Successful Real Estate Investing 2 – Keep an Eye on Your Yield

July 15, 2010

Yield can be calculated as Gross Yield or Net Yield – it is used both as a rough comparison on cashflow between competing investments and as an indicator of what income you should be expecting. Gross yield for example, is calculated by taking the annual rent on a property, and dividing that by the value of the property. I.e. if you were to buy a typical double unit house through Abbotsinch Capital, ( let’s say one on the sites front page, 119 Rounds ) the Gross rent would be $850 x 12 = $10,200 and the purchase price is $36,850 so the Gross Yield is $10,200/$36,850 = 27.7% (rounded to 28% in the brochure) Typically but not always, higher yields reflect perceived risk, and perceived security of returns – i.e. in theory the lowest yields in the world would be found in the safest investments.

In practice, this is a very imperfect market, partly due to the illiquid nature of real estate, and partly due to the fact that perfect information is rarely available in any market. The lowest yields are typically to be found in investments like Gilts (Government Bonds) of developed and rich countries (for example Switzerland) or you could say in easy access bank accounts (the returns are lower because of the liquidity) Moving up the yield curve, high end real estate, Blue chip equities for example will nowadays produce a yield of 3-6%, with the perceived reflected risk that these are quite ‘safe’ investments. Yields in high end real estate were as low as 1 or 2% in the boom times, (for example Grafton Street in Dublin) reflecting perceived ‘very low risk’ – and as the market corrected the prices and the rents fell accordingly, wiping out the fortunes of these ‘safe haven ‘ investors as they went.

The higher yields in investments can be one of or a combination of two things – it can either mean that the price of the investment is too low (i.e. its ‘undiscovered’) or its perceived as a risky investment (i.e. emerging market yields were traditionally higher than for example in US or Western Europe, until the boom came in these countries and temporarily put yields lower in Riga than in Vienna for example) yield. Now 10 years later the area has fully gentrified, and therefore not only have rents risen substantially, and tenant quality improved, but the prices have more than doubled, and therefore yields have halved to 7%, reflecting a more ‘safe’ investment (i.e. AFTER all the money has been made!!)

An example of this could be in 119 Rounds, Kensington, Buffalo – the average house price in Rounds Street according to is around $50,000, assuming we are renting for market rent (the houses on this street are all very similar size), giving an average gross yield of20 %. This would say that 119 Rounds has a lower than market price and therefore a high yield, compared even to its neighbours. If for example, however, the price of the house increased towards the average local price (say $50,000) then the yield would fall to 20% and the investor would have made $14,000 or 38% in capital growth over the period. This then illustrates an inbuilt ‘equity gain’ that can be taken into account when the yield is so high. However, not all areas will have the potential for so much equity gain, and this is reflected in the extremely high yields of some of the houses, where the areas are currently disreputable and deemed as ‘ghettos’ and therefore have limited capital growth potential. The high yields here (for example in 11 Moeller) reflect the risk of limited potential upside in long term capital growth.

In summary

1. Look to buy high yield that is more valued as ‘undiscovered’ rather than valued as ‘risky’

2. Yield is a more secure income reflector than capital growth, especially in a recession/depression.

3. Ultra high yields can be seen as moving towards speculative investments – i.e. over 40% typically (but not always) will mean that there are some issues with the area (i.e. it may be an ungentrifiable ‘ghetto’ or in a neighbourhood with bad demographics, or with substantial repairs required. However this said, this type of investment can be very profitable and does have a place as part of a larger portfolio.

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