Scarcely a week passes without the publication of yet another UK property research circular forecasting falling vacancy rates, rising rents and, best of all, falling property yields.
It is perhaps this forecast for property yields - capitalisation rates in the US - that is most interesting of all. At the core lie assumptions about the financial characteristics of property and their relative attractiveness to investors.
A recent circular from consultants Hillier Parker notes that the firm's bespoke All Property Average Yield shows the widest lead ever recorded over UK government gilts, 150 basis points. Property yields will fall, the argument goes, because they have almost always been lower than those on gilts and logic dictates that they will move back into proper alignment.
This raises two interesting questions. First, why should investors measure the value in property as though it had the qualities of a government bond? After all, government bond yields represent the risk-free cost of capital. Why should a property investor, buying a far riskier asset, be prepared to accept a yield lower than, or even equal to, that on gilts? For the higher risk he ought to expect a higher return and the only question should be how much higher.
Michael Mallinson, former head of property investment at Prudential Portfolio Managers and head of a 1995 working group that recommended reforms in the valuation process, says that expectations of future rent increases are the justification for the sub-gilt yields on property that have prevailed historically.
"In the last boom, people would buy retail property at yields of 3.5 per cent when gilt yields were 12 per cent," he says. "When property yields are above those on gilts, the market is saying rents are not going to rise any more."
However, during the recession of the early 1990s, rents actually fell, in spite of the prevalence of long-term leases that allowed for upward-only rent reviews every five years. Should this not have caused a pause for thought about the yields investors were prepared to accept?
"The argument about property yields is founded on a belief that rental growth expectations will more than cancel out the risk premium (over gilts) that investors should demand," says Andrew Baum, chief investment officer at Henderson Real Estate Strategy and professor of land management at the University of Reading, near London.
"But with low inflation and depreciation expense, it may well be that yields should be higher," he says.
Christopher Jonas, who runs a property advisory boutique, notes that with inflation stripped out, real gilt and property yields over the last 20 years in the UK have been roughly equal.
PROPERTY yields no better than those on risk-free investments might be justified if total returns are substantially higher. UK equities, for instance, currently offer dividend yields around 2.8 per cent, well below both gilts and property.
But Mr Jonas points out that between 1978 and 1998, the FTSE index produced average annualised total returns of 18.3 per cent while UK 10-year gilts produced total returns of 13 per cent. Property had total returns of 14.5 per cent, arguably too small a margin over gilts to justify gilt-like yields.
Could these numbers suggest that people are paying too much for property?
The second, equally troubling question about the relevance of yield as measure of value in property arises on examination of how it is calculated.
Yield, as it is calculated, does not take into account all the costs associated with the ownership and management of a particular property. For instance, it makes standard assumptions about transaction costs, although these vary widely. Also, it generally assumes that in a single-let property all overhead costs are borne by the tenant, makes no allowance for organisational management charges and excludes the cost of finance.
Therefore a variety of operating costs that ought to be deducted from rental income are not. A more realistic picture of a property's yield is arrived at by looking at what US analysts call cash-yield-on-cost, says Mr Baum.
Thus, a company able to pare its operating overhead, lower its tax rate or cut its cost of borrowing in fact earns a higher yield on its properties. To pretend that these costs do not exist is folly.
"Yields are extremely misleading pieces of information," Mr Baum says. "It's the emperor's new clothes syndrome. We all use these terms without really thinking about them."
Henderson's target yields are the current government bond yield, plus a premium for uncertainty and illiquidity, minus a discount for rental growth, plus a premium for depreciation, he says.
John Lutzius, analyst at Green Street Advisors, a California-based firm specialising in real estate securities, says that yield is useful mainly for general comparisons of property. "It's about as useful as a price/ earnings ratio for equities," he says. "It's useful if an investor wants a one-dimensional view of the price of a property."
Net cash extracted from an investment, he argues, is much more meaningful. For instance, Boston Properties Inc, a US real estate investment trust, recently purchased the Embarcadero Centre in San Francisco for £740 million sterling, prompting suggestions that it had overpaid.
GREEN Street's forecast for net operating income - which takes some management costs into account - produce a projected 1999 yield of 7.4 per cent. But on a cash basis, including debt finance and administrative expense, the yield is 6.2 per cent. This compares with a current 10-year US Treasury note yield of 5.4 per cent.
Better measures of value, he argues, are discount of purchase price to replacement cost or internal rates of return. Yield, he says, is something Green Street calculates "because our customers like it. But we just ignore it."
