Bonds and cash are about as steadfast as you can get, however, persistent low-interest rates make them unattractive to investors chasing reasonable returns. And as equity markets continue to behave like hormonal teenagers at the end of the summer break, investors are understandably scouting around for more stable assets.
Over the long term, commercial property is an asset that has also mostly behaved with the maturity of interest-based investments. The asset class’s steady-as-she-goes profile has provided fair stability in portfolios, balanced against rental yields that in the years after the Global Financial Crisis may have been less than mouth-watering.
And now, as a shortage of available properties in some sectors applies a pincer-like squeeze on the market, sluggish rental yields are beginning to sharpen nicely, thanks to healthy property prices.
For example, in May 2019, it was reported that the vacancy rate in Sydney CBD for commercial property was set to stay under 5% until at least the end of 2020. Earlier this year, it was also reported that Melbourne’s CBD commercial office space vacancy rate had hit a 10-year low of 3.2%.
This lack of available commercial space increases the rent on occupants renewing tenancies and available offices on the market. However, if your priority is less to do with cash flow returns and more about balancing your tax return, then it is worth understanding how yields work.
A rental yield is not the same as a return on investment (ROI). ROI, or total return, is the sum of what an investment has earned in terms of rent and it is retrospective. Rental yield, on the other hand, uses the income of a property and other metrics to measure how the property is likely to perform in the future, especially with regards to managing your tax position.
There are two types of rental yields to get your head around – gross and net.
To arrive at a gross yield, an investor will multiply the weekly rent by 52 weeks of the year. That figure is then divided by the price paid to buy the asset.
For instance, let’s say a tenant is paying $2,000 a week to lease a 400 sqm warehouse, which cost the purchaser $3M. The gross yield will be $2,000 multiplied by 52 ($104,000) divided by $3M and then multiplied by 100 to arrive at a percentage. In this case, the gross yield is 3.46% A standard rule of thumb is that a gross rental yield above 7% is optimal if you want to achieve a positive cash-flow asset.
In our example, 3.46% does not meet this test. However, a negative cash-flow asset – one with a low gross yield – will provide opportunities to write off losses against tax. So, if you are looking for an investment that will help your tax return stack up legitimately through negative gearing, calculating the gross yield should inform your purchase decision.
Note: it’s worth mentioning that there has been talk of abolishing negative gearing in Australia, so this may not always be an option in the future.
Calculating a net yield involves subtracting all the costs associated with owning the property, other than the cost of the mortgage, before multiplying it by 100 to achieve a percentage.
Some of these costs will be fixed and others will be variable. And it is important to account for both.
A net yield calculation more incisively informs a decision about whether a property will be negative or positive cash-flow generating if the gross yield calculation is borderline around the 7% mark.
As you know, commercial offices in the CBD and fringe areas currently sit between 5-6% yield. And, generally speaking, higher yields result in higher profits but come with some risk – the main being higher vacancy.
For instance, an ageing building in an undesirable location with shorter lease terms, tenanted by lesser-known businesses will usually attract a higher yield (say 8-10%) than a Premium or A-grade property rented to stable, well-known businesses (5%-6%) on a long-term lease.
Vacancies are an unfortunate consequence of your tenant going out of business or moving into better, bigger or smaller digs. Commercial property also tends to be influenced more by the overall economic picture than with residential property. So, if a downturn hits, it’s possible your yields will be affected in the future.
Vacancy rates fluctuate and are impacted by a number of factors including the size of the property, the lease and market supply/demand. While you cannot control fluctuations in market vacancy rates, you can reduce your risk for vacancy by securing a good, long-term tenant.
Over a year ago, we entered a cycle that saw vacancy rates begin to fall as demand for leases grew. This trend was underpinned by a strengthening local economy and an increase in business confidence. Demand from tenants also helped propel what had been rather sluggish rents.
When it comes to supply and demand, it’s important to remain aware of what development projects may be in the construction pipeline. A shortage of CBD offices one year can turn into a glut a few years down the track when new buildings open that may lure away your tenants.
It’s hard to factor in the impact of new developments on your yield. However, it pays to stay aware of what is planned for the areas you want to invest in.
Further “risks” or obligations arise depending on the capacity of your property to be positive or negative cash flow. And, thus, high versus low yield. These obligations mostly centre around taxes.
To recap, knowing the rental yield that applies to a commercial property can be an informative tool in the context of your portfolio’s overall ability to generate cash flow, profit, losses and, subsequently, tax deductions.
Understanding how rental yield is calculated can help you make smarter commercial real estate investments. But as commercial investments entail high-value transactions, getting the right advice to back your choices is imperative.
TGC brings years of experience in commercial investment opportunities in the Sydney CBD and surrounding suburbs. So, you can rely on TGC to help you purchase a commercial property that reaps the best returns. Contact a member of the TGC team today!