In the context of commercial real estate, yield refers to the annual income from the investment, expressed as a percentage of the investment’s total cost (or some cases its estimated current value). Yield is another name for the rate of return. There are two types of yield: levered yield and unlevered yield. The difference between the two is that levered yield takes into account the income earned after financing costs have been paid, while unlevered yield does not include financing costs.
The formula for yield is:
Yield (%) = Annual income / total cost
Yield is solely a measure of the income produced by a property and does not generally factor in increases in its value (appreciation). A property’s yield, while similar to its capitalization (cap) rate, can differ in that yield measures income / total cost, while cap rate measures income / price or value.
To illustrate unlevered yield, imagine that an investor purchases a property for $10 million and then spends another $2 million to redevelop the property to hopefully earn a higher rent, making their total cost $12 million. The property is expected to produce a net operating income (NOI) of $750,000 per year. Its unlevered yield would then be 6.25% ($750,000 / $12 million).
Now, imagine that the investor took out a loan for $8 million to purchase the aforementioned property. While the total cost is $12 million, they only had to use $4 million of their own money to buy it. However, the loan isn’t free - the principal and interest payments on the loan cost $400,000 per year, reducing annual income from $750,000 to $350,000. In this case, the property’s levered yield would be 8.75% ($350,000 / $4 million).
As you can see, the investor was able to earn a higher rate of return by using a loan to finance part of the property. This concept is known as leverage, which is one of the most fundamental principles of real estate investing.
Comparison vs. Stocks and Bonds
For investors with a background in stock or bond investing, the concept of yield as it applies to commercial real estate will probably seem much simpler. Because stocks and bonds are publicly traded and their price fluctuates constantly, there are multiple ways to measure yield on these investments.
As an example, imagine that you purchased a stock for $100 per share, and its market value has since increased to $120. If the stock issues a $2 dividend, its cost yield would be 2% ($2 / $100) while its current yield would be 1.67% ($2 / $120).
Bonds have three ways to measure yield:
- Coupon yield - the bond’s annual interest rate, which is set when the bond is issued
- Current yield - the annual interest rate as a percentage of the bond’s current market value
- Yield to maturity (YTM) - the total amount of income the investor will receive if the bond is held until its maturity date and the borrower does not default.