Effective vs. nominal yields – ‘as you value so shall you devalue’
Participants in the Polish real estate market may occasionally encounter the term ‘effective yield’ or ‘true yield’. This term sometimes appears as additional information in printouts of calculations for valuations prepared using off-the-shelf commercial property valuation software, or in self-drawn models by some valuers and analysts, as well as in specialist industry studies.
The extraction of this type of yield is due to the fact that the DCF income approach valuations use certain simplifications with regard to the frequency of rent payments by tenants. In the vast majority of cases, cash flows are constructed by assuming that rent is received once a year at the end of the latter. Meanwhile, Polish market practice is generally to pay rent monthly. In other countries, quarterly payments are also quite common. This fact has a certain impact on the amount of annual income actually obtained from the property, and therefore also on the rate of return from investing in it.
For example, if a property generates an annual income of 100 payable at the end of the year and is sold for 1000 then the transaction reflects a rate of 10% (100/1000=0.1 i.e. 10%). The situation already changes if the rent payment is made twice, every six months. In this case, the half-yearly rate will be 5% (50/1000=0.05 i.e. 5%). It can also be seen that the amount from the rent received after the first six months can be invested for the next six months. If we assume that it is invested in an investment similar to the investment in the property in question, we will have just obtained from such an investment an additional 5%, which we would not have obtained if the rent was payable in full at the end of the year. So, at the end of the year, we will obtain a slightly higher amount than in the first case of 102.50 (50 + 5% x 50 + 50).
In reality, therefore, the annual income on the basis of which the yield should be calculated is 102.50 and the yield itself 10.25% (102.50/1000 = 0.1025 i.e. 10.25%). This is the ‘true yield’, sometimes also referred to as the ‘effective yield’. Without taking into account the effect of investing the first income stream, the annual rate is still 10%. This is the ‘nominal rate’.
In case studies with a larger number of recurring rent payment periods per year, investment tables can be helpful, the most popular of which are the Parry’s Tables. These tables allow, for example, an easy conversion of rates between the most typical rental income patterns during the year. For example, it can be observed that a nominal yield of 10% for quarterly ‘upfront’ payments corresponds to an effective yield of 10.6577%. It appears, therefore, that for such a payment pattern, the simplification of using a nominal yield, and therefore not taking into account the possibility of reinvesting the funds coming from subsequent payments during the year, is already considerable.
For the most common case of end-of-period payments, the following formula can be used to convert nominal to effective yields:
r – true yield, effective yield
i – nominal yield
p – number of earning periods during the year
Using the above formula, it can be seen, inter alia, that an exemplary nominal yield of 10%, after taking into account the most common model in Poland of paying rent monthly ‘in arrears’, i.e. at the end of the month, corresponds to an effective yield of 10.4713%.
In theory, a change of nearly 50 basis points in the yield can affect the assessed value of a property very significantly. In practice, however, the problem of differences between nominal and effective yields is marginal. This is due to the fact that, in order to simplify calculations, practically no one probably analyses income streams from sold properties on a monthly basis but only on an annual basis. The existence of such a practice is also reinforced by the fact that the Polish PFSRM’s Interpretative Note on the income approach as well as the European Valuation Standards recommend considering income flows on an annual basis (obtained at the end of the year). Thus, it can be assumed that nominal rates are generally obtained from the market, so it would be a mistake to treat them as effective in valuations and apply them to monthly stream flows.
There is therefore some danger of accidentally (or intentionally!) breaking the principle of commensurability (‘as you value so shall you devalue’) by, for example, using a yield derived from a market survey and therefore at a verifiable and easily assessable level, to a cash flow built on a monthly stream basis, thereby leading to an overvaluation of the property.
A similar mistake is to discount annual flows not from the end of each year, but e.g. from the middle of the year, which is unfortunately a common practice in Poland. This results in higher present values of the individual annual incomes and thus a higher total, i.e. the value of the property. Whether an overestimation of the value of the property is created in this way will depend on whether or not adjusted yields have been applied to such a cash flow projection.
This is another important reason why valuers should be proficient in distinguishing between all types of yields and professional bodies should do everything possible to disseminate this knowledge.