on assets in a given year. These are simple yields calculated on the basis of profitability in a given year to compare the result to previous years. They do not contain any information on future profitability.
However, they include the risk element and the potential of revenue growth in the analysis. The risk concerns the changeability of the market and the potential increases and decreases that could take place in the future, which are estimated by investors based on their knowledge and market experience. In this way they end up with the so-called ?all risks yield', which takes into account the potential of properties over the longer term. This is, however, not included in the above- mentioned initial yield or running yield, which compare the revenue in a given year to the expenditure incurred on a project or to its value. "You need to be careful with the results of yield analysis based on transactional rent rates, which do not include rent holiday periods or rents varying in time - so-called ?step rents'. Step rents are usually lower at the beginning and higher in certain periods," comments Katarzyna Pawlak, a property appraisal expert at Polish Properties. She also adds that the situation is complicated even further in the case of retail properties, where part of the revenue comes from what are known as turnover rents.
Untangling the analyses
Investment market analyses often feature market benchmarks, but these usually only quote the yields on the best properties - fully-leased, top class buildings in the best locations. However, unlike prime projects, most properties are more likely to possess the average yield Even transactions typical for a given market vary in terms of lease contract periods, the quality of tenants and leasing conditions. This is why a single project should not be evaluated on the basis of general market analyses alone. This is when what is known as the equivalent yield comes into play, which constitutes a kind of average of the initial and reversionary yields. The reversionary yield is used to analyse revenue flow after an eventual change in rents, which could result from a contractual change in the rent or a lease contract expiry and factoring in the market rent instead. The definition of equivalent yield resembles that of the all-risks yield because it contains risks related to the changeability of rent revenue in the future; however, it also includes an element of greater certainty, as it takes into consideration the revenue guaranteed by leasing contracts.
Understanding the market
The yield which best reflects the market is the equivalent yield. This can be calculated based on comparable property transactions, naturally taking into consideration the differences between them. It makes it possible to exclude subjectivism in the choice of the yield in the most ideal way. Here we come to another yield - the equated yield. This is based upon discounted cash flow methodology. It does not contain the risk related to the volatility of revenue because volatility is an element of cash flow. It is seemingly the best method of project evaluation. However, it begs the question whether it is possible to include the actual changeability of future revenues in the cash flow analysis. "This kind of yield can undoubtedly be treated as one of the tools supporting investment decision making. However, it is definitely not a good tool for property evaluation because it has to be based on factual market data and reflect the knowledge of its players," explains Katarzyna Pawlak. Knowledge about the market and the entities that participate in it is fraught with uncertainty. An evaluation does not constitute a forecast as the latter is always subjective. "It can be based on market data. In my opinion the yields that best reflect the market are the all-risk yield and the equivalent yield. The equivalent rate can refer to the revenues resulting from leasing contracts even after the contracts have expired. They are capitalised based on the interest being a derivative of the initial yield and the yield adopted after the forecast period, i.e. after the expiry of leasing contracts. Both the all-risks yield and the equivalent yield restrict the subjectivism of the analysis and choosing the right one results directly from the knowledge of the transaction," argues Katarzyna Pawlak of Polish Properties.
So it is worth taking a look at some of the assumptions that lie behind the calculation of yields. And it is necessary to refer to more detailed data before making an investment decision.