In a typical commercial real estate investment, there are two ways that investors can earn a return on their capital. The first is the income produced by regular dividend payments, which makes up a small but consistent portion of total returns. The second is the profit made on the eventual sale of the property. This comes in one lump sum at the end of the holding period, but it can be a major contributor to investment returns. But, being able to estimate these returns at the time of investment means that investors must be able to estimate the futures sales price of the property.
There are a number of ways to estimate the future value of the property, but in this article we are going to focus on one known as the Yield Capitalization method. We will describe what it is, how it is calculated, how it compares to more traditional valuation methods, and the pros and cons of using it to estimate value.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As part of our pre-investment due diligence process, we use a number of methods to calculate future value, including the Yield Capitalization Method. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What if The Yield Capitalization Approach?
Yield Capitalization is a commercial real estate property valuation methodology that uses a property’s yield to calculate the market value of a property.
As the introduction describes, investment returns come from two sources, regular income and the sale of the property. With this in mind, the Yield Capitalization approach is used to estimate property value at the end of the holding period so that investors can calculate their potential total return on investment. This is done pre-purchase and, if the result is favorable, investors may proceed with the purchase. If not, they may choose to abandon the purchase.
A More Advanced Version of The Direct Income Capitalization Approach
The most commonly used valuation approach is the Direct Income Capitalization approach, which takes the property’s cash flow in the final year of the holding period and applies a “capitalization rate” to determine value. More often than not, the capitalization rate is chosen based on recent sales of comparable properties and then current market conditions.
To estimate the value of a commercial property, the Yield Capitalization approach is more sophisticated than the Direct Income capitalization approach in two ways.
First, it uses the investment property’s yield rate, instead of the capitalization rate, which could be a better way to estimate annual returns. Second, it considers the medium and long term cash flow produced by the property, as opposed to year 1 Net Operating Income, which is often used in the income capitalization approach.
How Is The Yield Capitalization Rate Calculated?
The Yield Capitalization rate isn’t as much calculated as it is selected based upon an investor’s desired annual rate of return. Here is how it works.
When an individual or firm is considering purchasing a property, they construct a proforma – which is a projection of the property’s gross income, operating expenses (like property taxes), and distributable cash flow over a multi-year holding period. While a proforma is an estimate, individuals and firms put a significant amount of work into creating them and rely heavily upon them to make their purchase decision.
The last line in a typical proforma is typically labeled as “cash flow available for distribution” – which includes the net sale proceeds in the last year of the planned holding period. Using the “Yield Capitalization Rate” real estate investors discount this series of cash flows back to to determine the present value of the series of cash flows, which heavily influences their view on an appropriate purchase price for the property.
So, to sum up how the yield capitalization rate is used, there is a two step process used by real estate professional: (1) investors create a multi-year proforma of the rental property’s income, expenses, and cash flow available for distribution – inclusive of the sales price at the end of the holding period. Then, (2) these cash flows are discounted back to the present period using the yield capitalization rate to determine the value of the property. Another name for this technique is Discounted Cash Flow Analysis (DCF).
How Yield Capitalization Is Used to Estimate the Value of Commercial Real Estate, an Example
To illustrate how the Yield Capitalization rate can be used to estimate value, an example is helpful. Let’s use a very simple one.
Suppose that a multifamily investor is considering the purchase of a property that has an asking price of $1MM. Let’s also assume that the property produces $10,000 in annual income per year for five years and then it is sold for $1.2MM. Finally, for the sake of simplicity, assume that there is no debt used in this transaction and that the yield capitalization rate is 8%.These cash flows would look like this:
Year 0: -$1,000,000 (cash outflow for the purchase price)
Year 1: $10,000
Year 2: $10,000
Year 3: $10,000
Year 4: $10,000
Year 5: $10,000 + $1,200,000 (proceeds from the sale)
When this set of cash flows is discounted back to the present at 8%, the calculated present value is $856,626, which is clearly less than the asking price of $1MM. So, the benefit of this exercise is that it can be used as a reference point to determine if the asking price is reasonable or not. In this case, the investor may go back to the seller to see if they can negotiate the price lower.
Yield Capitalization vs. Direct Capitalization
At first glance, the Yield Capitalization and Direct Capitalization valuation techniques may seem very similar, but there are several key differences:
- Changes in Cash Flow: The direct capitalization method used the first year of stabilized net operating income while the yield capitalization approach looks at the cash flows for each year in the holding period. As such, it accounts for potential changes in cash flow over the entire holding period versus just looking at the first year.
- Taxes: The direct capitalization approach looks at pre-tax income, a metric otherwise known as net operating income. The Yield Capitalization approach looks at cash available for distribution, which is after debt service and taxes have been paid. As such it may be a more realistic measure since it reflects after tax income.
- Sales Proceeds: Since the cap rate approach looks at year 1 NOI, it does not account for a potential sale of the property in the future. The Yield Capitalization approach looks at all years of cash flow plus the major inflow upon sale. Again, this may make it a more precise valuation methodology.
- Price Appreciation: Similar to the above, the income capitalization approach looks at income only. Since the Yield Capitalization accounts for the sale price, it also accounts for potential price appreciation.
- Comparables: The cap rate formula depends upon data from comparable sales to calculate current market value, which can sometimes be tough to come by. The Yield Capitalization rate is selected in large part based on the investor’s requirements rather than a calculated value, so it does not depend on real estate market data.
For all of these reasons, many investors believe that the Yield Capitalization method is a more precise and sophisticated valuation methodology to determine the market value of the property.
Yield Capitalization in Real Estate Syndication Investing
From the descriptions above, it is easy to see that calculating a fair offer price for a complicated commercial property can be tricky and time consuming. It requires a significant amount of expertise and a high number of deal repetitions to do it correctly. Individual investors looking to purchase their own commercial property may find that they don’t have any interest in this level of research and analysis.
Fortunately, they don’t necessarily need it. A commercial real estate syndication – like the type we offer – is a deal structure that provides individual investors an opportunity to purchase a fractional share of a high quality commercial property. With this approach, investors get all of the benefits of commercial property ownership without the hassle of managing it (the syndicator does that work). For those seeking passive income, price appreciation, and the tax benefits that come with depreciation, this is a compelling option.
Final Thoughts On The Yield Capitalization Valuation Approach
Yield Capitalization is a commercial real estate valuation methodology that provides investors with an estimate of a property’s market value, and some insight into the potential return it could produce.
In many ways, it is a more sophisticated and precise valuation methodology than the more commonly used direct income capitalization approach.
Key differences include accounting for variations in annual income, incorporation of after tax income, and accounting for sales proceeds at the end of the holding period.
For many individuals, this level of analysis may be too much from both a time and expertise stand point. For those that fit into this category, investing in a commercial real estate syndication may be a compelling option.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.