Blog - Commercial
What is Commercial Real Estate Yield & How to Calculate It
As equity markets continue to behave like hormonal teenagers since the end of the summer break, investors are understandably scouting around for more stable assets.
Bonds and cash are about as steadfast as you can get, however, persistent low-interest rates make them unattractive to investors chasing reasonable returns.
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.
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.
Types of Rental Yield in Commercial Property
A rental yield is not the same as a return on investment. A return, or total return, is the sum of what an investment has earned in terms of rent and it is retrospective. Rental yield 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 yield – gross and net.
To arrive at a gross yield, an investor will multiply the weekly rent by the 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 $2000 a week to lease a 400 square metre warehouse which cost the purchaser $3 million. The gross yield will be 2000 times 52 (104,000) divided by 3 million, and then multiplied by 100 to arrive at a percentage. In this case, the gross yield is 3.46 per cent. A standard rule of thumb is that a gross rental yield above 7 per cent is optimal if you want to achieve a positive cash-flow asset.
In the case of our example, 3.46 per cent 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.
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 are variable and it is important to subtract both. Fixed costs include things like purchase expenses, stamp duty, insurance, council rates and taxes. Variable costs cover things like fit-outs, general repairs and maintenance, interest and loan repayments, loss of rental income (if the property becomes vacant), rates, and property management fees.
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 per cent mark.
Things to Consider about Rental Yields
As we have written before, commercial offices in the CBD and fringe areas currently average around 6 per cent yield. And, generally speaking, higher yields result in higher profits but come with some risk.
On the other hand, other risks need to be considered with lower yields. This scenario can be accompanied by a higher vacancy rate. The lower the yield, the longer it will take to find a tenant if your property is vacant.
Vacancies are an unfortunate consequence of your tenant going out of business or moving into better, bigger or smaller digs. Vacancy rates fluctuate and are impacted by a number of factors including the size of the property, the lease and the 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 with the strengthening local economy underpinning confidence in the business community. Demand from tenants also helped to begin to propel what had been rather sluggish rents.
However, when it comes to supply and demand, it is worthwhile being 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 towers are built that may entice your tenants and convince them not to renew their leases with your property.
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. And these obligations mostly centre around taxes.
Here are some to keep in mind:
- Gearing – positive gearing occurs when the rental return is higher than expenses. If your property is positively geared, you will need to pay tax on the return you make. Generally speaking, a positively geared property has lower capital growth potential. Negative gearing, on the other hand, occurs when rental income is less than the expense of outgoings (like interest repayments and building maintenance). If your property is negatively geared, it means you are losing income and may be eligible for a tax deduction.
- Tax deductions – as a landlord, you can usually claim tax deductions for a wide range of expenses, including insurance, maintenance and repairs, loan interest and fees, rates, advertising and property management costs, and depreciation.
- GST – when investing, you may also need to register for GST. Visit the Australian Taxation Office (ATO) website for more information.
- Capital Gains Tax (CPT) – if you lease out your commercial property and make a profit, a CPT is usually payable on the sale of your property. The amount you’re required to pay will vary based on the profit you made from the sale.
If you’re looking to make substantial capital gains, invest in a property with room for improvement. But remember, you pay tax on your capital gains, and higher capital gains generally reap lower yields.
To recap, knowing the rate of rental yield that applies to your commercial property, or one you wish to buy, 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. With our years of experience in commercial investment opportunities in the Sydney CBD and surrounding suburbs, you can rely on TGC to buy commercial property that brings you the best returns. Contact us today!