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.
The yield itself is usually quoted on the purchase price, while the investor’s capital also pays for the acquisition. Transfer tax, notarial and legal fees, due diligence and the costs of arranging the loan sit on top of the price and earn nothing. In the Netherlands, article 14 of the Wet op belastingen van rechtsverkeer sets transfer tax at a general rate of 10.4 per cent, with other rates for the cases described in the paragraphs that follow, dwellings among them, and exemptions in article 15, and how that tax reaches a purchase of shares rather than of the building is set out in our note on Dutch real estate transfer tax in a share deal. A rent divided by the price and the same rent divided by the total cost are different numbers, and the second is the one that measures what the capital earns.
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 Spanish rules show how wide the difference can be. Under article 24(1) of the Spanish non-residents income tax law, income such as rent obtained without a permanent establishment is taxed, as a general rule, on its full amount. Article 24(6) lets a taxpayer resident in another Member State of the European Union deduct expenses, those of the personal income tax law for an individual and those of the corporate income tax law for an entity, provided it proves that they are directly related to the income obtained in Spain and have a direct and inseparable economic link with the activity carried out in Spain, and it extends the same rule to residents of European Economic Area States with which there is an effective exchange of tax information. Article 25(1)(a) of the same law sets the rate at 24 per cent as the general rule and at 19 per cent for residents of those EU and EEA States. Under these domestic rules a non-resident landlord without a permanent establishment and outside that group pays the higher rate on the larger base, the rent before interest, management and repairs.
Leverage and the limit on interest deductions
Debt raises the return on equity when the asset yields more than the loan costs, and that arithmetic assumes the interest reduces taxable profit. For a company taxed inside the European Union the assumption can have a ceiling. Article 4 of Council Directive (EU) 2016/1164, the anti-tax avoidance directive, limits the deduction of exceeding borrowing costs, broadly borrowing costs in excess of taxable interest income, to 30 per cent of the taxpayer’s EBITDA, and allows Member States, among other options, to grant a deduction of up to EUR 3 million by derogation from that ratio and a full deduction to a standalone entity. The directive applies to taxpayers subject to corporate tax, and its article 3 leaves Member States free to protect their tax base more strictly.
The Netherlands uses that freedom. Article 15b of the Dutch corporate income tax act disallows net interest to the extent that it exceeds the higher of 24.5 per cent of adjusted profit and EUR 1,000,000, and the disallowed amount is carried forward to later years under the conditions of the same article and of article 15ba, which can forfeit it after a significant change in ownership. For a leveraged property company, interest that cannot be deducted this year raises this year’s tax even if it is deducted later. We describe the mechanics in our note on interest deduction limits in the Netherlands, and the choice between funding a Dutch property company with debt or with equity in our note on debt versus equity in a Dutch real estate BV.
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 minimizes leakage; a poorly designed one adds a layer of cost and a layer of leakage at once.
Withholding tax is the most visible leak. A Dutch company distributing profit withholds dividend tax at 15 per cent under article 5 of the Dividend Tax Act 1965, and whether that charge is removed or reduced depends, among other things, on the conditions set out in article 4 of the same Act, which include an anti-abuse test, and on any applicable tax treaty. Separately, the Dutch Withholding Tax Act 2021 imposes a conditional withholding tax on certain dividends paid to a related entity in the cases set out in its article 2.1, which include, subject to the exceptions in that article, an entity established in a low-tax jurisdiction within the meaning of that Act, at the highest rate of article 22 of the corporate income tax act, reduced under its article 5.2 by the dividend tax withheld on the same dividends. Tax withheld and never credited or refunded is return lost between the asset and the investor, and tax refunded late is a cost of time. We set out the Dutch position in our note on Dutch withholding tax on dividends, interest and royalties.
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.
Currency also reaches the tax computation. In the Netherlands, article 15b(6) of the corporate income tax act counts currency results on loans, and the costs and results of transactions that hedge interest or currency risk on loans, as part of the net interest balance that the earnings stripping limit restricts. A hedge of a loan can therefore use up deduction capacity, and an exchange loss on a loan falls within the limit in the same way as interest. For a leveraged investor the currency decision and the financing decision are one calculation rather than two.
The exit belongs in the return
A yield describes a year, while a return describes a holding period, and the holding period ends with a sale. Selling costs, the tax on the gain and the time taken to receive the proceeds all reduce the capital that comes back, and for an asset bought on a thin yield the exit can decide whether the investment made money at all. We discuss how a holding period ends in our note on exiting a European real asset.
Spain again illustrates the mechanism. For a non-resident acting without a permanent establishment, article 25(1)(f) of the Spanish non-residents income tax law sets the rate on capital gains at 19 per cent, and article 25(2) obliges the buyer of Spanish property from such a seller to withhold 3 per cent of the agreed price and pay it to the tax authority on account of the seller’s tax. If that amount is not paid, the property transferred remains charged, without prejudice to any penalty for the infringement, with the lower of the withholding and the tax due. The withholding is calculated on the price rather than on the gain, so a seller whose gain is small carries a cash cost until the account with the tax authority is settled.
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.
A poor year is worth defining before the transaction rather than after it. It is the year a large tenant leaves and the space takes time to relet, the year the loan is refinanced at a higher rate, or the year the currency moves against the investor, and sometimes two of these at once. A projection that works in a normal year describes the asset’s central case, and the distance between that case and the poor year is the part of the return the investor is actually exposed 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.
The distinction also changes which costs matter most. For a core asset the recurring leakage, from withholding tax to the fixed costs of the structure, repeats in every year the asset is held. For a value-add asset the tax on the gain and the transaction costs at entry and exit carry more weight, because most of the return arrives in a single event. The same structure can therefore suit one strategy better than the other, and the meaningful comparison is between net returns under the structure in which each asset would actually be held.
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.