Residential Yields

Hi all,

I am trying to weigh up the pros and cons of various investment options for myself. I am fairly clued in when it comes to the stock and bond markets but for reasons of comparison I am looking for some pointers on property investment.

For those of you who are professional landlords, what yield in excess of financing would you want a residential investment property to return? I am not looking for a debate on the relative merits (or demerits) of property investment.

For example, I currently live in the UK and can get a 5.5% return on my savings. Despite the equity bull market I have still managed to find a number of liquid single stocks with yields in excess of 6% & reasonable growth prospects. Consequently, where does residential property fit in? Should I factor in a higer required yield for property than say the stock market because of the lack of liquidity or a lower one because property is lower risk that the stock market?

Thanks,

Johnboy

When calculating yield on property investment do you factor in both rental income (less expenses) and nominal capital appreciation?

Surely the yield on property (like on any other asset) is based on the income divided by the price - i.e. you cannot factor in capital growth when showing yield.

In any event, the capital growth is an estimate as is the capital growth on a share and we would not include estimated capital growth on share when calculating the divy yield.

I would say that the required yield on property should be equivalent to that required on equities - why the same:

In my opinion for these two reasons:

• Lower expected capital growth on property (v equities)
• Lower volatility (in terms of standard deviation of expected return) v equities

Coming from a background in capital markets I am used to applying a higher risk rating to less liquid assets, but I would also accept your point that property is probably less volatile than equities (though I am going to try and look for data to back this up).

And for Clubman, you do have a point in that the dividend discount model for equities assumes that the dividend grows over time and it is this growth that is discounted back to determine the theoretical present value of the share.

Yes but that would be dividend/rental income growth - not capital growth.

In real terms the dividend/rental income may not be growing at all though.

To answer Johnboy's question, the only yield in excess of financing I look for is enough to cover other property management costs. Once the net yield is covering the mortgage + property management costs, I'm happy ... beacuase it is to the capital appreciation I am looking for my return.

Another pro of property around the issue of yield is leverage. When I borrow for property - and if the net yield is covering my mortgage and property management costs - it means someone else (ie. a tenant) is paying the cost of my leverage and property management costs. This differs from shares, where if you borrow to buy shares, it is inevitably yourself that is paying the cost of that leverage. This allows one to buy property typically 4 times the asset value of shares.

So with no income from the property you would expect pretty decent capital growth I suspect. Since my stock market background is based more on value shares rather than growth, I find comfort in income and would have difficulty in purchasing a property that did not produce a net income but this illustrates my relatively risk-averse nature.

CapitalCCC - Since the dividend discount model assumes that the dividend grows, this is supposed to drive capital growth though it is a rather outdated model. Discounted cash-flow models, whilst more sophisticated, use a similar framework for equity valuation.

The more I think of it the more I realise that there is no correct answer to my question. For me property is more risky than equities because it is so illiquid and the market is so opaque (not to mention the high transaction costs), consequently I would look for a yield that exceeded my financing & other costs by at least 25%. But this just reflects my own attitude to risk and return.

Johnboy - The Discounted Dividend Model (as its name implies) values an asset as a stream of future income payments (dividends) - it makes no assumptions about capital growth or otherwise it assumes holding the asset in perpetuity and it may (or may not) assume that the dividend will grow in real or nominal terms.

I understand the shortcomings of this particular model because it essentially treats the share as a fixed income investment but there is a slightly superior version (the Gordon Growth Model) which takes into account both the required rate of return and the growth in the dividend. Admittedly this is only really suitable for valuing a mature company with a pedestrian rate of growth.

Yes but isn't the Gordon Growth Model basically just the : [D/(i-g)] model?

If that is the equation, then it makes no allowance for capital growth.

Guys-whatever model u use-the most fundamental issue is the price that u paid 4 share-it doesn't really matter if the share is in a maturing market-
1 example would be Telstra which I bought 3 months ago-this share was sold heavily in the last couple of years and coverage/sentiment extremely negative with subsequent downturn in shareprice.

Sentiment has changed in last couple of months and I'm sitting on a 50% profit(similiar story with quantas up 80%).

Both these companies are in highly mature markets but have shown massive growth in last 3 months due to excessive selling previously

To answer your question on shares v property-its' all about risk/return and biggest fundamental on both is price u paid compared to what u think market value is.I recently have bought property in Sydney Australia and rental yields here are 5-6%.
This has widen my investment portfolio and means all my eggs are not in 1 basket