For extra value, focus on yield

When buying a property for investment, the rental income it could attract is a key consideration

As a value investor, I am naturally attracted to investments that produce decent yields. This is because these investments tend to be more stable and less likely to give one a heart attack.

Other more gung-ho investors may prefer investing purely for capital gains, even if they are to get little or no yield.

My interest was therefore piqued when The Straits Trading Company last month offered for sale 10 units of its Gallop Gables condominium at Farrer Road by dangling a big carrot in the form of a guaranteed rental yield of 7 per cent for two years.

For those who are unfamiliar with the term, yield is the recurring annual income you get divided by the amount you paid for an investment. In properties, yield is derived from rental income. In stocks and shares, it is based on dividends that companies pay.

With savings in banks drawing a paltry annual interest of half a per cent or less these days, Straits Trading's offer was understandably snapped up by eager buyers.

Seasoned property investors will tell you that it's rare to get rental yields as high as 7 per cent, not unless you convert your property illegally into a workers' dormitory. For residential properties, a yield of 2.5 per cent to 4 per cent is the norm.

As an investment class, real estate generally provides a lower yield compared to investing in corporate bonds and equities. This is an acceptable trade-off as the risks of investing in physical properties are lower than those for stocks and shares.

The focus on yield, however, is only half the picture.

Another pertinent question an investor should ask is whether the current yield of a property is real or sustainable.

According to the Urban Redevelopment Authority, rents for private homes in the first quarter fell by 8.5 per cent. They had dropped by 5.3 per cent in the fourth quarter of last year.

In a prolonged economic downturn such as the one we are probably experiencing, there is further room for rents to fall. This is notwithstanding the recent revival in the residential property market.

On the demand side, numerous companies have slashed or are reducing head counts. Some have stopped operations altogether while many more have cut the pay of their staff. There is less discretionary income all around.

On the supply side, vacancy rates are likely to rise as more new homes are completed while some older developments that were earmarked for demolition have been put back into the rental market as their redevelopment plans get frozen.

Rising capital prices combined with falling rents spell bad news for yields, something property investors should be mindful of.

Equity investors tend to be more savvy when it comes to matters of investment yields and their sustainability.

Which is why the stock market today is littered with numerous instances of shares that seemed to be going for a song when measured against their historical yield. Stock investors are not buying these high yielding stocks because they suspect they will not repeat the high dividend payouts of the previous year.

To be sure, there are people who see real estate investing purely as a capital gain game. In the bull run from 2005 to 2007, many home owners were content to leave their units unoccupied while waiting for the right opportunity to resell them for a big profit.

Such windfalls are harder to come by in the current climate and a prudent investor cannot afford to look through the prism of 2007 and hope for a repeat of these fabulous gains any time soon.

For investors who acquire properties with the help of a bank loan, rental yield takes on added significance.

Mortgage rates currently vary from as low as 1.5 per cent to 3.75 per cent or more. As an investment, income from renting out a property should preferably be able to cover the monthly bank interest charges plus a portion of the principal repayment.

For those lucky enough to obtain a low rate such as Standard Chartered Bank's 1.5 per cent promotional offer for the first year, the bar for rental income is low.

But for those who are locked in to significantly higher rates, their rental income should at least match the interest they are paying for their mortgages if they don't want to end up working for the bank for free.

Don't forget, mortgage rates tend to rise over time as initial teaser rates give way to prevailing ones. One way for a borrower to maintain a low mortgage rate is through the regular refinancing of his home loan. But this assumes that the current low interest rate environment will remain benign.
Refinancing may not be feasible if the property's valuation has fallen sharply or if the refinancing bank decides to offer a lower loan quantum.

Unlike stocks and shares, yields on property investment are also more easily manipulated. A crafty seller can sometimes entice a buyer to overpay for a property by promising an abnormally high rental yield. To achieve this, the seller will sell his property and execute a leaseback agreement with the buyer.

In such a deal, the seller will guarantee the buyer for a limited period - typically not exceeding two years - a monthly rental income that will meet the promised yield.

The seller then sub-leases out the unit to a genuine tenant at the prevailing market rate. If the rent is below the guaranteed amount - as is likely to be the case for an overvalued property - the seller will top up the rental shortfall. But he does not lose out as he is able to count on the extra profit he had made earlier from selling his property at a higher price. The buyer ends up worse off even though he gets a higher monthly income rental for two years.

An example of how this can be done is illustrated in the accompanying table.

Rental guarantees are not illegal and, in fact, are the de rigueur practice of some developers that simply refuse to lower their selling price of unsold, completed projects during a downturn for tactical reasons.

They are also not necessarily detrimental to buyers.

Getting an attractive rental guarantee in today's market will appeal to investors who believe that home prices will recover by 2011 or 2012, as they will enjoy higher-than-usual returns in the next two years while awaiting the recovery to take place.

In the case of the Gallop Gables apartments, the buyers probably got a good deal.

Apart from getting guaranteed rental yield of 7 per cent for two years, these purchases were done, on average, at prices about 23 per cent below what Straits Trading had asked for last July.

The developer has since raised the price of the remaining few units to $1,400 per square foot (psf) from the $1,188 psf average it had sold at in the past six weeks.

But the cheapest unit still went for a tad above $3 million.

If only I had a few million dollars to spare.

Source: Straits Times, 31 May 2009