The Difference Between Yields and Cap Rates
For some reason in South Africa we use these two terms interchangeably, but they’re fundamentally different calculations. Knowing the difference might just save your life (financially speaking).
Yield: the income your asset is said to generate over the next 12 months (full breakdown here).
You’ve got a ‘blue chip’ tenant, with a watertight lease and 4 years left to run. You buy at an above market yield of 13%, and you’re smiling all the way to the bank.
Until you’re not.
I’m sure you’ve heard the great Yiddish proverb, Man plans and God laughs.
That’s about the time your ‘blue chip’ tenant loses its major clients and goes insolvent. You know, life happens.
Luckily for you, you quickly find a new tenant at a market related rental. Problem is – that rental is 20% less than the rental you were getting. Your investment just went from 13% to 10%. (See what Rode has to say about it here)
Cap rate: A yield, ‘adjusted for life’
Using the same formula to calculate a yield, a cap rate adjusts your income (and expenses) to reflect what the market would realistically deliver, should life happen.
One does occasionally find those gems, where your cap rate delivers a higher return than your yield, so when life happens, you laugh straight back. (For more on how to win in property, read here)
In a market like today, where asking rentals have moved sideways at best and lease escalations continue to climb, be very aware of this little kicker. It might just save your investment life.
For assistance with your cap rate and professional property services, contact Kat.