Don't Chase Yield When Buying Investment Properties

Anthony Guerriero, 9/25/18 8:02 AM

Investing in Stocks and Investing in Real Estate

Experienced stock investors make money by choosing their stocks wisely. They may invest in a well-established publicly-quoted corporation, be it large, medium, or small cap. They may choose to put their money in a promising IPO, or even in a non-traded business because they see its future very clearly.

Successful investors understand enough about the overall market, the industry, and the individual business entity before they part with their money. As a result, they maximize the likelihood of future profit.

a view from the ground looking up at gorgeous skyscrapers in Manhattan

One factor they take into account is yield. But yield is rarely the only factor because "chasing yield" requires the investor to wear blinders (or blinkers, as we say in some countries.)

Investors buy stocks and they may also invest in bonds. They make a clean decision "to be an owner" or "to be a loaner." There are advantages to both, depending on the investor's goals, timeframe, and the state of the market. Yield matters but it is only one factor in the decision.

The same is true of investing in real estate. Yield matters. Many inexperienced real estate investors, though, take what they consider to be the safe route to ownership by looking at the purchase price and the possible monthly yield they will receive from the rent their tenant will pay. They base that on either the rent the current tenant is paying or on what they assume a future tenant will pay.

This simple principle is reinforced by the idea that in real estate "you don't make profit on the sale of property, you build future profit into the purchase." Using this principle, less experienced investors believe that a tough negotiation will lead to a lower purchase price, so the yield will therefore be higher, so that is the way to go.

More experienced, and more successful, real estate investors know to look more broadly at the property purchase in the same way a successful stock investor looks more broadly at the stock. Let us explore that.

Why Investors Do Not Just Chase Yield

A corporation's percentage stock yield may be low or high for different reasons, and the investor may want to own stock in that corporation for reasons other than yield. By understanding the market and its probable future plus the corporation and its likely future, the investor can test those factors against her or his investment goals.

If the goal is to make a huge profit at some point, they may buy a low-yield stock. Google, Amazon, and Microsoft all delivered low yields, but their futures were bright enough to make chasing yield unimportant.

Some corporations pay high dividends and produce a high yield. But they may achieve that percentage by spending too little on, for example, growing their market share or on research and developing new products. By delivering a high yield now, they attract investors who only look at the current yield. Such companies may not deliver high yields for long because their competition will leave them way behind because they grew their own market share or developed new products that will compete successfully. The experienced investor takes such factors into account.

Investing in real estate has the same lessons.

Let us begin with a perfect example. An owner of a luxury condo may need to sell quickly to generate cash for an urgent reason. There are other, similar, condos for sale in the same development. They compete with each other for a limited number of ready, willing, and able buyers. The desperate owner advertises their condo at a lower price than the competition. The Law of Substitution says that an investor will buy the lower cost unit first. The likely yield from high rent paid by the current tenant of the luxury unit is there, plus the potential future profit on the resale makes it a clever choice.

But what other factors may be playing a part in encouraging those other unit owners to sell now? The experienced investor finds out. Perhaps the local government or the Condo Owners' Association is about to change its standards for rentals. It may be that the new rules will require tenancies of at least six months plus one day instead of a monthly minimum. Some cities redefine a condo which permits short-term tenancies, as a hotel. That changes the condo development's legal status.

looking out over manhattan real estate from an apartment window

It may be that future tenants must satisfy a minimum age test (to maintain the condo development's preferred ambience, and to prevent wealthy parents renting luxury units to their teenage, party-loving sons.) This may well limit the market for tenancies and, so, force down the market price for rent. In so doing it will negatively affect yield.

Here is a third example; perhaps the condo management is failing in some way, so some owners are liquidating early to avoid the rush of future sales when unit prices may drop even further. Potential tenants of a luxury condo will be wise enough to check on the management company and the amenities they will want to use before signing any lease agreement. Poor management or off-limits amenities drive down rents and reduce long-term yield. They also drag down future sale prices even after such problems are solved. "Give a dog a bad name" applies to condos as well as to other bad publicity situations.

A fourth example; let us say a separate development has been approved close by. That new project may negatively affect the condo development where the current unit is for sale. Yield and resale values could, therefore, be negatively impacted. The current owner knows that but the overseas investor does not, so it pays the potential buyer to learn more before investing.

How Do Investors Make Wise Decisions?

They make wise decisions based on all appropriate factors and they take advice from experts. Ricardo's Law of Rent (named for David Ricardo, 1809) governs the meaning of and the value behind rent. It, therefore, gives powerful reasons for basing a real estate purchase decision on much more than yield.

In a nutshell, it says that the market for a staple product that enjoys long-standing demand and is profitable will affect the price of other products and activities which support that profitable staple. To take a simple example, if a landowner knows tenant farmers can sell their crop for high prices, they will pay high rent, in order to grow their crop. The landowner also knows, that because the market for the crop will remain strong, when he sells the land he will make a good future profit as well as enjoying a high current yield.

There may be cheaper land available elsewhere, but if it does not produce high-quality crops to sell at a premium price, then tenant farmers will not pay the same high rent. If the cheaper land is fertile, but the costs of growing, reaping, and transporting the crop to market are too high, then the rent, and therefore the landowner's yield, will be low.

The experienced landowner knows to look beyond just the land's purchase price and the hoped-for future yield. The successful land investor takes more into account than current yields from similar, but not identical land elsewhere. By understanding basic economic laws, experienced investors reap higher long-term profits.

How Does This Principle Apply to Investment Property?

In Manhattan, for example, there are many high quality and high value properties. Some of them are for sale by the developer looking to generate cash. Those units being offered may be very attractively priced. They will produce zero yield because they are still being built but, on completion, the investor will make a high profit because finished luxury units in the right location will command a high price. Zero yield but high resale profit in two or three years.

To take a different example, a completed condo in, say, One57, a world-class development overlooking Central Park, is in a prime location and sought by very wealthy residents. The purchase price may be higher than a unit which does not overlook Central Park, but the rent here will be consistent with a product in that location, and the demand will continue. This should result in both an acceptable yield, low vacancy rates, and an acceptable profit on resale.

These are only two simple examples, but they show different reasons for investing In luxury real estate, based on sound economic principles that do not focus simply on chasing yield.

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