Investors will often hear the term Yield or Capitalisation Rate. (Cap Rate)
What is the difference between them?
Well not much…Essentially they are the same but are derived from different sides of the analysis.
From a valuation perspective in the case of an untenated property the rental is capitalised to determine a freehold capital value whilst a property that sells in the market with an income stream in place establishes the yield achieved.
Either way both terms establish the same thing and that is the relationship between income (rent) and the freehold value of the asset (property).
There is some calculation of brick and mortar replacement value but that is largely overlooked when yield is the main calulating factor.
Why is it then that yields can vary so much between assets within their own sector.
Well you have to be able to compare apples with apples. Not all commercial properties are the same.
So it’s easy enough to understand why an industrial premises yield is softer than a retail premises yield but how is it that adjoining premises that seemingly are near identical can have different yields.
That’s when the WALE comes in. (This is the Weighted Average Lease Expiry)
The lease will have a direct impact on the value depending on the length of the lease… and the type of lease.
One lease may be a gross rent and the other a net rent. One may be set to end in 2 years the other in 5. The lettable area may be the same but one may have a wider frontage.
These are all issues to consider when buying a commercial property as you need to drill down into the critical issues that drive and sustain value.
You also have a choice as to what investment yields you believe best fit into your own financial situation and goals.
Do you purchase an industrial property with a 9% yield or a retail premises with 5.5% yield?
It also helps to understand why the yields are further apart apart.
Some things to consider are that industrial tends to be in areas where there is more land to be developed whereas retail generally has tighter restrictions… that land is already developed.
This means that retail is more likely to attract capital growth than industrial. For that reason, the risk profile on retail can be less.
Retail property, on the other hand, is generally limited in terms of retail or shopping precincts with the requisite appropriate zoning. In contrast to industrial property, the majority of value in retail property value is tied up in the land component due to the scarcity element, i.e.,. limited areas can be developed in established locations.
As capital growth is all but assured over the medium term in recognised strips and precincts the investor has a lower risk profile and exposure and therefore retail properties trade at a firmer yield.
Of course, then you also need to consider what potential upsides there may be for each that could affect your value and income over time. In either case, the right property may allow you to manufacture growth
In the residential market, there are high yields achievable in lower socio-economic areas, but the higher return correlates with, the higher risk associated with holding a property in these places (e.g.,. property damage, tenant vacancy, rent in arrears).
In contrast, premier residential dwellings produce lower yields but have far greater Capital Growth prospects.
There are a vast array of submarkets within each property sector that have different risk profiles and varying yields.
If you can ask questions of your valuer, agents and even auctioneers you will build an understanding of what factors will add value to your properties and the properties you are researching and consequently where hidden opportunities lie.
If you can see things others can’t you may get into deals, others mistakenly overlook.