For stabilized commercial properties with predictable income streams, the rental yield can serve as a helpful valuation tool and can be useful for benchmarking opportunities against one another. Whereas, for properties that needs improvements and income is not certain, return on cost is the better way to evaluate economic value.
What is Rental Yield Rate?
A rental yield rate is the rate of return investors expect to receive from a property during the first year of ownership, excluding the cost to improve the property and financing costs. In other words, rental yield rate is the dividend one would receive in the first year if the property were acquired with all cash. The rental yield rate is calculated by taking the Net Operating Income (NOI), which is the property revenue, minus the necessary operating expenses, and dividing it by the purchase price.
Rental Yield Limitations
For multi-tenant properties, especially opportunities where one is making several value-added improvements, the yield rate is partially irrelevant because of the instability of the underlying cash flows. For example, an office building that is 20% occupied may have a negative NOI as the revenues are insufficient to cover the operating expenses, thus resulting in a negative cap rate.
However, this could prove to be an incredible opportunity if the owner stabilized the property through reinvestment. To value these types of opportunities, we use a different method called Return on Cost.
What is Return on Cost?
Return on Cost is a forward-looking rental yield rate. It considers both the costs: A. needed to stabilize the property B. purchase cost and the future NOI once the property has been stabilized. It is calculated by dividing the purchase price by the potential NOI.
One uses return on cost to determine if one potentially generate an income stream greater than what one could achieve if purchased a stabilized asset today.
Conclusion
The above methods are two of the many ways investors can use to evaluate a real estate investment. It is imperative to understand yield rate and its limitations to know how to use it when valuing real estate.
Read Detailed Article Here: https://yieldspace.com/blogs/how-to-value-completed-commercial-properties
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