How do I calculate yields on a commercial property?
In simple terms, the yield on a commercial property is the percentage return on your initial investment.
However, that’s where the simple part ends. There is a myriad of information that needs to be taken into account before determining the yield associated with a commercial or industrial building for sale.
Once you have made the decision to acquire a commercial or industrial property, you will need to calculate the yield on the property you intend to acquire. This is purely a desktop calculation and is by no means a true reflection on what the property is actually worth, or what you should be paying.
Determine net income of the property
First step is to determine the Net income on the property. Once you have determined the annual rental income, you are able to calculate the annual net income.
Net income is defined as the amount of free cash remaining after all expenses have been accounted for. This includes, but is not limited to, building insurance, rates and taxes, building maintenance provisions, property management fees, accounting fees etc.
Gross Monthly Income R100 000.00
Operating Expenses R20 000.00
Net Monthly Income R80 000.00
Annual Net Income R960 000.00
Purchase Price R10 000 000.00
Yield Calculation R960 000.00 / R10 000 000.00
Effective Initial Yield 9,6%
For this particular explanation, we will be considering a secondary investor (not the original developer of the property)
When making a property investment, research is critical. Remember, this is a long-term investment… not only are you looking to achieve an excellent yield but ideally capital growth in the asset as well.
Yields on commercial, industrial, and retail properties vary from time to time.
Simply making your decision based only on the initial yield, could be a financial disaster.
Critical factors to take into consideration when evaluating an acquisition for yield purposes:
- Current interest rates
- Is the yield in line with the type of asset you intend to acquire?
- Interest rate trends for the next few years
- Location of the asset
- Property prices in the immediate geographical area
- Electricity provider (Eskom or Municipal)
- Quality of the tenant
- Lease period
- Age and condition of the building
- Benchmark current market rentals – is the building over rentalised (is the rental above the current market)
- Are there annual rental escalations?
- Is there an exit clause in the rental agreement? Is there a revision of rentals to market at any stage during the lease period?
- If your tenant defaults, will you be able to find a replacement? What’s important to remember is that you are buying an income stream.
An important point to consider regarding the power supply of Eskom vs Municipal, are the rates charged by the relevant authority. Currently, Eskom rates are substantially lower than those charged by Municipalities. While you as the investor are not liable, as consumption charges are covered by your tenants, it ultimately may be a deciding factor in a tenant’s decision to occupy your premises or not.
One of the reasons you need to investigate if the property is over rentalised, is to determine what the likelihood is of replacing the existing tenant (if the tenant absconds or goes into liquidation) with a new tenant at the equivalent rentals. If the answer is no, and the market rentals are substantially lower, the value of the property should be lower, and the yield should be higher.
Lease periods are also important. If there is an exit clause after 3 years on a 10-year lease, you will only really have a 3-year lease – the banks will look at it this way as well when considering the finance. Lease periods are relevant for determining the yield – the longer the lease period, the lower the yield.
Rental revisions can work both ways. To protect both the tenant and the landlord a good lease agreement should have both a cap, and a collar, when it comes to determining the rentals at the revision date. In other words, there should be a minimum rental and a maximum rental for the revision period, taking the prevailing market conditions into account.
Having taken all the above factors into account, you may need to re-consider the yield that you would like to acquire the property at, considering all the risks associated with the investment. The higher the risk, the higher the yield and the lower the value of the property. Clearly it would make no sense to acquire an asset if you were borrowing from the bank at 11% and only getting a return of 9,6%. You will have a cash shortfall and need to continuously inject cash into the property.
Let Steve help you with any commercial or industrial queries.