Marcin Malmon

Initial Yield

Despite the fundamental nature of the all risks yield, the initial yield is still the most popular in Poland. This is probably due to the low availability on the market of reliable information on the terms and conditions of investment transactions and on the rental structure of commercial real estate sold. This is also not helped by the still low awareness of market participants about the nature of the different types of yields, including the serious drawbacks of using initial yield.

This yield is in fact the quotient of the current contractual annual income from the property and the property price. The initial rate of return is referred to in English terminology as the initial yield and sometimes also as straight yield, running yield, flat yield or going-in capitalization rate[1]. Due to its ease of calculation, it is relatively often used and sometimes even equated with the „yield” in general. In particular, many large international real estate companies operating in Poland report initial yields by exchanging information on recorded yields in recent investment transactions.

The information that the yield in a recent transaction at, for example, 6.5 per cent was the initial yield is partial information and insufficient to be used directly in the property valuation being prepared. Indeed, the rate is useless if the current contractual annual income is not representative of the property in question.

For example, recently built and leased, well-located office buildings are an attractive investment product on the real estate market. However, in such buildings, at the beginning of their operation, there is often still vacancy, which only after a certain period of time, gradually reaches the market level, through subsequent signed leases. In addition, in recently signed leases, tenants often still benefit from so-called ‘rent-free periods’, which often extend to several months’ exemption from paying rent. Thus, the rental income in subsequent years can be significantly higher than the current annual income. Of course, the opposite situation is also possible, where an old lease with a rent significantly above the current market rent ends soon and the new tenant will certainly not want to pay as much. There will therefore be a decline in rental income in subsequent years. Also in such a situation, which is so often encountered in everyday practice, the initial yield is of little use.

To illustrate the scale of the problem, the table below shows a summary of the true annual Net Operating Income of one of Warsaw’s actual office buildings, which was valued at € 15,400,000. The lowest row of the table shows the initial yield, but calculated separately for each of the subsequent forecast years.

A real life example shows that the rate varies significantly from 3.03% to 9.97%. Thus, depending on which year of the forecast the transaction of this property would have taken place, its analysis for the determination of the initial rate of return would have given any of the results in the indicated range. It therefore becomes obvious how low the usefulness of this type of analysis is and how dangerous the subsequent use of such data by valuers in property valuations is.

Of course, it cannot be ruled out that the subject of the valuation is to be a property with a very similar pattern of income volatility as the property that is the subject of the transaction from which the initial yield was derived. In such a case, a rate of this nature will be able to be used in the valuation almost straightforwardly, without further adjustment. However, the probability of this situation is quite low.

In most cases, due to the encountered problem of the lack of representativeness of the current property income at the date of the analysed transaction, there is a temptation to somehow “make up” for the shortfall in income resulting, for example, from the high vacancy rate in the first years of the property’s operation. One may therefore encounter proposals to make up for the shortfall in rental income in a given year with a hypothetically achievable rent at market level. However, such a procedure means that the result of such an analysis will no longer be the initial rate of return. Secondly, it already constitutes the introduction of subjective assumptions of the analyst into the transaction analysis, which in itself is not desirable and may lead to different results depending on the person performing the analysis. Meanwhile, the rational direction of exploration should be to maximise the objectivity of investment transaction analyses and thus subsequent property valuations.

Another flawed solution that can sometimes be encountered is the proposal to determine initial rates of return using effective rent. Again, the result will no longer be the initial rate of return, which by definition is supposed to show the relationship between the current annual income and the sale price, whereas the income calculated on the basis of the effective rent already takes into account the fact that, for example, the tenant has been granted a “rent-free period” or the landlord has contributed to the cost of fitting out the space, etc. Such an analysis ignores the fact that the circumstances taken into account in calculating the effective rent occur at different times. Such an analysis, however, ignores the fact that the circumstances taken into account in calculating the effective rent occur at different points in the lease term. After all, a 6-month rent exemption in the first year of the lease has a different impact on the value of the property and a 1-month exemption in the six subsequent years of the lease, although nominally the cost of such a bonus to the landlord is the same. So trying to calculate the initial rate of return on the basis of the effective rent is not a good solution, as it ignores the element of the changing value of money over time.

Both of the proposals for ‘improving’ the initial yield found on the market are therefore imperfect, although they could perhaps be accepted if it were not for the fact that there is no established practice in the market for doing so. To put it bluntly, no one currently knows quite how transaction advisers calculate what they call ‘initial yields’, and this is already a highly dangerous situation.

It is also worth remembering that when analysing a recent transaction of a property rented at market rent, the initial yield determined for that transaction will also be the all risks yield. This is why some valuers use these terms interchangeably, which, however, is not true in every situation.

[1] According to R. Hungria-Garcia, H. Lind, B. Karlsson in ‘Property yields as tools for valuation and analysis’, Royal Institute of Technology, Stockholm 2004, after M. Hoesli, B.D. MacGregor, ‘Property Investment. Principles and Practice of port folio Management’, Longmax, Essex – The term going-in capitalization rate is used in North American countries, as opposed to the others mentioned in the text, used mainly in Commonwealth countries.

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