Yield compression is a concept I first learned about when doing Jeremy Brooke’s Executive Development programme back in 2019, but since I didn’t know much about real estate development then, it was a concept to be filed away for the future.
Fast forward four years and I find myself CFO of a real estate development company, building shopping centres in Zimbabwe.
What is yield compression in real estate?
In simple terms, yield compression is about generating capital growth in real estate, based on enhancing rental income, and de-risking an investment.
To generate a profit in real estate, one must sell a development for more than the costs of acquiring the land together with the costs of construction and any finance costs.
We can apply this concept to a shopping centre development. Say a developer acquires a piece of land for $1m, and spends $4m to construct a shopping centre, the total cost is now $5m. The developer then lines up tenants to lease the shopping centre which will pay a rental of $58,800 per month, or $706,000 per year. To be conservative, we assume 15% of rental income goes towards costs such as property management fees, insurance and repairs and maintenance, so the net rental income achieved will be $600,000 per year, or $50,000 per month. This provides the developer with a net rental yield on cost of 12% per annum.
Then after a year, the developer wishes to sell part or all of the development to earn a profit, and to use the proceeds to develop the next property. They market the property to a range of buyers, and each buyer does their due diligence to value the property. Of course, the major buyers and owners of real estate around the world are pension funds and increasingly REITs. Pension funds have a low return, low risk profile, and so are happy to earn a lower yield on their investments, because they are about preserving and growing their assets over the longer term rather than making quick profits.
The pension funds may be happy with a 6% net rental yield, and so they work out what value they can pay, to generate a return of 6%. Since the net rental income achieved is $600,000 per year, the value they can pay is therefore $10m.
The developer has doubled their money, by selling a building for $10m, which cost $5m to develop. Let’s say there are selling costs of 5% of sale price, or $500,000, and capital gains tax of 20%, or $1m on the gain, the developer has earned a cash profit of $3.5m, on a $5m investment. Assuming only 20% of the construction cost is equity financed, with the balance financed by debt, the return on equity is 250%, over an 18-month period, or whatever period it takes to complete the project.
Comparison to high yield bonds
The principle of yield compression in real estate is comparable to other securities such as stocks or bonds. Take high yield bonds, or as they are commonly called in Wall Street parlance, “junk bonds”; the yield to maturity (YTM) is inversely correlated to the price. When the price of the bond falls, the yield increases and vice versa. When investors are afraid of holding a security, the price falls as sellers outweigh buyers, but because the coupon is fixed, the yield increases. I remember a few years ago when Venezuelan bonds were trading at yields to maturity of over 30%. This means if you bought the bond, and held it to maturity, your interest coupons and repayment of principal at maturity would theoretically result in a return to the bond holder of 30% per annum. This sounds attractive, especially when banks at the time were paying almost 0% interest to hold your money, however bonds like this are called junk bonds for a reason, in that a lot of the time, the borrower defaults and the investor loses most of their money. If however, maybe due to an informational advantage, or luck, an investor buys a high yield bond, and the risk decreases, this will lead to the bond price increasing, as investor confidence rises, and the bond investor will make a healthy profit. In this example, the yield has “compressed” leading to a capital profit.
Summary
In summary, high yields generally mean higher risk and reducing prices, whereas narrowing, or “compressing yields”, means lower risk and increasing prices. The target is to buy or develop assets at high yields, and sell at lower yields.