An asset advertised at a seven per cent yield rarely delivers seven per cent to the investor. The distance between the headline and the money that arrives is made up of costs that are individually unremarkable and collectively decisive, and an investor comparing opportunities on gross yield is comparing numbers that do not mean the same thing.
The layers between gross and net
Start with the gross rent. Deduct non-recoverable service charges and the cost of vacancy, which even a well-let building carries between tenancies. Deduct property management and letting fees. Deduct the annual capital expenditure the building genuinely requires, which is not zero for any asset and is substantial for an old one. Deduct insurance, local property taxes and, in several jurisdictions, taxes that apply to the ownership itself rather than the income.
What remains is the net operating income, and it is typically well below the number in the marketing material. Then the financing cost is deducted, then the tax, then the cost of the structure itself.
Tax is where cross-border investors lose the most
An investor holding a foreign asset faces local tax on the rental income, and the deductibility of financing costs varies with the investor’s residence and structure. In Spain, for example, the deductions available to a non-resident landlord differ depending on whether the investor is resident in the European Union or outside it, which changes the after-tax return on a leveraged asset materially. We set that out in our note on non-resident borrowers in Spain.
Two investors can buy the same building on the same day at the same price and earn returns two points apart. The building is identical. The structure is not.
The structure has a running cost and a leakage cost
A holding structure costs money to maintain, in accounting, filings, directors and audit, and those costs are fixed rather than proportional, which means they weigh more heavily on a smaller asset. We set out what a Dutch structure genuinely costs in our note on what a Dutch holding structure actually costs. Separately, the structure can leak: withholding tax on the way up, non-deductible costs, timing differences. A well-designed structure minimises leakage; a poorly designed one adds a layer of cost and a layer of leakage at once.
Currency, for investors who do not think in euro
An investor whose home currency is not the euro carries a currency exposure on both income and capital, and a return calculated in euro says nothing about the return received. Hedging costs money; not hedging is a position rather than a neutral choice. Either way it belongs in the underwriting rather than in the surprise.
What to ask instead of the yield
The useful question is not what the yield is but what the investor receives, after all of it, in their own currency, in a normal year and in a poor one. That number requires the business plan, the structure and the tax analysis to have been done, which is precisely why it is quoted less often than the gross yield. An investor who insists on it will decline some transactions that looked attractive and will be right to.
The strategy sets the expectation
Core assets deliver most of their return through income, so the erosion between gross and net matters enormously. Value-add assets deliver most of their return through capital appreciation at exit, so the running erosion matters less and the exit assumption matters more. Comparing a core asset and a value-add asset on gross yield is comparing two different propositions on a metric that is central to one and secondary to the other. We set out the distinction in our note on core, core-plus and value-add.
Montclare manages and structures European real assets for institutional and private investors, from acquisition through to exit. Our services are set out on our services page.
This article is informational and does not constitute investment, tax or legal advice. Asset management and investment advice are regulated activities and the treatment of any transaction depends on its facts. Each engagement is subject to scope and applicable regulation.