Welcome to today’s episode: 5 Sources of Yield from Real Estate Investing.
[00:00:06] We do have five sources. Most of you know what they are. But I’m going to go into a little bit more detail and insert my bend, or my perspective, on the five sources of income that generate yield which leads to a higher internal rate of return when they’re all deployed by your investment dollars.
[00:00:27] The first is income. Income of course is often 90 percent or more of the yield that is generated by real estate investing. We rely on income to pay the bills for the property. But let me give you a definition from my book How to Read a rent roll- a definition of rental income.
[00:00:50] It is your gross rental income and all the amount you receive as rent. Rental income as any payment you receive for the use or occupation of property.
[00:01:00] Another definition: rental income is any payment you receive for the use or occupation of property.
[00:01:08] That’s our rental income. That’s not the only source of income for a rental property. We also have ancillary income and ancillary income I break down into three categories. One is straight fee income; which means applying institutional standards to a multi-family property, or a rental property, that you’re using industry standard fees and not just ones that you decided are appropriate. Really dive in to see what people are charging within the industry and apply that metric to your rental property. Next is referral fees which is self-explanatory.
[00:01:52] The third is fees for services which means fees that you earn on a monthly basis usually. Fees for services is emerging is something that’s becoming a higher percentage of income. These are services that your residents use while living on the property.
[00:02:07] This third category of ancillary income, fees for services, means earning monthly fees for new or fast emerging creative ways of giving extra levels of service to your rental housing residence by creating a living environment that they don’t want to leave; concierge services that brings services to the door of your residence. Ancillary income is another segment of the income metric.
[00:02:37] The third income source is a focus on renewals. Every time you can increase the lease term of an existing resident then you are adding to your income going forward. The more you can do on the renewals front the less you have to put time, energy and effort into finding new customers.
[00:03:08] It’s no different than with any other large business, whether you’re General Motors or Best Buy like these big businesses do; if you can bring people into your store and they are accustomed to and comfortable with the level of service they keep coming back. They don’t have much competition for their core audience and the same can be true for a rental income property. If you’re taking care of your customers, you can focus on them and not have to devote as much time to perpetually finding new customers.
[00:03:43] Consider a small property, 50 units, 100 units, that has an industry standard turnover of 50 percent per year. That means 50 percent of all the units that are occupied will have new occupants by the end of the next 12 months. If you can reduce that number by just 10 or 20 percent that is a substantial amount. That will increase your income for that property concurrent with lowering expenses. That’s why I add renewals to the income category because a focus on renewals will assist in increasing income.
[00:04:23] Getting back to the 5 sources of yield from real estate investing; income will always be number one of course. Followed by those categories I gave you for income; rental income, ancillary income and renewals.
[00:04:38] The next category is appreciation. Appreciation is straightforward; it is an increase in the value of real estate assets over time. Now it’s not always a straight line. We do now know that values can go down in addition to going up. Appreciation is not just a one-way street.
[00:04:58] Increases in value from appreciation can occur for several reasons including demand, an increase in demand or a weakening in supply. We’ve seen that in the last decade, whereas, demand didn’t necessarily increase dramatically but because of the slowdown of construction there was less product available even as more families began to form. Another way of saying that is as family formation trek along and increased it at its natural rate there was not enough product in the market to accommodate. That caused rental rates to increase and with rental rate increases we see appreciation and value of rental property. Appreciation is a very important factor in the source of yield.
[00:05:51] Next is depreciation. Depreciation is an accounting method for allocating the cost of a tangible asset over to useful life and that has a different impact depending on who the investor is, what their tax brackets are and how your accountant goes about utilizing depreciation. It’s different for everyone but it is a factor in the yield for Real Estate Investing.
[00:06:17] Next is mortgage pay-down. Pay-down refers to the repayment of an outstanding loan. The pay-down I’m referring to is when your mortgage is reduced, when the principal balance of your mortgage is reduced, based on making those monthly payments and in so doing the borrower is paying down the debt and the principal balance of the mortgage.
[00:06:41] People refer to this (mortgage pay-down) as a forced savings plan just by owning a piece of property that has that based on making that monthly payment every month every month you’re paying a little bit of that principal down so that little bit does add up over time. Mortgage pay-down also has a positive impact on yield.
[00:07:01] The fifth area, one that I like to concentrate on and promote as being just as important as the other four categories, is active management. Active management means that even if you are a passive investor that you keep your eye on the ball with respect to property management and asset management.
[00:07:23] If yours is a relatively large organization or one that’s structured for institutional investment there will always be an asset management team between owners and property management. But even if you’re a smaller owner and you’re acting as your own asset manager that doesn’t mean you can just kick the ball to property management and look at the reports at the end of the year. You need to be actively engaged and knowing what’s going on, more than with just capital improvements but to, a larger degree, assuring that the business plan that set out for that property is being implemented and implemented in an effective manner.
[00:08:06] You can’t just not be there even if you are in a passive investment position and your asset manager is reporting to you. Those reports need to be read. You need to have an understanding on how active management is affecting your investment. Because even if everything else is going fine. If no one’s watching the store there will be a decrease in value over time just based on indifference. Indifference is the worst thing that an investor can do. Indifference is just another way of saying I don’t care.
[00:08:46] If you don’t care then that’s not an investment you should be in. If you don’t care to watch it, if you don’t care to know what’s going on and how it’s affecting your overall investment portfolio then probably needs to be removed from your investment portfolio so that you can re-allocate those dollars into something that you do care about.
[00:09:08] An investment in real estate that has all five sources of yield working on its behalf will have a greater internal rate of return than if any one of these is left out or lacking.
[00:09:22] What is an internal rate of return? What is an IRR? Internal rate of return is used in capital budgeting measuring the profitability of a potential real estate investment as compared to other real estate investment. Internal rate of return is a discounted rate that makes the net present value of all cash flows from deal equals zero.
[00:09:53] We use internal return to return to rank prospective real estate investment opportunities on a relatively even basis. When you and IRR, if our cost of capital is the same for all the investments then the deal with the highest internal rate of return would always be selected to capture your investment dollars because it would provide you with the highest overall yield. The highest yield on real estate follows the highest internal rate of return that’s provided and implemented by management and ownership.
[00:10:32] They do mesh together, the five sources of yield from real estate investing, have to match up with a stated internal rate of return so that you know what you’re getting. It shouldn’t be something that’s off-handed or ignored because that internet rate of return will allow you to compare various real estate investments and select that one that has the best opportunity for success the highest potential IRR. Again, that presumes that your cost of capital is the same for the array of investment opportunities that you’re looking at within real estate.
[00:11:10] To recap the five sources of yield from real estate investing include income, appreciation, depreciation, mortgage pay-down and active management. And with active management we’re talking about property management and asset management both being engaged at a high level to assure that the other four sources of yield are all engaging appropriately on your behalf.
[00:11:40] Thanks for listening today. This has been John Wilhoit on Real Estate.
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John Wilhoit is a real estate professional specializing in residential asset management and property management. John has an undergraduate Degree in Business and a Master’s Degree in Urban Studies. Learn more about John here.