Don’t confuse net income yield with a capitalization rate

08-05-2006

The terms “capitalization rate” (or cap rate) and “initial yield” are frequently used interchangeably in the South African property investment environment. However, these terms are not synonymous.

Tony Bales, deal maker at Bales Delaporte Investment Property Dealmakers, says that far too often when properties under- or over-achieve compared to market-related rental incomes, they are referred to as being bought with an initial yield of say 10%, when in fact the cap rate of the deal is different. However, these people will then report to the market that they bought at a 10% cap rate, clearly confusing the two terms.

Bales says, “It is important for people to understand the difference, particularly in a low inflationary environment where contractual rental income can run ahead of market rentals. It is quite conceivable for market rentals to grow by, say, 5% per annum, while contractual rentals escalate by 10% per annum. After a mere 3 years the contractual rentals will be 15% higher than the market rentals, hence the approximately 15% difference between the net income yield and capitalization rate. Property players must clearly understand the impact this difference can have.”

Erwin Rode, CEO of Rode & Associates, points out that for this very reason, Rode’s Report supports a drive to use different terms for changes in contractual rentals in terms of a lease (‘escalate’) in contrast to market rentals (‘grow’). “To use the term ‘escalate’ for growing market rentals is confusing,” says Rode.

The glossary in Rode’s Report defines the standard capitalization rate as the expected net operating income in the first year of an investment, assuming the entire building is fully let at open-market rentals, divided by the purchase price.

In contrast, the initial yield is defined as the first year’s net operating income, based on existing leases and other income reasonably expected, divided by the purchase price.

Therefore, it follows that a standard capitalization rate and an initial yield are only the same in those rare cases where a building is fully let at open–market rentals.

When market rentals grow slower than escalation rates for a protracted period, capitalization rates would be significantly lower than the initial yield. The converse is also true.

“During the downswing phase of the property cycle, especially the latter part thereof, one would expect capitalization rates to be lower than the initial yield. This is visible in the office property market at present, because market rentals had hardly moved over the last few years until very recently, while contractual income kept escalating at 9 to 10% per annum”, says Rode.

Rode explains that of the two yields, the capitalization rate is the only valid and appropriate yardstick to evaluate (through capitalization) the market value or price of a property. This is so because it standardises the rental assumption by assuming market rentals. This enables comparisons between properties with different lease profiles. “By ‘different lease profiles’ we mean, for example, leases that had different starting dates or different escalation rates, resulting in one building being over-rented and an identical building next door being under-rented.”

Investors employing initial yields instead of capitalization rates could − depending on the extent to which these two rates differ − arrive at grossly incorrect market values.