Yield Compression - Key Factors

Rental Yield

This is a common indicator to guage the performance of investment property. In simple terms, it is the percentage of rental return (Year 1) from your investment, assuming you pay cash for the investment property.

For example: Gross Rental Income $5.00m pa, with a Purchase Price of $62.50m

The Gross Rental Yield is 8.00%

To determine a Net Rental Yield you need to deduct various expenses such as Rates & Taxes, Insurance, Management, and all other general Building expenses.

Yield Compression

This is simply the reduction in the implicit yield paid for real estate in the investment market. Therefore, as prices increase the inverse applies to rental yields, as they decrease. This is called yield compression (or alternatively, commonly known as capitalisation rate compression).

For example: A property with an annual net rent of $10.00m pa with a yield of 8.00% would be valued at $125.00m. However, a reduction (compression) in the nominal yield to say 7.50% would increse the market value to around $133.30m (+$8.30m).

It is important to remenber that today's price also incorporates expectations about the rental income gains and potential future price of the property, by way of capital appreciation.

Key Drivers to Yield Compression

The low interest rate environment and continued strong interest in Australian Property should further drive yield compression for quality investment properties. This may result in the differential (spread) between property yields and Government Bonds to narrow over time.

The key drivers are:

  • Stable economy, political and monetary system

  • Higher property yields relative to fixed interest investment

  • Positive investor sentiment

  • Limited supply of quality retail, office and industrial properties

  • Volatile sharemarkets improve the sentiment for property investment

  • Increased asset allocation weighting for investment grade property

  • Quality assets with long weighted lease expiries, due to Bond like characteristics

  • Foreign investors seeking a relative safe haven in the Australia property market

  • High property investment returns in Australia, compared to international property markets

In Summary

The risk premium for Australian prime retail and office assets is expected to decrease (or remain stable at worst), and align more closely with global yield spreads. Given the prolonged period of low interest rates in Australia, there is the expectation of continued strong interest from both domestic and foreign investors. This is evidenced by the robust sales market for Australian investment grade property over the past year.

Interestingly, there may be a flow-on effect for quality secondary investment grade property in the medium-term. There is the opportunity to refurbish and improve the 'sustainability' credentials of these properties, and potentially benefit from any upside in future capital appreciation.

Peter Flynn - Director Intercommercial Property Group

Intercommercial Property Group is an independent consultancy firm specialising in strategic property advice. Peter Flynn provides clients with the knowledge and confidence to make an informed decision.

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