Whitepaper
The Residential Investor Jigsaw Part One: Yields
Julian Roche Chief Economist
Yields and Capitalisation Rates Investors in residential property, for the most part, take a close interest in the income they may wish to receive from the real estate they buy: what is typically described as the yield of the property. Calculating residential property yield is, in principle, no different from any other real estate. It is Net Operating Income (NOI) divided by value. And just as with other real estate, when market values rise, unless rents also rise to the same extent or more, yields will fall. In practice, there are a number of definitional and calculation issues that complicate both investor decision-making, in general, and comparing properties and markets, in particular. The first major issue should be framed in terms of the difference between the yield and capitalisation rate for a property. In financial theory, market capitalisation rates for freehold real estate should be determined by the risk-free nominal rate of return plus the risk premium (RP) less the expected growth rate, with an allowance for depreciation1. In practice, as those making this observation themselves readily conceded, real estate markets are more complex, and less transparent, than financial theory requires for this equivalence to hold. Investors are not even certain about what risk premium they should be using. It is always best to turn to the market rather than to theory. The market is where one can discover cap rates. This difference in practice is not to suggest that the difference between specific properties and the market does not matter just as much. Rode & Co provided what has become the classic distinction between yields and capitalisation rates. They pointed out that especially when inflation is low and market conditions are changing rapidly, existing leases can have a considerable influence over how NOI is calculated. Whereas the standard capitalisation rate is the expected net operating income in the first year of an investment, assuming the apartment or villa is let at open-market rentals, divided by the purchase price, the initial yield is defined as the first year’s actual net operating income, based on existing, actual leases and other income reasonably expected, divided by the actual purchase price. In their example, market rentals are growing by 5% per annum, but are contractually twice that. After just three years, the contractual rentals will be 15% higher than market rentals. Clearly, the standard capitalisation rate and the initial yield will be very different. In fact, they will only be the same at the exact time when an apartment or villa is let at an open-market rent. After that, if the lease is any longer than one year, they will diverge: if market rents grow slower than contracted rents, as they tend to do in the downswing phase of a real estate cycle, then market capitalisation rates will be lower than initial and running (current) yield, and vice versa. Rode argued2 that of the two yields, the capitalisation rate is the only valid and appropriate yardstick to evaluate the market value or price of a property. This is so because it standardises the rental assumption by assuming market rentals, which will overtake existing leases and therefore dominate the valuation within a few years, unless the property is held on a very long lease, which is unusual for residential real estate, even in the Gulf. This explains why for many residential markets, agents calculate NOI either going forward, for the next twelve months, or generalised from a particular historical period, whether three, six or twelve months.
1 Crosby, N., Jackson, C. and Orr, A. (2016) Refining the real estate pricing model. Journal of Property Research, 33:4, 332-358, DOI: 10.1080/09599916.2016.1237539. 2 Rode & Co (2005) Don’t confuse net income yield with a capitalization rate. Available at: https://rode.co.za/node/5138 Retrieved 31 October 2019.
In practice, US advisors Green Street, for example, quote NOI definitions on a pro-forma income basis3, but they are dealing with sizeable commercial properties. With much smaller residential properties and less experienced investors, the opportunities for confusion and, as a result, market arbitrage, are much greater. Buyers, beware. The second, well-known issue is that, to the great regret of real estate investors everywhere, NOI is an entirely movable feast. There are several explanations for this. First, the distinction between gross and net yields: expenses such as purchasing and transaction costs, vacancy losses, repairs and maintenance costs, insurance, service charges, agency fees, and property taxes can easily eat up almost half of the gross rental income of a residential property, especially if the first two components are included and NOI is measured over a relatively short term. These expenses also vary widely between properties, as well as between sub-markets in the UAE. Whilst an experienced investor will be able to forecast these losses and expenses, the market makes general estimates which may not be appropriate to individual properties or investors. This means that evidence derived from the market may not always be the right benchmark for individual properties. Second, capex: although residential property may not usually face the same kind of major capex considerations as commercial property, which is a help, including future capex (for example, on roofs, cladding, lifts, or air-conditioning) or not can still make a considerable difference, especially for apartments. Vendors of older properties may prefer to quote NOI independent of capex, and of younger properties, inclusive of it.
Why Do Yields Matter? Wise investors recognise that yields are an important, but not the only, measure that should drive their investment portfolios, which ought to be managed for, and judged by, total return in relation to risk – as measured, for example, by the Sharpe ratio (the average return earned in excess of the risk-free rate per unit of volatility or total risk). Significantly for the global market, however, the wave of increasingly elderly baby-boomers, all in need of stable cashflow in retirement, means that yield is acquiring ever more importance in the global fund management industry, as has been predicted since the beginning of this decade4. Traditionally, the investment class of choice for yield-conscious investors has been bonds, whether sovereign or corporate. But in an age of low, if not zero, interest rates and associated government bond rates, real estate yields are now casually quoted in the US, for example, as delivering twice the yields of instruments to which they had been regarded as competitors even a decade ago5. In 2017, BNP Paribas noted, ‘The yield gap between property and bonds is at very high levels compared to history…When measured over the last 15 years, data shows that volatility for property yields is between 30% and 40% of bond yields’6, which is surely an extraordinary testimony to the financial-gravity defying ability of real estate
3 Green Street Advisors (2019) Many Ways to Quote a Cap Rate [blog]. Available at: https://www.greenstreetadvisors.com/insights/blog/many-ways-to-quote-acap-rate Retrieved 31 October 2019. 4 Segal, J. (2012) Surge of Baby Boomer Saving Will Transform Capital Markets. Institutional Investor [on line] 19 November 2012. Available at: https://www. institutionalinvestor.com/article/b14zpp7lxtz6xk/surge-of-baby-boomer-saving-will-transform-capital-markets Retrieved 31 October 2019. 5 e.g. Kimmons, J. (2019) Net Rental Yield Calculation for Real Estate Investors. Thebalancesmallbusiness [online] 20 August 2019. Available at: https://www. thebalancesmb.com/net-rental-yield-calculation-for-real-estate-investors-2866812 Retrieved 31 October 2019. 6 BNP (2017) The Relationship between Bond Yields and Interest Rates: Some Thoughts. Available at: https://reim.bnpparibas.com/sites/default/files/2019-03/ BNP_Paribas_REIM-Property-yields-and-interest-rates.pdf Retrieved 31 October 2019.
to deliver returns at the very edge of the Sharpe curve, as recent research has shown7, virtually defining the efficient frontier of investment. As a result, investment allocations from pension funds to real estate have risen from around 4% in 2001 to 10% more recently, with little sign that the transition has ended. As AMP Capital recently observed, ‘With the baby boomer generation entering advanced retirement in the 2020s, annuity incomes will become the dominant investment strategy, but where to place it in the current real estate cycle is challenging’8. In developed countries, residential property has not been of much help in developing a yield-based real estate investment strategy. Generally, within the range of alternative real estate investments, residential yields have always been considered to likely be less volatile than commercial property, as in the popular view, ‘people will always need somewhere to live, whereas businesses can and do go out of business’9. As a result, they have traditionally also been lower. Commercial assets typically, as a result, employ much lower levels of debt, with Australian Stock Exchange-listed real estate trusts, for example, carrying an average of 30% debt on their balance sheets, compared to 70% or even more for typical buy-to-let residential investments. It should be recognised, however, that as the percentage of owner-occupied properties in a developed market such as the UK falls, as it has been doing, residential real estate stands to lose its relative lack of susceptibility to market conditions and lose both those relative qualities. Another way of putting this is to suggest, albeit tentatively for the time being, that residential property viewed by millennials, in particular, is becoming just another type of commercial real estate; there is some evidence for this already, for example from India, as noted below. Cyclicality also matters. In rising markets, yields will tighten as rents, especially when contract periods are longer than six months or a year, will fail to keep pace with market conditions, and vice versa. What ultimately matters to investors who are concerned about yields is not the initial yield. It is not even the running yield of actual properties over time – that is, comparing current valuations of properties with existing leases – which in a rising market tend to decline more than initial yields for comparable properties. No, what matters to investors is a more complex and necessarily opaque figure: the value to them today of the future yields of the property, year by year, compared to the purchase price, over the projected holding period. We may call this average future yield. It depends on future rent rises, and in turn, on macroeconomics as well as the obsolescence or otherwise of the property they are analysing. Yield-seeking investors are therefore as dependent on when they buy in the cycle, and on accurate forecasting, as those exclusively concerned with capital gains, or what is ought to matter to them. They should also be interested in how long their property will stay ‘fresh’, which will depend on both local geography as well as the measures they can take to increase their yields, whether by judicious refurbishments, sophisticated marketing - including the standard tools of the trade for commercial property such as rent-free periods, renewal options and even turnover rents – renting by room, or minimising any void period, always the darkest enemy of the residential real estate investor, through careful management of the headline rent.
7 Melser, D. and Hill, R.J. (2018) Residential Real Estate, Risk, Return and Diversification: Some Empirical Evidence. The Journal of Real Estate Finance and Economics 59(1), 111–146. 8 Dixon, L. (2019) Rethinking property investment in the hunt for yield. AMP [on line] 5 April 2019. Available at: https://www.ampcapital.com/au/en/insights-hub/ articles/2019/april/re-thinking-property-investment-in-the-hunt-for-yield Retrieved 31 October 2019. 9 Hardy’s Real Estate (2015) Yield: what is it & what drives it in commercial real estate? Available at: https://www.hardysrealty.com.au/media/Yield-what-is-it-whatdrives-it-in-commercial-real-estate-/126.aspx Retrieved [from cache] 31 October 2019.
Residential Yields in International Markets Analysis of international real estate investors during a local boom has shown that as residential property prices increase, rental yields generally fall. This is due to the large amount borrowed by investors compared to what they receive in rental income. Australia has been a case in point: rents in Melbourne and Sydney, in particular, rose, but failed to keep pace with prices. Banks may have said that in their opinion, yields of below 5.5% suggested property overvaluation, but no one was listening to them. Much the same applied during the global boom in a market such as London, whereas Hong Kong residents invested in lieu of putting their money into savings accounts that generated zero or even negative real returns, completely unlikely to outpace even moderate inflation, let alone real estate prices. By contrast, during the boom, gross rental yield from a London residential property could be between 4-6%, plus any growth in value.10 Clearly, as prices rise yields fall and this tendency may accelerate, certainly contributing to a choking off of any boom11. What has now changed is that the problem of yield has now spread to other markets which have hitherto been regarded as ‘developing’ and therefore immune to this kind of risk. The slowdown in the global economy, which ‘ought’ to have done to real estate markets everywhere what has happened in Australia, has not had its expected effects everywhere. One of the most obvious examples is China, where yields on residential property got so very low, at 1-1.5%, that some investors have been reluctant to let out their properties at all. In India, yields on residential property have fallen to historically low levels, around 2-4% per annum in cities . Although striking differences between localities are revealed by the most recent Magicbricks residential real estate report for Mumbai13, possibly accounted for by data variations in transactions, the overall perspective is exactly that was summarised by the Mumbai World Property Show: across India as a whole, residential yields are an average 3%. With interest rates poised to rise, and with attractive returns available in bank fixed deposits, public provident funds and other instruments such as stocks and mutual funds, the lucrativeness of residential real estate as an investment class in India has, they suggest, lost its sheen. Magicbricks does have three suggested solutions for the investment yield problem in India. First, they suggest investing in affordable homes, where yields can still be above 3%. Second, they point out that in micro-markets and some towns and cities where property values are lower, yields can be higher, although still only a shade above 4%. Finally, the possibility now exists to invest in co-living arrangements for millennials, where yields can reach as high as 8%14. Even an Australian investor could surpass that if they were prepared to stretch the definition of ‘residential’ to include senior living or childcare centres15. The problem, however, is that all these suggestions carry one penalty: increased risk, for example from long leases and client demand. It is then of little surprise that Indian High Net Worth Individuals (HNWIs) are looking to the outside world for their residential real estate investments. Where should they look?
10 Geman, H. and Velez, T.M. (2016) Ownership Yield and Prime Real Estate in Alpha Cities. The Journal of Wealth Management 19 (3) 116-130; DOI: https://doi.org/10.3905/jwm.2016.19.3.116 11 Altmann, E. and Yang, Z. (2017) Here’s why Chinese investors spend big on Australian property. Busjness Insider Australia [on line] 2 May 2017. Available at: https:// www.businessinsider.com.au/heres-why-chinese-investors-spend-big-on-australian-property-2017-5 Retrieved 31 October 2019. 12 https://www.worldpropertyshow.in/assets/img/wpis-brochure.pdf 13 Magicbricks (2019) Property Rates in Mumbai. Available at: https://www.magicbricks.com/Property-Rates-Trends/ALL-RESIDENTIAL-rates-in-Mumbai Retrieved 31 October 2019. 14 ET Contributors (2019) What kind of residential real estate can get you higher rental return on investment? Times of India [on line] 22 April 2019. Available at: https://economictimes.indiatimes.com/wealth/real-estate/what-kind-of-residential-real-estate-can-get-you-higher-rental-return-on-investment-find-out/ articleshow/68962479.cms?from=mdr Retrieved 31 October 2019. 15 Charter Hall (2014) Beyond Core Real Estate Investing – What are the Opportunities? 26 June 2014. Available at: https://www.charterhall.com.au/News/newsarticle/2019/02/11/beyond-core-real-estate-investing-what-are-the-opportunities Retrieved 31 October 2019.
MENA Prime Residential Rates and Yields The Gulf, evidently, is one of those potential investment locations, and Indian foreign investors head up the list in the UAE. A comparative review of high-level gross rental yield data from the Global Property Guide (GPG)16 begins to explain why. On its list of eighty-nine countries, the UAE (Dubai) ranks by yield 36th, at 5.19%, which one might at first sight think entirely unexceptional. When one looks at the countries that have higher yields, however, the relative attractiveness of the UAE stands out very clearly. Amongst the developed country opportunities, there are only a handful of European countries, mainly in Eastern Europe, notably Ireland (7.09%), Poland (5.5%), Croatia (5.43%), Hungary (5.24%) and Portugal (5.45%), that rank higher, along with New Zealand (5.48%). By comparison to the Gulf, however, international (non-EU) investors – including British investors, after Brexit - face significant restrictions in all these jurisdictions. They also involve taking on equally significant currency risk for USD investors. Finally, all of them are taxable jurisdictions, and the after-tax rental yields will look less attractive than the figures quoted above. The same problems are also faced by potential investors in the developing countries that rank higher than the UAE, to which can be added political uncertainly, as in Indonesia (7.09%) or Egypt (9.4%). For an explanation, one might suggest that in most parts of the Gulf, the transition to viewing residential property as a form of commercial property has already occurred. This factor alone could explain the apparent investor arbitrage available. Moreover, as Cavendish Maxwell research indicates, far from presenting a homogenous pattern of yields to the potential investor, individual MENA markets are currently experiencing very different yields. Cavendish Maxwell data based on transactions shows that yields in both Dubai and Abu Dhabi range from 4-7%, quite close to the GPG estimate, but suggesting that even in the most developed and populous of the emirates, individual localities may provide better opportunities than the average. A striking comparison is with Morocco, clearly in the developing country category but where yields are at a similar level, at around 5-6%. A slightly more yield-driven investor could buy in Oman, where Cavendish Maxwell suggests yields exhibit a wider variance, between 5-9%. On the other hand, an investor for whom yields are a dominant investment concern might choose Bahrain, for instance, where residential property can be purchased with a yield between 7-11% yield, or Kuwait at 8-12%, each of which is significantly greater than all but 17 and eight, respectively, of the 89 countries in the GPG guide even for the lowest of these estimates. At the highest, none of the 89 countries could match these returns, not even Jamaica (9.75%). A more adventurous investor could choose Riyadh, where residential property can still achieve double-digit yields, 10-12% according to Cavendish Maxwell. Vacancy rates are high, however, with time-to-let periods certainly exceeding historical averages, so this high-yield level is accompanied by significant dispersion around the mean, which amounts to risk for the investor. This is one explanation for the wide range of yields in Jeddah at 5-10%, but even the mid-point of these estimates places these Saudi Arabian cities well ahead of most world cities for residential yield. The exception is Dammam, at 3-5%, where investors will have to look to the very different market conditions there for a return of another sort17. If even these returns and risks are not sufficient, then the investor could turn to Cairo, where rental yields for residential property are still up around 12-16%, in a market that has already experienced a significant devaluation against the USD. In fairness, the GPG suggests a figure of only 9.4%, but even a rebalancing of all the GPG data against the Cavendish Maxwell benchmark still leaves the international investor with very few less risky alternatives to Saudi Arabia, Bahrain or Kuwait. Softening markets might of course take Gulf yields in either direction in the short term, but if the market follows historical trajectories worldwide, yields might even rise in the next few years.
16 Global Property Guide (2019) Rental Yields: Why Are They Important. Available at: https://www.globalpropertyguide.com/rental-yields Retrieved 31 October 2019. 17 Capital growth, to be covered in the next part of the Jigsaw.
Yields in Sub-Markets Just as in India, the UK or Australia, investment in UAE sub-markets can pay off in terms of residential property yields. Three ways to characterise sub-markets are of known importance in the determination of yields. The first, perhaps, is location. In Dubai, most localities have all in recent years shown consistent betterthan-average performance, both for apartments and villas. Property Monitor data shows that the current ‘top ten’ localities for apartment rental yields have maintained their position ahead of the pack for several years now. Each of these can return yields above 8%.
Apartment Yields (%) in Dubai Locality
Sept-16
Sept-17
Sept-18
Sept-19
Uptown Motor City
8.3%
8.6%
7.9%
8.0%
Emirates Living
7.5%
8.4%
7.9%
8.1%
IMPZ
8.5%
8.4%
8.2%
8.2%
Zabeel (World Trade Centre Residences)
7.1%
8.3%
7.9%
8.4%
8.8%
8.4%
8.5%
City Walk Jumeirah Lakes Towers
7.9%
9.2%
8.5%
8.6%
Al Furjan (Avenue Residence)
7.6%
8.8%
8.5%
8.7%
Jumeirah Village Triangle (Imperial Residence)
9.0%
8.7%
8.4%
8.7%
Dubai Sport City
9.6%
8.9%
8.7%
8.8%
Discovery Gardens
9.0%
9.4%
9.1%
8.9%
This makes a good comparison with the lowest ten localities for yield. The actual comparative advantage of a 2% average yield difference over a ten-year holding period, in the absence of any change in capital value, would depend on the investor’s reinvestment rate. To calculate a present value, it would also depend on the investor’s time preference. But assuming the two are equivalent, a 20% comparative performance advantage over a decade is evidently a material difference.
Apartment Yields (%) in Dubai Locality
Sept-16
Sept-17
Sept-18
Sept-19
Dubai Residence Complex (Sky Court Towers)
8.6%
2.9%
2.9%
3.1%
Dubai Marina
6.4%
5.6%
5.4%
5.5%
DIFC
6.5%
5.4%
5.2%
5.5%
International City
8.8%
5.7%
5.4%
5.6%
Palm Jumeirah
5.9%
5.9%
5.8%
5.8%
Downtown Burj Khalifa
5.7%
5.8%
5.7%
5.8%
Remraam
8.0%
5.9%
5.8%
5.8%
Culture Village
6.7%
6.2%
5.7%
6.0%
Jumeirah Beach Residence
6.0%
6.3%
6.3%
6.3%%
Business Bay
5.9%
6.7%
6.4%
6.4%
The explanation for these kinds of differences evidently lies within the socio-economic composition of the individual sub-market and the level of service charges, as well as the completion of individual infrastructure projects which are either under construction or in the planning stage and, where relevant, local legislative and boundary issues; although these are less important in the UAE and elsewhere in the Gulf than in jurisdictions such as the UK, where sub-market localities still influence such issues as schooling and local taxation. The logic of demand and supply is impeccable, however, in this case, higher yields are associated in a mature market like Dubai either with new districts, or those that find less favour with owners and tenants alike. This may actually be associated with succeeding less in maintaining that ‘fresh’ ability to command premium rents, but prices have overtaken rents on the way down and yields have risen as a result. Investors are constantly faced with the shifting boundaries of sub-markets as well, which makes long-term statistical analysis of variation difficult. Still, a similar pattern can now be found emerging across the Gulf in cities such as Riyadh, Jeddah, Muscat and in Bahrain, and this can be expected to develop in importance over the next decade. Second, apartments, especially smaller apartments, have generally produced higher yields, as the charts below for villa yields demonstrate for Dubai, but this may be more evident in gross than net yields, given service charges and vacancy rate considerations. It is noticeable how relatively stable villa yields have been over recent years, somewhat more so on average than apartments.
Apartment Yields (%) in Dubai Locality
Sept-16
Sept-17
Sept-18
Sept-19
Al Furjan Villas
5.1%
5.0%
4.8%
4.8%
Arabian Ranches
5.6%
5.4%
5.4%
5.4%
5.4%
5.3%
5.1%
4.6%
4.3%
4.6%
4.6%
4.4%
4.6%
Arabian Ranches 2 Dubai Silicon Oaisis (Cedre Villas)
4.8%
Falcon City of Wonders Motor City (Green Community Motor City)
5.5%
5.3%
5.2%
5.0%
Jumeirah Golf Estate Villas
4.2%
4.1%
3.9%
4.1%
Jumeirah Islands
3.7%
3.6%
3.7%
4.0%
Jumeirah Park
5.4%
5.2%
5.1%
5.2%
Jumeirah Village Triangle Villas
5.6%
5.1%
4.9%
5.2%
Mohammad Bin Rashid City (Polo Townhouse)
5.3%
5.1%
4.6%
4.7%
Mudon
5.7%
5.2%
5.0%
Reem
7.1%
6.8%
6.7%
Palm Jumeirah - The Fronds (Garden Homes)
3.0%
2.9%
2.9%
3.1%
The Villas
4.8%
4.7%
4.5%
4.6%
Dubai Investment Park
5.7%
5.4%
5.2%
5.6%
Dubai Sport City (Victory Heights)
5.6%
5.4%
5.2%
5.3%
Emirates Living
5.5%
5.3%
5.2%
5.7%
Third, short-term lettings, for example, to host events, or via Airbnb, have undoubtedly created a subclass of residential property letting which has been able to achieve returns significantly greater than the residential letting average. As yet, however, this sub-class remains relatively small by comparison to the overall market, and there must also be important questions to raise over the sustainability of supranormal returns obtained through this means: if higher short-term rents are balanced by longer void periods, as seems quite possible, then overall returns may be no higher, and even lower, than obtained through conventional lettings. Stable rents are, after all, a pre-requisite for the effective use of any form of capitalisation estimate18.
18 D’Amato, M. (2017) Cyclical capitalization and lag vacancy. Journal of European Real Estate Research 10(2), pp. 211-238.
Conclusions Comparing residential yields in the Gulf, especially in the UAE, with comparable jurisdictions worldwide strongly suggests that, at least at present, yield-driven investors in an increasing range of international markets beset by lack of opportunity would be well-advised to put the Gulf high on the list of possible destinations for their investment. The absence, as yet, of corporate and individual tax benefits all investors, whilst those denominating their returns in USD obviously have the additional advantage of the currency peg. Closer examination, however, reveals that such investors should not expect all parts of the entire region, or even of any one jurisdiction, to be of equal attractiveness. Close attention not just to national, or even city, but to individual sub-markets, which could be summarised as local due diligence, also plays a decisive role in achieving successful yield-based residential investment. But investment yields are only one part of the residential investment jigsaw. The second part, capital values, is equally or more important in determining overall investment return and will be addressed in the next white paper.
D U BA I
ABU DHABI
M U S CAT
2205 Marina Plaza Dubai Marina P.O. Box 118624 Dubai United Arab Emirates
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T: +971 4 453 9525
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www.cavendishmaxwell.com