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Investing
Measuring the return of your investment property
Nick Renton AM - May 01, 2008
 Donal Henahan once cynically observed: "Next to the writer of real estate advertisements, the autobiographer is the most suspect of prose artists."
Strictly speaking, only after an investment property has been finally disposed of does it really become possible to measure objectively just how good an investment it had been. This can then be done by calculating the compound rate of return per annum inherent in the transaction - a figure usually referred to as the "yield" - and comparing this with the returns which alternative investments would have produced.
"Yield" can be defined as "the net rate of interest at which the sum invested equals the present value of all income payments plus the present value of all capital payments."
At the time of acquisition of an asset it is, of course, not possible to calculate with the benefit of hindsight the actual yield which will be achieved over the period during which the asset is held. Thus the optimistic forecasts typically made by estate agents when marketing investment properties need to be viewed with some scepticism.
In an extreme case, as investors in failed companies know only too well, some specific investment might well result in a total loss, even if that possibility looked remote at the time of its acquisition. However, investments are normally entered into on the basis of their prospective or expected yield, calculated on some set of expressed or implied assumptions. In many cases, several different alternative scenarios may be taken into consideration.
The term "yield" is often used more loosely, particularly in the case of shares or property, where it may just represent the expected income over the first year divided by the current market price excluding transaction costs, expressed as a percentage.
The returns from property investments are usually measured in terms of the nominal yield ignoring capital growth and inflation, being the rent per annum divided by the purchase price or the current market value (according to context).
It is really necessary to distinguish between a gross yield (based on the gross rent) and a net yield (based on the net rent after deducting depreciation and any outgo, apart from interest, which is being borne by the landlord). The "outgo" should notionally include an allowance for repairs and maintenance in an average year.
Both of these concepts can also be looked at on a "before tax" and an "after tax" basis.
An investor using borrowed funds can also have regard to the net return on the investor's equity. This is obtained by dividing the rent per annum (net of the landlord's expenses) less the interest commitment per annum by the value of the property less the amount of the loan.
In contrast, returns from shares are usually expressed as a dividend yield (dividends per annum per share divided by the market price per share) or as an earnings yield (earnings per annum per share divided by the market price per share). The latter is the more useful concept, as better indicating the underlying performance including growth.
In the case of franked dividends the dividend yield really needs to be grossed-up in order to reflect the attaching imputation credits. If this is not done then like will not be being compared with like.
Should investors seeking to buy a property look for a yield of over, say, 10 per cent? Or should they be willing to accept a yield below 5 per cent? This is really a nonsense question - basically sensible investors when buying assets will normally get what they pay for.
A low initial income return can be quite acceptable provided that there are corresponding prospects for future capital and income growth. However, as always, the old adage of "the higher the return, the greater the risk" will usually apply.
Property yields are not uniform. They vary enormously according to a number of factors, including the type of property (residential, commercial, industrial, rural, and so on), its location, the quality of the building and the unexpired term of the lease.
As a general rule, older buildings will require a higher yield to compensate for the likely cost of future repairs and because they are less appealing to tenants.
Some investors pay considerable regard to the quality of the present tenant at the time of purchase, but this can be a trap because the tenant may decide not to stay on beyond the term of the lease.
Quite irrationally, yields on residential properties are usually considerably less than those on commercial or industrial properties. This comes about because of the incidence of unsophisticated investors who favour this category of investment over others despite its drawbacks, partly because they think that they can assess it more readily. They live in a house and know what to look for in other houses, but they are unfamiliar with what the attributes of a factory or office should be.
Typically, nominal residential yields might be 5 per cent or even less, with the landlord paying all the outgoings, at a time when industrial yields might be around twice this level, with the tenant paying the outgoings. Other things being equal the capital growth expectations for both categories would be roughly the same.
Whatever your views, you can discuss this article - or any of Nick's articles - on our message board Your 2 Cents.
Nick Renton AM is the founder and first president of the Australian Shareholders' Association. He is a consulting actuary, commercial arbitrator, company director and writer. He is the author of 62 published books covering shares, property, managed investments, taxation, wills, the Internet and the Australian economy. He has written books about more different topics than any other Australian author. He was made a Member of the Order of Australia in 2004.
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Investing: Measuring the return of your investment property
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