How Do Fund Managers Make Money In Real Estate Investing?
The Myth of Yield Superiority
Contrary to popular belief, yield income represents a very small fraction of most real estate fund managers’ returns.
By far the most important aspect of real estate development investing for institutional investors and those with very large portfolios of property assets are derived from capital gains returns, either as a result of purchasing and selling assets, or purchasing and refinancing the same assets at a higher valuation after a given period of time.
While refinancing real estate investments is much more difficult for private investors to do without taking on unnecessary levels of risk, very few property buyers are aware of how they can assimilate moderate yield income into quite high levels of capital gains returns.
However, with the large number of property developments springing up all over the British countryside right now, U.K. property investors are perfectly positioned to do just this. All it takes is understanding how yields and capital gains work in tandem with one another.
Today’s property investors mistakenly assume that a relatively high guaranteed income yield is preferable to the risk of considerable capital gains.
Let’s assume for a moment that you purchase a property for $100,000, and the developer you purchase the property from gives you a 6-year rental guarantee of 8% per year.
This sounds great, initially, since you earn half your money back in just over half a decade and still own the title at the end of the guarantee period. But let’s say the property is rising at a 5% clip year-on-year within the same period. Are you really getting a good deal?
Let’s take a closer look at the numbers according to the above example:
Year Price Rental Yield
Y1 $100,000 $8,000 8%
Y2 $105,000 $8,000 7.6%
Y3 $110,250 $8,000 7.3%
Y4 $115,760 $8,000 6.9%
Y5 $121,550 $8,000 6.6%
Y6 $127,620 $8,000 6.2%
In the above example, it’s clear that the 8% rental guarantee is not really an 8% rental guarantee at all: in fact, if you average the yield over the 6-year period, the rental guarantee falls to 7.1% (and 6.9% if you exclude the first year, which many developers do since they count this year as Year 0, during which construction/refurbishment is taking place).
Rather, what is being promised is a rental guarantee with a (potentially exponentially) declining yield. This is because as the price of the property rises, the real yield percentage falls.
You might argue that one might expect rental income to go up commensurately with the property price increase, except that property price increases do not often result in commensurately higher rental increases. This is simply because the more demand at the most basic level for property (in the form of tenancies), the greater the attraction of such properties for purchasers.
Either way, at the most fundamental level, it’s clear that developers who promise 8%, or even 12%, fixed rental income guarantees are not promising anything of the sort.
Now consider that at the end of the period, the investor is left with an apartment that is yielding 6.2% in annual income (and which is declining by the year). One option the investor has is to sell the apartment. If they choose to do this, they will realise a $27,620 capital gain.
If we take the capital gain of the property over the 6-years, and add it to the net rental yield for the same period, the investor nets $75,620.
Translated into an average annual return, this equates to a 12.6% return per year. But this assumes that the investor will be able to realize the property at the top of the market; further, it is highly likely that following the 6-year rental period, the property will require some sort of reinvestment to achieve such a sale price, or else the return will be much lower. Thus, the real return per year is likely to be more in the region of 8–10%, making the capital gain function a much less significant feature of the property investment.
Capital Gain Yield Assimilation
Now let’s say that instead of getting back $8,000 a year for 6 years, instead you were to purchase the property for $48,000 less from the developer, and allow them to claim that amount back off rental income over the subsequent years. Further, at the end of the 6 years, you agree to sell the property back to the developer for a slight (around 5%) discount to market price.
In such an event, you would pay $52,000 (plus fees for financing and administration upfront) for something you end up selling for $120,000.
Assuming upfront fees for such a service were applied totaling 3.3% for the interest-free developer financing, and 8% for the buyback option, your returns would look like this:
(((p x 52%) + (p x 3.3%) + (p x 8%)) / p) / y
= ((p x 63.3%) / p) / y
= Annual Yield Assimilated Return (AYAR)
where p = price paid for asset and y = number of years the asset is held
The end result is that you would end up with an 89.5% capital gain, or a capital gain assimilated return (AYAR) of 14.9% per year. That is a full 40% to 65% above what you would get if you took a standard 8% annual rental guarantee and then looked to sell your property (after reinvesting in fixtures) on the market.
DMH & Co. Developer Financing Enhancements
DMH & Co. is unique among property developers in being able to offer annual yield assimilation return (AYAR) specific products to investors on all its properties. In environments of aggressive price increases (which is nearly always the case where large yields are concerned), this means a substantial difference in what you have to gain from the property investment.
In certain cases, it can mean earning double what you would in other instances get from buying from competing developers with weaker balance sheet assets and hence, more traditional (and thus restricted) purchase offerings.
Whatever the case, make sure that you investigate all the various income possibilities from a property investment before committing any money. Sometimes things aren’t always what they seem — especially when it comes to physical assets with the potential for depreciation unless reinvestment is committed, and where the investments span a number of years. Make your developer commit to what they promise you, and make sure you squeeze the most out of them that you can get. In case you were wondering, that’s exactly how fund managers make so much money from property investments!
About Daniel Mark Harrison & Co.
Daniel Mark Harrison & Co. (DMH & Co.) is the North of England’s largest property development company based in Singapore and Manchester with over SGD $150 million of real estate assets and sales of SGD $40 million per year. The company’s Manchester-based Orchid Point developments are the fastest-selling properties in the North of England and are yielding 8% annual returns. DMH & Co.’s founder, Daniel Mark Harrison, is the oldest of 9 generations of the founding family of Europe’s oldest security printers, Harrison & Sons Ltd., founded in 1750 and sold to De La Rue PLC in 1997.