Exit Yield
A fairly common term, also among Polish real estate professionals, is exit yield. This is the rate used to capitalise the expected income from a property on the date of its disposal[1]. In the context of commercial property valuation, a hypothetical sale is also understood as the moment after the end of the period of expected changes in the profitability of a given property, i.e. the moment at which the valuer estimates its residual value. This is because this value corresponds to the price its owner can then obtain. Hence, the exit rate is often defined as the rate reflecting the value of the property, generating or likely to generate income, at the end of the analysed period of variable income[2].
From a theoretical point of view, the exit yield is the quotient of the projected future annual income from the property to the sale price of the property. In practice, however, it is not possible to determine it from the market in this way. It is therefore determined by adjusting other types of yields (e.g. All Risks Yield or the initial yield) derived from today’s market. The adjustments applied should reflect the expected future level of risk of investing in the property after the end of the income volatility period (cash flow period). In property valuation, the exit yield is applied in so-called explicit cash flows, where it is acceptable to project future market changes directly in the income flows themselves. In such a projection, the exit rate therefore generally assumes a level different from the discount rate (equated yield).
From the reversionary yield, the exit rate is distinguished by the type of annual income, which in this case (albeit theoretically) should be the projected future market income. In the case of the reversionary yield, it is the current market income.
The residual value of a property is usually estimated for the DCF technique in the form of direct income streams using the direct income capitalisation technique. This value is then discounted at the valuation date and summed with other discounted income flows from earlier years, giving the market value of the property at the valuation date. It is worth noting that, in most cases, the capitalisation rate used to estimate the residual value will be higher than the initial rate of return that we would use to estimate the market value at the valuation date if the value were estimated using the direct capitalisation technique[3]. This is because, in estimating the residual value, we are estimating, as it were, a property that is older than the property actually being valued i.e. the property as it will be at the end of the period of expected income volatility i.e. usually after 10 years or some other period, depending on the assumptions made. This is because the exit yield must reflect the shortened remaining economic ‘life’ of the property. However, the opposite situation is also possible, when, for example, major renovations and upgrades to the property are included in the period of the projected variable income streams. This is because it may turn out that at the end of the projection period the property will be in better condition than on the valuation date, hence the exit rate should then be lower.
As can be seen, adopting an appropriate exit yield should not simply boil down to equating it with current market initial yields or All Risks Yields for new properties. A better solution in this case would be to compare the property being valued to other properties with buildings of a similar age to the one the property being valued will reach at the end of the forecast period. In the conditions of the Polish property market, due to the lack of an adequate amount of reliable market data, this is an extremely difficult task. Moreover, the necessity to take into account in the estimation of the exit yield the expected events taking place during the forecast period, which will affect its condition after the end of this period, introduces significant elements of subjective assessments into the estimations, which does not seem to be desirable. Also forecasting the future itself generates additional risk, which shall be reflected in higher exit yield.
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[1] Commercial Property Glossary, Lambert Smith Hampton http://www.lsh.co.uk/commercial-property-glossary
[2] R. Hungria-Garcia, H. Lind, B. Karlsson w “Property yields as tools for valuation and analysis”, Royal Institute of Technology, Stockholm 2004
[3] P. Wyatt “Property Valuation: In an Economic Context”, Blackwell Publishing 2007