Compromise may be the best we can achieve as we strive for internationally comparable yield data, as Michael Haddock explains
Trends in the real estate investment market are developing quickly. It is not long ago that the vast majority of real estate investors effectively confined their activities to a single country. Now it seems that regional investment is the norm and there are many genuinely global investors.
This internationalisation has always created problems of comparison. In all the mature markets, conventions for measuring the market have grown up independently and the measures used vary. This problem is not confined to real estate. For example, in the bond market calculation of accrued interest assumes a 360-day year in the US but a 365-day year in the UK.
For the purposes of strategic decision making in real estate investment there is usually little need to compare the absolute value of market measures between markets. For example, it doesn't matter much that gross take-up in Madrid in 2006 was higher or lower than in Brussels. It is much more important whether the trend in Madrid is up or down, or the level is higher or lower than the long-term average. All that matters is that the data are accurate and consistent within that market.
There is an exception, however: market yield.
Where one is looking at comparing two specific investment opportunities and real information is available, it is possible to calculate the ‘yield' by whatever consistent definition the investor chooses. At a strategic level, however, trying to decide whether to put one's resources into targeting opportunities in Paris (where the prime yield according to the local market convention is now 3.6%) or Milan (where it is 5.25%) might well be influenced by the underlying definition of these two numbers.
At first sight, this does not appear to be too complex. All one needs in order to put the two on a consistent basis is an understanding of the local market definition, a standardised definition, and estimates of the elements (such as purchase costs) needed to convert from one to the other.
Understanding the local market definition is sometimes more difficult than ought to be the case. Often the local convention is so ingrained into valuation methodology that many of the assumptions ‘go without saying'. However, it is just these automatic assumptions that need to be challenged to arrive at a full explicit definition of local market practice. Most UK professionals, for example, would say that market yields are quoted on a net basis (the net rent(1) divided by the total purchase cost(2)), as additional running costs faced by a landlord are generally recovered by way of a service charge and all purchase costs (legal and professional fees and tax) are taken into account. However, there are non-recoverable costs (such as rent review fees) that are normally ignored, but ought to be taken into account to arrive at a genuinely comparable measure.
Arriving at a standard definition that is applicable to all markets is a more intractable problem. The conventional approach to standardising yields across markets is to convert them all to a net basis.
The top of this equation is relatively straightforward, although VAT can complicate matters. However, the tax status of the buyer can have a big impact on the bottom half of the equation. In Portugal, for example, some local funds do not pay certain property transfer taxes and under the new regime in Italy, there is a lower rate for local funds.
This raises the question of whether the ‘standardised' definition should reflect a foreign or a local buyer. As the whole purpose of the standardisation process is to facilitate cross-border investment the logical response would be to assume a foreign buyer, but it is sometimes possible for a foreign buyer to obtain the same status as a local buyer by using a locally registered company as a vehicle for the purchase.
Assumptions on deal structure also have a huge impact on the net yield, particularly where transfer taxes are high. In Ireland, where commercial property transfer tax is 9%, it is very common to use special purpose vehicles (SPVs) that attract the rate of transfer tax of 1%. A notional yield of 5% assessed on the assumption that the buyer would pay the full rate of tax turns into a yield of 5.4% if one assumes that the deal would be structured within an SPV.
The use of an undifferentiated net yield to compare the ‘value' offered by different global property markets will therefore result in certain markets appearing to be less attractive than is actually the case.
The other natural solution is to use gross yield(3) as the basis for comparison. This looks an attractive solution, as yields on bonds and equities are typically quoted on a gross basis. However, this multi-asset case for using gross yield does not hold up for long. The difference between gross income and net income for bonds and equities is negligible (not always the case for property) and the round-trip costs (fees and taxes) of investing in real estate are very much higher, typically between 700 and 900 basis points compared with 70-100 for equities and just 10-20 for bonds.
Even when just comparing real estate markets the gross yield is a poor measure. In markets where the gross rent already includes a substantial amount for extra services such a measure would make the relative market return appear much higher than will in fact be the case. That said, the gross yield does have the benefit that it is relatively easy to convert into the net yield for a specific investor.
In conclusion, although the problem can be solved from the perspective of a specific investor, there is clearly no single definition of market yield that works for all investors and all markets. The unqualified use of a standardised definition may itself create more problems than merely reporting the yield according to local definitions if it misleads investors into thinking that they do not need to make their own allowances for individual circumstances. However, some sort of hybrid definition of market yield (such as net income divided by purchase price before costs) may be the most useful as an interim stage to an investor-specific net yield.
(1) The rent receivable, minus VAT paid on to the government and the non-recoverable costs of property maintenance and services provided by the landlord.
(2)The purchase price, plus legal and professional fees and non-recoverable property transfer taxes.
(3)Gross rent receivable divided by purchase price with no addition for fees or taxes.
Michael Haddock is director, research and consulting, CB Richard Ellis