Using the true equivalent yield when analysing the prospective performance of investment property conveys little useful information, and could even be misleading, argues Derek Epstein
Alastair Ross Goobey, in his recent articlein Estates Gazette (16 Feb 2002, p50), quoted someone as saying: “Since the equivalent yield does not purport to represent a true rate of return and is often not particularly relevant to investment pricing, any benefit obtained by seeking to make it more ‘sophisticated’ is illusory.”
Who could have written such a thing? It was I. The quote is from a letter I addressed to him last November and, oddly, he claims that it supports his argument in favour of using true equivalent yields.
As he rightly says, my statement was a conclusion and it was a conclusion of a set of reasoned arguments which will I summarise below.
These are my personal views, not those of Jones Lang LaSalle or the Property Valuation Forum – although I am aware that I do have some vehement support.
The equivalent yield is not a rate of return, so the measurement scale is irrelevant
A “capitalisation rate” of, say, 8%, is not, in any way, a statement as to the anticipated return from the investment. It is, purely and simply, a pricing measure that states that such properties trade at 12.5 times the rent.
The all-risks equivalent yield performs the same function for an investment with a variable income. If you want to estimate the rate of return – the “true yield” – you need to forecast the cash flow and exit value and calculate the anticipated internal rate of return.
Since the all-risks equivalent yield is simply a rule-of-thumb multiplier used for comparing investments, it matters not whether it is measured on “nominal” annual or “true” quarterly scale, or any other.
Maybe it would have avoided confusion in the minds of critics such as Ross Goobey if we had just stuck to the term “capitalisation rate” rather than calling it the “equivalent yield”.
Quoting the true equivalent yield does not provide useful additional information
Not all other investments have their yields quoted on a “true” APR basis. For example, the quoted GRYs on gilt-edged stocks are twice the half-yearly yield.
Some investment agents argue that, since investments are often debt-financed, it is important to quote “true” equivalent yields since the fact that rents are received in advance and interest paid in arrears is a significant advantage, and such investors trade “on-the-margin”.
This is a wholly simplistic attitude – whether in the context of measuring the equity IRR to the investor, or the lending criteria of the banker.
Both of these processes require considerably more sophistication than just comparing the “true” equivalent yield to the borrowing rate.
In any event, interest rates are usually quoted in nominal terms.
The true equivalent yield is counter-intuitive
An investor might justifiably be confused if asked to choose between a rack-rented investment priced at £100,000 with a rental income of £10,000 pa, showing an initial yield of 10%, and an identical investment, let with one month rent free remaining (hence no initial yield), also priced at £100,000, which, he is told, will yield him 10.55%.
Describing the alternative measure as a “true” equivalent yield is misleading and counter-productive
It is misleading and counterproductive to suggest that this new measure is the “true” rate of return that a property investor will earn from the investment. Property would not compete successfully with other asset classes if investors believed that its overall return is equal to the “true equivalent yield”.
Conclusion
For my conclusion, see the sentence above, so accurately quoted by Ross Goobey in his column.
Ross Goobey expresses surprise and disappointment at the lack of enthusiasm for true equivalent yields. Maybe the explanation could be that investors, investment advisers and valuers, who originally expressed support for the idea because they did not wish to seem other than “modern” and “innovative”, have found the concept to be, in practice, rather less relevant than they had expected.
Derek Epstein is an associate director in Jones Lang LaSalle’s City investment department and chairman of the Property Valuation Forum’s valuation methodology group
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An ancillary consideration |
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Why pricing does not depend on equivalent yields |
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Equivalent yield is often not the main consideration in investment pricing. It is, of course, a truism that changing the method of analysis and valuation does not, of itself, change the value or the price. I assume that Mr Ross Goobey is not suggesting that property investors don’t realise that rents are receivable quarterly in advance. I can assure him that they do! Many, perhaps a majority, of investments are priced, and therefore analysed and valued by valuers, not by reference to equivalent yield – whether nominal or “true” – but rather by reference to initial and running yields. Quite clearly, an investment with an equivalent yield of 8% (initial 4%, reversionary 12%) is very different in risk terms from one with an equivalent yield of 8% (initial 7.9%, reversionary 8.1%). This yield-spread defines the risk profile, for the equity investor and the lender, and is therefore often the principal consideration in investment pricing. |
