When Buying … Why Would You Accept a Passing Yield Lower Than Market Level?

ON THE FACE OF IT … there’s no logical reason why you would.

Unless of course, you were intending to occupy the property when the current lease expires. In which case, the initial low rental is really of little (or no) importance to you.

You see, you have a specific reason to purchase the property. And may well be prepared to pay a premium as a potential owner-occupier – in order to secure that particular property, which ideally suits your purpose.

Alternatively, you may already own one or more adjoining properties, which you have previously purchased at attractive rates. 

Therefore, the above-market price you may pay to secure the final property (to consolidate your holding) … will simply be averaged out across the other properties – making the overall price per square metre, more in line with the current market.

However, not every sale represents such special value to the purchaser. More often, the reason for accepting an initial low yield could be that …

• There is a pending review, to bring the rental in line with market level;
• You have a strong tenant and a long lease, and place some added value on having a secure cash flow; or
• The property has good upside with redevelopment potential, and there is only a short-term remaining.

When are you able to snare a Higher Yield?

Sometimes the remaining lease on a property may be short, with no certainty the tenant will continue on. And to attract a buyer, the vendors need to offer a higher yield.

Therefore, despite the rental being appropriate … your passing yield may well end up higher than usual. Because, in effect, you’re being compensated for the lack of security in cash flow.

However, there are several other reasons why you may obtain a higher passing yield …

• The rental is above market, and likely to fall when the lease expires;
• The building itself is obsolete, and would soon in need of upgrading or replacement;
• The property is currently occupied under a non-conforming-use permit.
• The tenant could be considered financially weak; or perhaps …
• The property is purpose-built and only suitable for a narrow range of alternate uses.

That means, when your tenants vacate, they can only be replaced by others of a similar occupant. 

Examples of this may be medical clinics or child-care centres, which are generally found within a Residential zoning – despite the buildings being more akin to commercial structures.

Bottom Line: You must not simply accept every passing yield as “reflecting the Market”, whenever you’re looking for comparable sales.

Instead, make sure you look behind each and every sale. And you need to fully research whether … the rental was at market level; the tenant and lease period were secure; or if there may have been any hidden potential for further development.