Returns Too Big To Be True Probably Aren’t

Returns Too Big To Be True Probably Aren’t

A current worry among many real estate investors around the world (the ones who haven’t lose their holdings altogether to foreclosure or other calamity) is that their property assets are worth less today than they were a few years ago. We’re all in this same boat. However, worth less is not the same as worthless. Remember that capital appreciation is only one play in the real estate investing game, and property investors paying attention, including my colleagues and clients, have turned to a different one. About 18 months ago, we began investing, not for growth, but for yields.

Properties that generate cash flow are a critical part of any portfolio. Invest in something that throws off a decent yield, and you’re happy to hold on to that property even if its value drops. You don’t mind waiting for potential recovery, as long as the cash flow remains stable.

Rental properties come in different types: long-term rentals, short-term rentals, condo-hotel units, even farmland. Generally speaking, your net yield will work out more or less the same across the board, in the same range of 5% to 8% per year over the long term. However, arriving at and certainly projecting your true net yield can be complicated, as the expenses of owning, maintaining, and renting vary market by market. This is why many real estate types (especially those trying to sell you on a particular opportunity) speak in terms of gross yields.

Don’t make this mistake. Drill down to a net figure.

The rule of thumb for long-term rentals in the United States is 1% of the property value per month, or 12% gross yield per year. However, the net yield on that gross could be less than 5%, depending on your costs. Depending on the state where you’re operating, for example, property taxes can take a big bite out of your gross. By way of comparison, the gross yield on a rental I own in Panama City is 9% right now. My net in this case is more than 8%, thanks to low costs and no property taxes.

Another point when projecting and tracking your yields: Understand the difference between making your calculations on original purchase price versus current value. Rental yields work like bond yields. If the property value goes down and the cash flow remains the same, then the yield goes up. And vice versa. Calculating current yields on the purchase price of a piece of property can lead to bad decisions. Especially if you’ve owned the property for a long time or prices have recently spiked.

Returning to the Panama City rental example from above, the net yield based on purchase price would be more than 13%, as I bought the apartment several years ago when prices were much lower than they are today. That yield is misleading. If I sold the property and reinvested the proceeds in another investment, I wouldn’t be able to earn the same yield on the greater capital amount.

Yields are the name of the game right now, so, I say again, as you set off in search of them, be sure you understand how to calculate and analyze them. This is critical to your ability to compare different opportunities. A colleague in Bali got my attention last year by quoting rental yields of up to 18%; however, when pushed for details, it turned out that true net yields are running more in the range of 5% to 6%.

References to exceptionally high yields are one of two things–blatantly untrue (once you drill down to true net) or a market distortion creating a window of opportunity that won’t last long. A few years ago, for example, you could, in fact, earn double-digit net yields from a beach rental in Punta del Este. After a couple of years, though, the gap between cost of acquisition and annual rental revenues narrowed, and, today, net yields in this part of Uruguay are in the range of what you should more or less expect generally–5% to 8%.

As I’ve mentioned, Panama City continues to offer opportunity for better-than-average net yields. Where else is that true?

The Philippines. I’ve seen one condo-hotel offer quoting net annual returns of as much as 19%. However, after further analysis, I realized that that figure is dependent on what I believe was an unrealistic ratio for splitting revenue between owners and the management company. Management was promoting a 75/25 split, with 75% of net operating revenues going to the owners. I don’t see how a split like that could continue long term. However, even if that ration fell to a more typical split of 60/40 or 50/50, the net returns would still be excellent.

Other deals I’m finding in the Philippines also quote higher than average net returns. There’s a reason for the distortion. The condo-hotel units are selling at prices based on local real estate values and local construction costs. Meantime, hotel rates in the tourist areas (where you want to invest) are based on what the foreign tourist clientele currently can afford and is willing to pay. These premium rates relative to the capital cost of the condo-hotel properties is creating the kind of market distortion you want to be looking for.

Good net yields are also to be found right now in the Algarve, if you buy right. With distressed developers still trying to move close-out inventory, it’s possible to find properties capable of generating net yields at the upper range of typical–that is, close to 8%. The key (to state the obvious) is to buy units with the greatest rental potential. This comes down to size, location, and amenities.

Another key is the management company, but we’ll leave that discussion for another time.

Lief Simon


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