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Equivalent yields are the UK property market’s mechanism for communicating the current level of return on commercial property investments.
In many other countries this would simply be the relationship between the current rental income from the property after all landlord expenses had been stripped out as a return on the capital value at the beginning of the year; the initial return or yield.
Non-UK rents are often fixed under agreements whereby they increase annually often in line with consumer or other price indices so initial yield forms a reliable measure of the relationship between current income and current capital value. This measure also performs a useful function in other asset markets.
But in the UK there are rather more complicated lease structures with rents often fixed for periods of 5 years between rent reviews which are virtually always based on the contentious upwards only provision.
In rising or falling markets, the relationship between rent and the actual letting value of the property, the market rent, can start to diverge quite sharply and the initial yield and the reversionary yield (rental value divided into capital value) also widens. Neither of these two measures is deemed to be a reliable indicator as neither of them take any account of the timing and extent of reductions or increases in value at lease expiry or rent review.
The solution has been to determine the internal rate of return of the current income to the next rent change and then discount the perpetual current rental value thereafter. This produces a weighted average of the initial and reversionary yields. It therefore takes no account of any future change in rental values over and above what has already been observed in current markets. The application to complex lease structures can be difficult and interpretation of these can lead to some variation in the basis of reporting these yields, for example voids on lease expiry, assumptions about frequency of rent payments, etc. But equivalent yield also forms the mainstay of the main method of market valuation of commercial investment property in the UK.
The equivalent yield calculation in its simplest form is:
CV = r/y + (RV-r)/y (1+y)-t ] where;
CV = current capital value
r = current rent under the lease
RV = current rental value (or market rent as defined in valuation standards)
t = time to next rent change
y = the equivalent yield
Equivalent yield forms an important measure within the UK’s largest property performance measurement system and their precise interpretation within this practice application can be found in the IPD Index Guide. Current general levels of equivalent yield across the UK property market can be found on the CBRE website. in their UK Rent and Yield Monitor.