Copyright David Lawson - Property Week 2004
What’s a yield? Pretty obvious really: the return on an investment. Something anyone involved in property investment would know. But what is the difference between a running yield, an equivalent yield, an initial yield, a redemption yield – and so on.
Textbooks are little help for the uninitiated. They sternly insist returns and yield are not necessarily the same and hairsplit into more than 50 variations. And that is just a start. Property is awash with jargon. So how do you cope with those embarrassing moments when the office junior [or, worse, the chairman] casually asks: ‘But what is gearing/securitisation/diluted net asset value/whatever?’
For the next few weeks, we will be taking a walking holiday through the foothills of finance, snapping some crucial landmarks and making far-too-simple notes about their meaning.
So let’s start with the elusive yield. Perversely, yields fall in good markets, which is more understandable when you realise that demand drives up property prices, which reduces the ratio of rents to capital. To avoid confusion, commentators say yields ‘harden’ rather than fall ‘soften’ rather than rise.
Now for the hair-splitting. The initial yield is based on annual passing rent. Beware of calculations using headline rent, which may not take account of concessions such as free periods. Some retail property is also moving to turnover rent, where a portion of the payment to landlords is linked to sales, so calculations are more complex.
Company reports often use investment yield or yield on present income to summarise returns on a portfolio, and current or running yield as a snapshot of past year’s performance. Valuers dig deeper, incorporating risks and potential for growth in what they call an all risks yield.
This is a theoretical method of comparison rather than a return rate but recognizes the real value of an investment lies not in what it earns today but over a period of time. If a property is close to a rent review or lease renewal, it will be valued by the reversionary yield based on the estimated, hopefully higher, rents to which rents are expected to rise. This will be set according to the ERV [estimated rental value], which reflects the worth at the rack rent for that property let on the open market.
Market reports quote sector benchmarks but these are often the prime yield, which is narrowly defined for a fully rented property of the best physical quality, the best location and with the best tenant covenant. Most investments would be better compared with average yields, but even then individual properties will vary according to lease lengths, covenant strength [the economic solidity of tenants] and time left before review.
Reversions are not always welcome. In a falling market property can be over rented [tenants are paying more than the market level]. Upward-only rent reviews are meant to protect investors but tenants will be unsettled, often willing to pay a reverse premium [lump sum] to get out of a lease. Valuers will often allocate uncertain areas as a marginal yield.
A rounded view of investment worth is encapsulated in the equivalent yield, which averages the initial and reversionary yield to produce a real income stream over time. This also known as the IRR [internal rate of return].
But that opens a whole new can of worms. Future income is worth less than that coming in today, so the IRR has to be worked out by DCF [discounted cash flow] methods which, as it says on the tin, discounts back to current value. This adjusts future returns by a set formula called the capitalisation rate – a logical label as it converts future income to present capital value.
Watch out for a confusing wrinkle. Equated yield is slightly different, building in assumptions about future rent growth drawn from general market knowledge. As stock market punters have shown, past performance is not necessarily an accurate guide to the future.
At the end of the process comes the gross redemption yield. This is seen more commonly in shares and bonds but can be a good disciplinary tool for property. Instead of vague predictions based on hope and judgement, investors can set a target for total returns [rent + capital growth] over a specific period. In fact, they will be doing this more and more as retail vehicles become more common and funds need to imply a target return to attract the man in the street.
They will work backwards from a target all-in return to decide whether the target yield can be achieved after making assumptions on growth. It also provides a benchmark for comparison with alternative investments such as gilts [government stock]. If the latter have a redemption yield of 8%, it makes little sense investing in an office or shop at 6%.
Comparison of asset classes can also lead to confusion over a plethora of similar terms. Shares can be rated by an earnings yield or dividend yield, calculated by profits net of corporation tax or dividends as a percentage of the current stock market price.References: Annual reports by British Land and Land Securities. Jones Lang LaSalle Glossary of Property Terms
Once upon a time in a remote and dusty office far, far away, a bean-counter was musing on life while photocopying the annual accounts when a revelation struck. The cost of every sheet would register within figures the machine was regurgitating. Yet the vastly more expensive building in which it stood might as well have been invisible.
Both were leased, so why the difference? Copiers are held on what are termed finance leases, assiduously listed among the minutia of costs and benefits. Buildings are classified as operational leases, a strange distinction under which rents never shown up in detail.
The pain of a discovering a potentially vast liability was excruciating. Over the years it spread via that strange telepathic connection between accountants to produce changes which could shake property to the core.
From next year under EU harmonisation rules, listed companies must prepare to include premises in their accounts. That means not just current rent payments but the potential outgoings for the life of a lease.
International Accounting Standard 17 appears yet another obscure EU regulation that makes little sense. It is not certain, for instance, how the system can work. Property could be split into the land beneath [an operational lease] and the building above [a finance lease]. With no clear line on how the rent is allocated, accounting and rent reviews become mind-boggling.
In any case, it seems academic hair-splitting, as recording future rents as a liability is balanced by a similar entry for the benefits of occupation as an asset. But the impact could be far reaching according to valuers who have been trying with increasing desperation to get the message across to property and finance directors.
‘The clock is ticking,’ says Adam Calman, corporate strategy partner with Cushman & Wakefield Healey & Baker. Profits could be hammered and some companies even go bust unless they realise the threat.
Future rents will be classed as a debt or liability, calculated at current or net present value [NPV]. These will count against current year earnings and some companies could see a 10% drop in profits in the first year, says CWH&B.
These reforms may shift the whole structure of the industry. Occupiers will press for shorter leases so the burden of future rents is reduced. Those committed to longer leases because they need time to pay off high fit-out costs will demand break clauses so the rent burden is calculated only five or ten years ahead.
Retailers could push harder for turnover rents, as these would be recorded as royalties and play no part in calculation of liabilities.
Occupiers could face bigger problems than landlords, however. This new method of capitalising leases may raise debt levels above gearing ratios agreed with lenders. Directors should check now for loopholes in covenants that would enable a change in gearing to trigger a call-in. Some funders might jump at the chance to renegotiate loans they consider ‘un-commercial’.
Private companies might feel rather smug about being left out of this latest EU directive but the new standard will percolate outwards. Most unlisted companies are likely to prepare financial statements this way in future, say Rob Hall and John Knowles of DTZ.
They point out that a further directive, IAS 40, controlling how investment property is treated in the accounts of both tenant and landlord, will add to the pressure for shorter leases. This could push up rents as landlords seek to cover increased risk.
And they warn about another pitfall which could stifle one of the most fruitful areas of finance over the last decade. Many owners have outsourced property to raise capital for core activities. This has the advantage of being ‘off balance sheet’, so gearing ratios have not been threatened. In future, these will be considered finance leases, and come back on the books to negate much of the benefit of sale and leaseback.
[A continuing glossary of financial terms]
Off-balance sheet finance - techniques which allow companies to incur debt, usually via associated companies or joint ventures, without this appearing in the consolidated accounts and affecting the gearing ratio.
NPV – net present value, calculated by discounting future income
Gearing ratio – total borrowings including bank overdrafts, less short-term deposits, corporate bonds and cash, as a percentage of equity shareholders’ funds.
Capitalisation - valuation in relation to expected future income (rental) stream.
Capital value - the value of an asset as distinct from its annual or rental value
Amortisation - reduction of a debt by periodic payments to repay the capital at the end of a period as well as cover interest on the outstanding balance throughout that time.
Weighted average debt maturity - each tranche of debt multiplied by the remaining period to its maturity and divided by total debt at the period end.
Weighted average cost of capital (WACC) - market cost of debt and risk-adjusted cost of equity capital.
An investment milestone slipped by almost unnoticed in the calm of the holiday season. Private investors across the world now hold more property than institutions.
The margin is slim - $4.9 trillion compared to $4.8 trillion, according to World Wealth Report 2004, by Cap Gemini and Merrill Lynch. But it shows an important shift as investors become more sophisticated in the hunt for better returns.
Blame it on the Hunwies. Just as Yuppies [Young Urban Professionals] transformed city life after the Big Bang 20 years ago, the High Net Worth Individual [HNWI] is doing the same for real estate. There aren’t that many: around 7.7m people hold more than $1m (£550,000) in financial assets around the world, according to the study. But their love affair with property reflects changes going on right down the pecking order.
This shift is often attributed to the flight from failing stock markets, yet Hunwies made most of their gains last year by shrewd moves back into recovering equities. But they also boosted property holdings from 15% to 17%, and this excludes the soaring value of their homes.
The move was relatively easy for most of this elite band. They live in the US, and can nip down to the local mall to pick up shares in a real estate investment trust [REIT]. Direct investment is more common this side of the Atlantic.
Commercial property is becoming a major component of the 100,000 self-invested personal pensions [SIPPs] that have sprung up since 1995. Interest rate rises have dampened enthusiasm recently but an extra boost is expected in two years when housing becomes a permitted investment.
This could also coincide with a UK version of REITs. In the meantime, investors have not been sitting on their hands. Property unit trusts [PUTs] and special vehicles like limited partnerships have boomed and now hold between £30bn-£40bn of property, according to a study by the Investment Property Databank and Oxford Property Consultants.
Corporate and local authority pension funds provide most of the capital but private investors are also making their mark. A handful of these trusts are ‘authorised’ to be sold to the man in the street. They stagnated for decades but Morley points out that one of the major drivers in its leap to the top spot in the league of fund managers has been growth in its authorised Norwich Property Trust.
Individual investors are also immune from new rules which have driven around £15bn of investment offshore. Stamp duty land tax [SDLT] is now imposed on trading within limited partnerships but private investors rarely, if ever, sell during the life of a fund, so they are not penalised, says Peter Roscrow of Close Brothers.
Off-shore status can be useful, however. These vehicles pay out gross of tax, which suites small pension funds and investors based abroad. Close Brothers was so overwhelmed with demand for its Fifth Special Opportunities Fund that the initial target of £6m was doubled and then tripled.
Minimum investment in such schemes is as little as £25,000, so it gives private investors a way into a market dominated by big spenders. About 40% of the new Close fund, run in partnership with Palmer to back UK regional development schemes, has been taken up by individuals and 50% by SIPPs.
Some critics berate steep fees for these kinds of scheme but Roscrow points out that with an internal rate of return of 20% over three to seven years, investors appear content to pay.
A further shift by private investors into property is expected following a shakeup in financial controls which will lead to a new class of authorised trusts. In the past these suffered because a large chunk of investment had to be in cash or shares to enable members to get their investment back quickly. The new ones will hold 100% in property with redemptions deferred for six months to enable managers to raise the cash.
Roscrow is unimpressed, as they will still pay corporation tax. But the Inland Revenue is understood to be considering giving unit trusts similar tax advantages to the UK REIT, both of which will be introduced around 2006. That would widen choice, as trusts are open ended, accepting continuous investment, with units valued according to the assets held. That compares with closed end REIT-style vehicles which are valued like listed companies according to the market value of their shares.
Developers are also looking at better ways to serve smaller investors. Trevor Silver, chief executive of Akeler, believes business parks could be set up as trusts, either individually or in groups and is looking at the possibilities for its schemes in Glagow, Leeds and Manchester.
Glossary of Property Finance
SIPP – self Invested private/personal pension
Securitisation - where assets are split into units or securities for rease of trading. Property company shares are one form; mortgage-backed bonds another.
Unitisation – similar to above to create a property unit trust [PUT]