Net yields vs. Gross yields
Yields encountered in investment analyses and property valuations can appear in gross or net form. This fact can cause a great deal of confusion and be the cause of many misunderstandings, not only because of the sheer need to distinguish one rate from the other, but also because even in the literature on the subject and in everyday practice, different types of “gross” and different types of “net” can be distinguished.
The first, most important criterion for the division into “gross” and “net”
The first criterion that can be used to distinguish between gross and net yields is whether or not the costs of the real estate transaction are taken into account.[1] In particular, this refers to legal services and the costs of the transaction agent. Typically, these costs in Poland oscillate around 2% – 3% of the sale price.
In the Polish real estate market there is a fairly well established practice of not including transaction costs in valuations, i.e. not making any price/value adjustments for these costs. However, there are occasions when such expectations are raised by clients, most often German banks operating in Poland. There is usually a request to specify two variants of value, ‘with’ and ‘without’ transaction costs. It is therefore important to be able to distinguish between these types of interest rates and to analyse investment transactions accordingly and subsequently use these rates in valuations.
The net yield in this case is the quotient of the annual income from the property and the sale price of the property, plus transaction costs of the buyer.
The gross yield, on the other hand, is determined using the transaction price alone, without adding in the cost of sale.
Thus, it can be seen that by using the net yield in the valuation of the property, we will paradoxically obtain the gross value (i.e. including the costs of the sale transaction on the buyer’s side). However, since in Poland the net value of the property is usually determined, the gross rate (gross yield) should be used to estimate it.
Do you really know what the market is saying?
This raises the question of how many participants are aware of this yield distinction. It is always useful to know, if only to orient oneself as to which companies in the industry use net yields and which use gross yields.
Isn’t it great to report record low prime yields in a State of the Market report without going into such ‘minutiae’ as saying that these are net yields? There can also be a temptation to pose as an appraiser or firm that is pricing ‘optimistically’ because it is using ‘low’ yields. Who cares that these are net yields and to estimate the market value of the property using them the result will have to be reduced by the buyer’s transaction costs at the end anyway. The value will probably be the same as using “gross” yields but what a marketing effect. In any case, this is one of the reasons why it is useful to know that there are different types of yields, including in particular the distinction between net and gross rates according to the criterion cited here.
The second criterion for the division into “gross” and “net”
The second criterion for distinguishing gross and net yields is to use either gross or net operating income to determine them. Using gross income, we will determine the gross yield. On the other hand, using net operating income we will obtain the net yield. [2] Interpretative Note No. 2, already referred to, recommends that net operating income should be used to capitalise income.[3] It follows, therefore, that it is preferable to use net yields as well, although this only applies to the “net” resulting from the use of net income rather than gross income for its determination. Indeed, if one were to use the criterion of including in the transaction price the costs of carrying out the transaction, in Poland it is preferable not to include them and thus, as mentioned above, “gross” yields are preferred. This shows best how much confusion arises on this background and how erroneous conclusions can be reached without defining the basis for differentiating yields into ‘gross’ and ‘net’.
The third criterion for the division into “gross” and “net”
The third, and arguably the least common, distinction between net and gross yields is that resulting from taking into account the tax to be paid by the entity entitled to the property income. Disagreements on this point are fortunately less and less likely, as it is already commonplace to use pre-tax income for analyses of real estate investment transactions and thus to derive gross rates as a result. Indeed, the opposite solution could be subject to the error arising from the fact that different types of entities are subject to different tax rules. [4] Consequently, comparisons of yields in net form (i.e. net of tax) would reflect not only the investment attractiveness of the properties themselves, but also the status of the entities deriving income from them, which from the point of view of property valuation is irrelevant and could lead to errors in estimates.
Thus, it can be seen that we can encounter at least three different pairs of gross and net rates in different types of studies and market analyses, hence it is extremely important each time to understand the criterion for distinguishing them before any of them is used in the property valuation process.
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Wyrównana stopa zwrotu (equivalent yield)
Początkowa stopa zwrotu (initial yield)
[1] S. Jayce, J. Smith, R. Cooper, P. Venmoore-Rowland, „Real Estate Appraisal: From Value to Worth”, Blackwell Publishing 2006
[2] C. Brooks, S. Tsolacos, „Real Estate Modelling and Forecasting”, Cambridge University Press 2010
[3] Punkty 4.1.7. i 4.2.5 Noty Interpretacyjnej Nr 2
[4] E. Shapiro, D. Mackmin, G. Sams, “Modern Methods of Valuation”, wyd. 11, Routledge 2013