Many investors use gross yield and net yield to assess differing property investments in order to determine which course of action represents the best decision from a financial point of view.
But there is another calculation which is often ignored which is instrumental in determining how to deliver the best returns on an investor’s equity. This calculation is called the Capitalization Rate and is an important indicator for investors to consider. In the post Global Financial Crisis (GFC) period, yields from any type of investments became increasingly harder to find and without doubt, the post global recession environment saw investors having to take greater levels of risk to generate acceptable and goal satisfying yields. Dubai’s rental yields have always been strong, particularly when compared to countries where rental income is taxed at high marginal tax rates. With a market that boasts an Average Gross Yield of around 7 percent, it has for some time stood as a beacon for those who appreciate the significant structural and regulatory development that the market has undertaken which, in reality, decreases the risk perception associated with investing in the market. A close look at Gross Yields can reveal a number of insights. It can provide a retrospective view or learning opportunity by revealing how accurately market factors were comprehended, analyzed, forecast and modeled when planning a particular development. Gross Yields can also highlight inefficiencies because inefficiencies, unless corrected, must be eventually supported by either Gross Yield or margin reduction. Investors are concerned with what can be put into his wallet and expectations of Net Yield will always pressure Gross Yield and the cost of resources required to generate that Gross Yield. In times of tight supply, inefficiencies in construction, administration, maintenance and operating methodologies are hidden because elevated Gross Yields driven by excessive market demand are more likely to drive acceptable Net Yields for investors. However, the real test as to effective Yield management is when supply exceeds demand. But really, what is the true meaning of Gross Yield? Gross Yield is the income on an investment prior to expenses being deducted expressed as a percentage. Simple. But Gross Yield only measures the income as a percentage of the original purchase price and does not reflect the effects of significant underlying fluctuations in underlying asset values such as those that have been witnessed in Dubai during the last 5 years. Now, what is the Capitalization Rate (Cap Rate) of an existing property? Cap Rate is the rate of return on a real estate investment based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor’s potential return on investment. The Cap Rate may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property, where NOI is the total revenue derived from leasing the property less operating costs. Simply put, the Cap Rate = Net Operating Income/ Current Market Value. Given that the capital values for property in Dubai has, in many cases, shown significantly greater volatility than the income being derived from the property, we need to look at the Net Operating Income being generated from the property at today’s value. This allows us to see whether the property’s wealth generating performance is improving or declining by referring to the Cap Rate. If the Cap Rate is declining, it may lead us to conclude that to sell the property and reinvest elsewhere would generate greater income and/or overall wealth even if the Gross or Net Yield still looks impressive.
Cap Rate is used as part of the objective when establishing a client’s property portfolio. We will determine the lowest cap rate that the client should accept in order to make the investment worth-while. Typically, we will suggest a Cap Rate of between 5 and 10 per cent depending on expectations of asset value fluctuations going forward. As revenues are typically locked in line with rental contracts, the ability to accurately forecast the potential and likely shifts in property asset values will be essential to establishing realistic Cap Rates and forming longer term portfolio strategies. Another useful application of the Cap rate is to determine an estimation of the payback period of an investment. When you divide 100 by the estimated Cap Rate you arrive at an estimate, expressed in years, which will provide an indication of the payback period of the investment. For example, an investment with a cap rate of 7 per cent will have an estimated payback period of 20 years. Caution must be used when using this ratio, however, and it must be reviewed periodically as the underlying asset value and the revenues generated from the asset will always exhibit different rates of volatility.
