In real estate, yield is calculated by dividing the annual cash flows received by the value of the asset:
|Yield:||Annual Cash Flow|
|Current Value of Asset|
For example, a property that is worth $500,000 and returns $50,000 per year in rental income has a yield of 10%. Note that yield does not account for net cash flow or profits – only the amount of cash that an asset generates over a period of time. Comparably, for stocks and bonds, yield is the dividend or coupon payment divided by the security’s value.
For real estate, there are two methods for which investors are compensated: rental cash flows and capital appreciation. Total return for an investor is a combination of rental cash flows received plus capital appreciation of the asset. Given an expected total return, yield (rental cash flows) and capital appreciation will adjust based on expectations.
How Yield Is Determined
So, what determines yield for real estate? Unfortunately, this topic is worthy of book to itself. Nonetheless, as a basic overview, yield is determined by several primary factors:
- Asset quality and characteristics
- Stability of cash flows
- Yields on stocks and bonds
First, asset quality and characteristics is a major determinant of an individual asset’s yield. Generally, the newer and nicer the building, the lower its yield will be. This is because current prices and returns must factor in all future expenditures. Additionally, factors such as location and asset type are major determinates. These factors contribute to capital appreciation expectations. Generally, the higher the capital appreciation expectations, the lower the yield – all else equal (an investor is compensated for total return).
Second, the stability of cash flows is a primary determinant. Properties with longer-termed leases with reputable tenants, such as major retail stores or corporations, will demand a lower yield for the reduced risk in cash flows. Properties with leases soon to expire or poor tenant quality will most often offer higher yields.
Third, in the spectrum of risk and return, real estate sits between stocks and bonds. Stocks offer the highest risk and highest returns, with bonds offering the lowest risk and lowest returns, all on average. If bond yields are compressed (as they are now), property yields will also compress for a multitude of factors beyond the scope of this blog post. However, the takeaway is that real estate returns tend to float between stocks and bonds, so if expected returns for stocks and bonds drop, so too will those for real estate. Ultimately, yields for real estate are determined by investor expectations for return and risk.
At the Law Offices of Richard Palumbo, we have successfully helped individuals and businesses plan their real estate acquisitions and overall strategies. We combine our in-depth legal acumen with business know-how to help you evaluate the risk of a real estate investment in light of your overall portfolio and need. Similarly, we have significant experience advising sellers to ensure that they receive the greatest price possible. If you are considering acquiring or disposing of a property in Rhode Island, please contact our office to set up a consultation or complete the contact form.