In our last information letter we covered the yield of a capital investment property and how one buys properties with regard to the yield. In this letter we want to give further important tips on optimizing the yield. As a reminder: yield in percent = annual net rental income divided by the sales price * 100
The question can be answered clearly: one only gets an exactly calculable, fixed yield for a fixed time period in case of an investment with a fixed interest rate – for instance fixed deposits or federal savings bonds. But that does not apply to real estate. If one spends half a million DM today and in three years a repair of 50.000 DM needs to get done, which one cannot cover by raised rents, then one’s yield gets less of course.
If tomorrow one has a vacancy of 50% (as it has been the case again and again in the new federal states) then one’s yield also goes down by 50% - unless the other tenants pay a 50% higher rent (probably the reverse would rather be the case – they then pay irregularly or less if they still want to live there, because the market rent has dropped!)
If one has a tenant who doesn’t pay rent for two years and one needs to take legal action against him (with advance payment on court fees) then this reduces the yields tremendously and increases the emotional dislike of the property as an investment.
Conclusion: vacancy, losses of rent and incidental renovations are factors that one needs to take into consideration to some degree, for they push down the yield and one’s mood. This, however, needs to be countered by the following:
To achieve a yield of 8 or 9% and to achieve it with a capital investment paid by outside finances basically can be compared to a goldmine for free. There are instances when someone is lucky and the property keeps its high yield. But one should also be satisfied if, for some period of time, one “only” achieves a yield of 6-6,5 % and compare one’s own yield with the general interest rate of the money market. “Greed eats mind” is an old saying of the branch, and all too often it applied to investors hooked on yield in past.
Let us come off from the yield for a moment (or net yield) as we defined it above and instead have a look at a different factor: namely, that “total yield”, that economic total sum that is the result after 15, 20 or 25 years. This total yield is the result of several factors:
Point 1 needs no much explanation: if one raises the rent by an average of 2% annually then the yield increases accordingly. Precisely it looks like this: with a purchase price of 300.000 DM and a rent of 1.200 DM per month, the rental yield at the beginning is 4,8% per year.
In case of a rental increase of 2% annually the monthly rent will be 1.434,11 DM after 10 years and the rental yield will then be 5,7%.
After 20 years the rent will be 1.748,14 DM and then the rental yield is 7%. You will have noticed that the rental yield, however, has become a very uninteresting percentage – for who, after 20 years, is still interested in how much the property has once been purchased for! What is more important is the second factor: the appreciation.
This appreciation is, of course, no money received in cash – but that’s also not what you get from your life insurance every year, instead the life insurance first needs to “nap” for 25-30 years (in control of the insurance company) and only then brings in the final sum.
It is similar with the appreciation of the property: it only adds to the total return once you resell the property. Only then does one get the “final balance” – the sales profit (after taxes, or without any taxes if one awaits the speculative period) is only determined by the actual total yield which one achieves at the time period of the investment. Only by then does one really know how much money one won (or lost) in comparison to other investment forms.
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Let’s get into the figures a little more, keeping our example: let us say the theoretical property appreciation is 2% per year. We simply add this appreciation (less the increasing costs needed for maintenance and administration) to the rental contract as a theoretical factor. Let us even assume the maintenance and administration does not just increase by 2% but by 2,5% annually.
Then one gets the following picture:
The “total yield”, after deducting the costs and including the appreciation, is 5,8% in the first year; after ten years it is 6,9%, after 20 years it is 8,3% and after 30 years it is 10%. Calculating over a time period of 30 years we get an appreciation of 540.000 DM and have earned about 450.000 DM after deducting the costs. Selling the property, we then have a tax-free gain of 240.000 DM.
Let us ignore the financing when calculating the total yield and let’s say we have been paying the property in cash back at that time. Then 300.000 DM have become 990.000 DM in total. So the figure grew to 330% of the sales price.
The “average yield” can be calculated easily: 230% / 30 years = 7,66% annually. However this is mathematically incorrect, since the factor compound interest has simply be ignored.
Yet the most important point is: in case of selling the property after ten years – in the case of rented out space; if it is owner used it would be two years – the rate of appreciation is tax-free. Of courses taxes need to be paid on what is earned, which however reduces according to the tax advantages on the interest paid in case the property has been bought by means of outside finances.
And with that we are at point number three, the financing. Is there a connectivity between the yield and the financing, and especially: can one optimize the yield by means of the financing?
One thing is clear:
As long as one is not paying the property utterly with one’s own funds, one needs to get the money from somewhere. This has got an advantage but also a disadvantage. The advantage is, with no doubt, that the real estate is practically the only financial investment which one can acquire with up to 100% (or more) outside finances. The disadvantage is: since one borrowed this money, one needs to pay interest on it over the whole period of time. So in order to now calculate how much the property actually brings in (aside from joy, anger and work) we need to implement another factor in addition to the yield – let us call it the gross balance.
The gross balance is that very sum that remains after one has fully done the income-expenditure-calculation. So now, in addition to rental income, administration, repairs and maintenance, also interest and amortization come into play.
The gross balance changes from year to year. It can be negative or positive in the respective year.
A negative gross balance can often result in tax decrease. A positive gross balance will generally have an effect of increasing taxes, as long as it isn’t being kept completely secret from the state or the state does not offer any possibility of release.
Annual net rental income: 45.000 DM
Annual interest and amortization expenses: 36.000 DM
Gross balance: plus 9.000 DM
Annual net rental income: 45.000 DM
Annual interest and amortization expenses: 66.000 DM
Gross balance: minus 21.000 DM
And now we will ask a really stupid question: which property has the better gross balance now?
Of course you have seen through it: neither one can instantly be designated as the one with the better gross balance. Perhaps you noticed: it even is the same property – but: in the second example the amortization is 6X as much – which simply means that the property will be paid off within a very much shorter amount of time.
So the gross balance does not play a role when comparing the yield of various properties.
The gross balance is rather that figure which one keeps in the end or which one pays on top, after one has the income and expenditures balanced. Of course, when doing this calculation, we have to take into account all cost allocations as income and include all housing allowances for water, electricity, garbage, janitor, administration, drives, repairs etc in the calculation. So the final result is the gross balance. This is why you should, by the way, always request the current housing allowances to be paid when purchasing a freehold flat and then calculate how much of this you will wind up with as the owner, and how much the tenant will pay. Another factor is increased maintenance costs or special cost allocations due to incurring special repairs at the house or the common property. One also has to consider that members of the owner’s association which are not paying are usually charged to the remaining owners, which can impair the gross balance tremendously.
So now we illustrated that yield and gross balance are two different kettles of fish. Let us stick to the following: the yield is regarded independent from interest and amortization – it is an independent factor calculated from the purchase price and the net rental income. The gross balance is that factor which shows how much one ends up with in one’s pocket – meaning the cash flow, including all income, expenses and tax advantages. The appreciation remains out of consideration when it comes to the gross balance, since it doesn’t affect the cash flow.
Yet the most important factor, as mentioned earlier, is the total yield; that percental increase which your property has actual brought in over the years, including the appreciation.
And before you get overwhelmed by all the digits: just keep in mind that yield and yield of a property are two different things. One gets very different results, depending on what factors one underlies. For a real estate property is not a savings book, but a land register.
In a later infoletter we will explain how the total yield can be tremendously influenced by the factor financing – be it positive or negative. After all this is where you decide how fast the property becomes a real profitable investment to you and how you can increase the gross balance with this, namely independent from whether you want to resell the property or not and when you want to do so.
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