The yield, our guru?

Numbers don't lie.

If we consider the Swiss gross value creation, which measures the income from economic activity as the deviation between the output of an economic unit and the input required for the provision of services, the construction sector, which has an annual turnover of almost 20 billion (as of 2018), is becoming increasingly relevant. While the construction sector accounted for 4% of total gross domestic product (GDP) at market price in 2000, its weighting rose by half in ten years to 6%. If we also consider the price trend in the construction sector, prices for apartment buildings rose by 1.3% in the second quarter of 2019 compared with the first quarter, to an annualized 3.1%. The rise in prices shows that the market for investment properties is drying up.

The importance of the construction sector would be greater if it were also to include sectors outside the construction industry, which produce exclusively construction-related products and services and thus also play an important role.

These figures confirm the continued stability of the construction sector, despite price cuts in other sectors.  

Influence of yield on investment on value creation

Buyers of investment properties strongly influence the market value with their yield expectations. All the more reason for entrepreneurs operating in the real estate market to have to deal with different yield concepts. In essence, static and dynamic return indicators can be distinguished. The statistical gross and net returns can be used as success and comparison yardsticks for the operative use of real estate in relation to the market value. While the gross yield is determined from the ratio to the current market value, the figures for the net yield must be corrected to the net return (Fig. 1).

Dynamic indicators such as the cash flow (DCF) method, the economic value added (EVA) approach, the internal rate of return (IRR) or the pay back method are more sophisticated and more widespread in current valuation practice.  

1. With the Economic Value-Added approach, the "excess profits of a project are no longer calculated as a lump sum, but by means of differentiated scenarios for the first five to ten years.
2. With the Economic Value-Added approach, the "excess profits of a project are no longer calculated as a lump sum, but by means of differentiated scenarios for the first five to ten years.
3. By means of the internal rate of return method («interner Ertragssatz»), the exact financial mathematical calculation of the (gross) yield of a project can be determined.
4. The payback method indicates how long it will take for the positive cash flows of a project offset the initial investments.
   
   

What yield is to be expected  

Purchasing matters are currently very rare due to the dried-out real estate market. The preferred investment properties in good locations and at a reasonable purchase price have become scarce. According to an expert survey, some apartment buildings in need of renovation in the city of Zurich are bought at a gross yield of less than 2%. However, yield benchmarks for the expected net yield, taking into account real estate-specific risks such as location, condition and construction quality, are between 4% and 5% for residential buildings and between 5.0 and 5.25% for commercial buildings. On the other hand, an increase in sustainable construction methods such as Minergie-P is expected to lead to a lower initial expected return. Although the originally higher costs push the return down, sustainable construction increases the values in the area of sustainability and creates added value in the long term. In conclusion, excessively low returns can represent a major risk, as the gross income must be used to finance costs such as bank interest, administration costs, maintenance costs and, in particular, the creation of renovation provisions.

New construction or renovation? An important decision for the return on investment

In addition to high purchase prices, renovations can also be a killer of returns. All the more reason to examine this topic closely.

In the case of properties in average or poor locations and regions, there is currently a real renewal dilemma. The properties require major renovation, but this would lead to rents that would not be paid by those interested in the location in question. For this reason, only the most necessary maintenance is currently carried out on these buildings to avoid construction defects and vacancies. There is a danger of strong decay or even the formation of slums.

According to a study by the Institute for Energy at the Basel University of Applied Sciences, the following factors are important for the individual decision to renovate:

• Structural problems
  Noise problems, replacement, pipes, renovation “building shell”
• Functional and structural deficits, inadequate market and location justice
  Inappropriate apartment layouts, rooms that are too small and make one feel trapped, missing elevator, missing balconies, insufficient sound insulation, apartments that are too small
• Existing utilisation reserves, which can be exploited in a total renovation.
• Location of the property
  The location is the central criterion for the rent potential and thus for the possible standard that still finds demand at a certain location.
• Tenancy law: Transfer and provisioning rules, notice periods
  The tenancy law only permits the transfer of a maximum of 50%–70% of the investment to the rent for complete refurbishment. In practice, the emptying of a property takes 6 months to 2 years.
• Tax law framework
  In the case of privately-owned apartment buildings, value-enhancing renewal investments could be deducted from taxes. Since the abolition of the Dumont practice, building maintenance and repair of old properties can be tax-deducted more easily.

According to the study, no significant differences are to be noted in the cost analysis of both renewal variants. The prerequisite is that all cost elements (including vacancy and re-letting costs and different fees) are taken into account from the moment the decision is made to carry out a complete renovation until the full re-letting of the complete renovation or the replacement new building. In principle, it can be stated that replacement new buildings have greater scope for cost savings as long as they are in a good location and from the high quality desired by the customers willing to pay. The higher demolition and vacancy costs can also be compensated by higher property utilisation. This leads to a higher rent potential. Nevertheless, there is also great potential for minimising rent losses in the overall refurbishment process, because in poorer or average locations it will be difficult to exploit the specific advantages (modern, technical and qualitatively future-oriented apartments) of replacement construction. As far as the ecological aspect is concerned, the additional construction waste and emissions during demolition and new construction deserve special attention. The ecological evaluation of both renewal options depends on the use of the construction waste. It is neutral if a high recycling and reuse rate is achieved.

Challenging tasks for the modern planner

The planner's tasks go far beyond the intensive debate between space and environment. In addition to technical, functional and design planning, he increasingly bears a complex ecological and economic responsibility. The desire for timeless architecture and the shaping of architectural styles must increasingly be reconciled with the economic viability of the object.

Sources

Bundesamt für Statistik «Wertschöpfung»;

BFS- Volkswirtschaftliche Gesamtrechnung

Immobilia

Rudolf Vollkart, CF Grundlage von Finanzierung und Investition

SBV