In today’s world of rising real estate prices, it’s common to hear commentary about bubbles or that “prices are crazy”.

That’s a great way to get a headline. But just because the talking heads think a real estate market is nearing bubble territory, that doesn’t make it true.

And in today’s low-interest rate world, many prices aren’t what they first seem.

So how can you tell if property prices are crazy – or not as irrational as people think?

I suggest looking at yield.

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Public Property
Image source: Wikimedia Commons

What is yield?

Yield is not a complicated concept, but it does have a few twists and turns.

Yield is a term applied to lots of things that people do. Farmers talk about yield – how many bushels of wheat (corn, sorghum or whatever) can be produced per acre of land. Miners will discuss yield in terms of ounces of gold, tonnes of copper and tin per thousand tonnes of earth dug up. Bitcoin miners might talk in terms of bitcoins mined per unit of electricity consumed, for example.

This notion also applies to stocks and bonds. What is the dividend income I can expect to get from buying a certain stock or bond?

In simple terms, yield expresses the relationship between output gained from a given amount of input.

In real estate, yield refers to rental income generated per unit of capital invested. Say I buy a property for US$1 million and it produces US$60,000 rental income per year. Then the yield is 6 percent (60,000/1,000,000 = 0.06 = 6 percent).

Of course, this is a very simple notion of yield. A property investor probably has certain costs that need to be met during the year. Some management fees or some local authority taxes. So the initial calculation is a gross yield. The net yield is what is left after paying the necessary expenses that the landlord has to bear.

When I am looking at a property that is going into an investment portfolio, the existing (or likely future) yield features strongly in my investment decision.

I might ask, “What is the yield that I should expect from my property investment?” Or put another way, “How much am I prepared to pay for a property to get $X per year in rentals?” If I am prepared to pay more, I am saying that I am comfortable generating a lower annual return on my capital investment.

A few considerations in the price/yield equation

First… how does the yield on this investment compare to that from a similar real estate investment in that market? Is this investment in line with current market conditions?

Second: Risk. A higher yield normally goes hand in hand with higher risk and vice versa. Retail real estate, for example, is often considered riskier than most high-end office property. Therefore, investors expect to receive a higher rental yield to compensate for the perceived higher risk. The investor is prepared to pay less per dollar of rental income for riskier assets than for lower-risk assets. Location differences can also account for differences in yield.

 

Comparisons can also be made across asset classes. For example, comparing yield on real estate against yield on corporate or government bonds.

Third is the cost of capital consideration. How much does it cost to borrow money for investment? If my expected yield from a certain real estate investment is, say, three percent, but my borrowing cost is six percent, I may be cautious about making such an investment. Where cost of capital is substantially higher than the anticipated rental yield, more focus might be placed on the likelihood of capital gains on the property.

Whenever I see a market where the rental yield is substantially lower than the interest rate, a warning bell rings. This has often been a signal that property prices are going to come down. In such circumstances, for yields to come more in line with interest rates three things can happen: 1) Prices come down relative to rentals. 2) Rentals go up relative to prices. 3) Interest rates go up. That third possibility may be a signal for property prices to come down also.

Are they crazy?

Often, when a property market has been rising, we hear endless commentary about bubbles, that “prices are crazy”, and similar claims. But if we compare cost of capital with property rental yields, then perhaps things are not as crazy as they seem. For example, in recent years, interest rates have been very low and prices in many markets have gone up substantially more than rentals. So yields have come down.

When I hear the “crazy prices” commentary, I stop and look at prevailing yields in the market. For example, many real estate investments in Hong Kong, widely known to be a very hot market, can give investors a yield of around 4 percent or more.

When the cost of borrowing is around about 2.3 percent, that yield of 4 percent may seem perfectly reasonable. So prices are not so “crazy” or irrational if the rental yield is substantially higher than the cost of capital.

But when I see the equation going the other way, as we have on various occasions over the years, then the alarm bells start ringing.

So if you happen to be looking at buying real estate in a market where people are talking about a bubble, take a look at the yield in relation to cost of capital and you might find the prices are not as irrational as people are saying.