Know the difference between Cap Rates & Initial Yields

Posted On Wednesday, 26 November 2008 02:00 Published by eProp Commercial Property News
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When purchasing a commercial investment property, most people regard the initial yield in year 1 as the cap rate. That is fine as long as the market rentals and the contractual rentals are similar

Property-Housing-ResidentialHowever, when the market rentals differ to the contractual rentals, this distinction can become a costly mistake!!.

For example;

1,000 sqm at say R120/ sqm = R120,000 in year 1, escalated by 10% p.a. contractually equates to R175,692 in year 5.
Should the market rental only go up at say 5% p.a., then after 5 years this is only R145,861.  The contractual income streams of the property will be roughly 20% above market.

Hence, if sold at say a market cap rate of 10%, would mean that it's initial yield should be 12%.  Worded differently, one could buy the property at a 12% yield, but only a cap rate of 10%.

The scenario in worldwide commercial property at the moment relates directly to this understanding of cap rates vs initial yield.  In the UK, one can pick up good investment properties at initial yields of around 9%, BUT what is the intrinsic long term cap rate if the market rentals go down at 2% p.a. for the next 4 years?. (as has been reliably predicted by property economists). Minus 2% p.a. = 94% of the starting rental over 4 years (the period predicted by economists before true rental growth may be seen again), hence a property yielding 9% currently, may in effect have a cap rate of only 8,5% - AFTER 4 YEARS, WITH NO RENTAL GROWTH.
 
In SA, we have been lucky in recent years as our rental growth has been excellent in nominal terms which has saved most property investors, but with the bleak worldwide economic outlook, we may very well be facing a different scenario in 2009.  Property investors need to take a very close look at Initial Yields vs Cap Rates  ....  they ARE different and can be used to one's advantage, whether one be a purchaser or seller.



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