The yield game: how to profit on foreign real estate

Tranio has been focusing on investment property abroad since 2012. When I started working in this field, I realised that everyone had their own understanding of the term "yield".

For some, the yield is the net profit after tax and expenses or the internal rate of return (IRR), which is a figure calculated on the basis of cash flows with the discount rate and the conditional sale price in 10 years. For others, the yield is the annual revenue divided by the property's value. And everyone is right, to some extent.

The ambiguity in its definition causes investors to make poor decisions, choose low-quality properties or just lose time. It is important to understand how your business partner makes calculations and understands yields and risks.

There are a number of factors to consider when assessing yields.

Location

Many clients are interested in properties with high yields, but ultimately, few of them would purchase a low-quality asset, even a high-yielding one. The majority wants a property in good condition, in a well-located neighbourhood, and yielding at least 5–7%. However, in most cases, high yields mean that the property is not well located. High-quality property is impossible to buy at a low price, as the demand for it is high in hot markets.

One of our clients owned an office property in central Berlin. He recently received four offers from major institutional buyers ready to purchase the property with a yield rate of 4% before expenses. At the same time, I showed the building to a Vietnamese client who only agreed to 5%, despite the fact that the quality of the property and the market situation at that time did not allow for an opportunity to buy anything similar with such a yield rate. Eventually, the building was sold to a Canadian buyer with a yield rate of 4%, and the Vietnamese national is still looking for the perfect property in central Berlin with a yield of 5% per annum.

Financial leverage

Buyers often do not fully understand how the yield rate is calculated when taking a loan. Russian clients are not used to the fact that leveraged finance can sometimes be cheaper than the rent. Therefore, it is difficult for them to realise that using a loan can raise the return on investment significantly.

For example, in Germany, one can take a loan of up to 50% of the property value at 2–3% per annum. So if the average rental yield is 6.5%, the investment yield (IRR) in view of the loan could be up to 7–8%.

The developer's share

In addition to the rental business, many investors have recently become interested in Value Added projects. The scheme usually includes: buying, constructing or renovating a property, achieving high levels of rental income, and subsequently taking over ownership or selling it when its value increases.

If a developer participates in such a scenario, the project yields would be different from what the investor would actually get as the developer would take a cut. For instance, the project IRR may be 30%, but the investor might only receive 15%.

Financial model manipulation

The companies that carry out Value Added projects often manipulate financial models to artificially overstate the indices: change the cost of leveraged finance, the loan volume or the capital return rate, understate expenses or provide income estimates that are too optimistic. All this can make the project seem more economically attractive. If the expectations do not materialise, the investor might not obtain the declared yield.

In this case, one should closely scrutinise the financial models and only work with developers that are ready to invest a significant volume of their own funds in the project so the investor's capital is not the only thing at risk.

Risks

Most investors understand that the yield rate is positively related to risks. However, many of them want to buy higher-yielding property, while not always aware of the risks this carries and the measures they would take in the case of a negative scenario.

For instance, Tranio carries out development projects in Greece without project financing, using only our own funds. at the same time, we achieve investor yields of about 12–15% per annum after tax and expenses. One of our clients said that in Germany it was also possible to earn 15% on construction (which is not an easy task, by the way). However, it is important to note that in Germany, projects are usually 70–80% leveraged, which means that there is a risk of capital loss. In Greece, there is no such risk, but the risk of not selling the property and eventually having an illiquid and low-yielding piece of Greek real estate is there. Which of these scenarios is worse — losing everything or obtaining lower yields?

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Partners should agree in advance the definition of every term, calculation methods, and the risks that the strategy implies when assessing the financial characteristics of projects. Otherwise, misunderstandings and money and time losses are likely to occur.

In my opinion, in the case of rental projects, it makes sense to analyse the simplest index only — the annual rental revenue divided by the property value (yield or cap rate) — in the first place. In the case of Value Added projects, the investor’s yield after management company expenses and the local tax before the investor's personal income tax should be taken into account.

George Kachmazov, managing partner at Tranio