CAPITALIZATION RATE … Why it’s important.

In the post GFC period, yields from any type of investments became increasingly harder to find and without doubt, the post global recession environment saw investors having to take greater levels of risk to generate acceptable and goal satisfying yields.

Dubai’s rental yields have always been strong, particularly when compared to countries where rental income is taxed at high marginal tax rates. With a market that boasts an Average Gross Yield of around 7.0%, it has for some time stood as a beacon for those who appreciate the significant structural and regulatory development that the market has undertaken which, I reality, decreases the risk perception associated with investing in the market.

But really, what is the true meaning of Gross Yield? Gross Yield is the income on an investment prior to expenses being deducted expressed as a percentage. Simple. But Gross Yield only measures the income as a percentage of the original purchase price and does not reflect the effects of significant underlying   fluctuations in underlying asset values such as those that have been witnessed in Dubai during the past 5 years.

Nevertheless, the ration has its uses.It can provide a retrospective view or learning opportunity by revealing how accurately market factors were comprehended, analyzed, forecasted and modelled when planning a particular development; it can highlight inefficient and costly construction methods and techniques; it can highlight future price / revenue adjustment opportunities, new segment or geographic concentration opportunities; it can reveal superior (or inferior) sales, branding and marketing techniques or superior product attributes; it can highlight impending revenue and eventual margin pressure where yields appear a little too extravagant when compared to the market or even highlight where an  industry is with regards to its cycle. Gross Yields can also highlight inefficiencies because inefficiencies, unless corrected, must be eventually supported by either Gross Yield or margin reduction.

Logically, expectations of Net Yield will always pressure Gross Yield and the cost of resources required to generate that Gross Yield.  In times of tight supply, inefficiencies in construction, administration, maintenance and operating methodologies are hidden because elevated Gross Yields driven by excessive market demand are more likely to drive acceptable Net Yields for investors. However, the real test as to effective Yield management is when supply exceeds demand.

At Harbor, we are also interested in the Capitalization Rate (or Cap Rate) of an existing property. Capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor's potential return on his or her investment. The capitalization rate of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property, where NOI is the total revenue derived from renting or leasing the property less all operating costs. Put simply, the Cap Rate = Net Operating Income / Current Market Value

Given that the capital values for property in Dubai has, in many cases, shown significantly greater volatility than the income being derived from the property, we need to look at the Net Operating Income being generated from the property at today’s value. This allows us to see whether the property’s wealth generating performance is improving or declining by referring to the Cap Rate. If the Cap Rate is declining, it may lead us to conclude that to sell the property and reinvest elsewhere would generate greater income and/or overall wealth even if the Gross or Net Yield still looks impressive.

We also use a Cap Rates as part of our suite of objectives when establishing a client’s property portfolio.  We will determine the lowest cap rate that the client should accept in order to make the investment worthwhile. Typically, we will suggest a Cap Rate of between 5% and 10% depending on expectations of asset value fluctuations going forward. As revenues are typically locked in courtesy of rental contracts for at least 12 months or, in the case of Commercial leases anywhere up to 5 years, the ability to accurately forecast the potential and likely shifts in property asset values will be essential to establishing realistic and achievable Cap Rates and forming longer term property portfolio strategies.

There is another useful application of the Cap Rate. When you divide 100 by the estimated Cap Rate you arrive at an estimate, expressed in years, which will provide an indication of the payback period of the investment. For example, an investment with a cap rate of 7% will have an estimated payback period of 20 years. Caution must be used when using this ratio, however, and it must be reviewed periodically as the underlying asset value and the revenues generated from the asset will always exhibit different rates of volatility.

About The Author:

Dubbed “The Wolf of Real Estate” in the April 2014 edition of Property Times, and the subject of the front cover exposé as “The Godfather of Asset Management” in the February 2015 issue of Gulf Property, Mohanad is an award-winning real estate professional and entrepreneur, and the CEO of Harbor Real Estate whose leadership has led to Harbor winning the highly-coveted title of “Best Agency for Property Management” in the People’s Choice Awards 2015. (Harbor Real Estate currently manages institutional portfolios worth AED 14.8 Billion).

Mohanad is also an Advisor and Instructor at the Dubai Real Estate Institute (DREI) – the official training and certification arm of the Dubai Land Department (DLD), the Content Producer and Presenter of “MEMAAR” the first-of-its-kind property reality TV show in the Middle East which is broadcasted weekly on Dubai TV & Sama Dubai TV, and One of the Eight Founding Steering Committee Members of the United Nations (UN) Global Compact Initiative UAE Network.