The Dangers Of Gross Yield Offers And The Pitfalls Of Fixed Appreciation Projection
There are a lot of scammers out there.
And not all of them are trying to sell you a bridge.
Some fraudsters bilk unsuspecting investors into handing money over for bogus developments.
But far more common are the legal scams where a seller dupes unseasoned investors by hyping information that doesn’t have any bearing on actual value.
A prime example of this is using gross cash flow to imply future earnings or arbitrarily fixed capital appreciation projections as a reason to pay more for a property than it’s worth.
These flim-flam artists dazzle you with information that looks appealing on the surface in the hope that this distracts you from what’s actually inside the deal.
When they use gross cash flow projections and financing, these scoundrels can claim rental “yields” of over 40% per year.
This sounds like a stunning return and makes you willing to pay more for the property.
From the developer’s point of view, the beauty of it is in the disclaimer in their paperwork stipulating that the numbers are just gross projections and not a guarantee.
Even deeper in the contract they mention that the projected IRR doesn’t include the construction period… which is often up to two years.
If you only keep the property for six years, this two-year building period would mean a 33% loss in earnings. Ensure you calculate your rental return including any lost construction time over the life of your investment.
These are soft scams… but they are legal because the developers tell you what they are doing, but they do it so smoothly and quietly you forget to ask the right questions.
“Gross” is a dangerous number to take at face value. It is just the income a property produces and doesn’t consider any expenses at all.
Gross rent yield = (gross income/purchase price of property) 100
Only looking at the income is useless when trying to understand an investment. You have to be aware of the many costs associated with owning an income property, and these vary wildly with location and property type.
A property might produce US$50,000 per year in income, but without factoring in mortgage, HOA fees, maintenance, property taxes, rental management, marketing fees, etc., you don’t know if you have made a profit or not.
When I analyze the numbers for rental properties I always talk in terms of “net yields,” which take into account all expenses.
Net rental yield = ((gross income – expenses)/purchase price of property) 100
This gives you an accurate picture of the state of your investment.
Factors To Consider When Evaluating An Investment
1. Income
How does the salesperson present the future rental income? What is the realistic rental income for your property? What do comparable properties in the area rent for? Are rents rising, and if so, how quickly?
Will you be doing long-term rentals or short-term lets for higher nightly prices? If you are doing short-term lets, is there an off-season where you won’t have any income at all?
What are local occupancy rates? Ensure your projections reflect low season occupancy rates.
Will you have to do additional marketing yourself to ensure it keeps high occupancy to meet expectations?
2. Expenses
Property management costs vary depending on the country, company, property type, and the type of services you require. I’ve seen costs range from 6% to 30% of gross income depending on the market and amount of advertising required.
3. Essential Management Consideration
The availability of reliable local property management should be an essential consideration in any property purchase. Do your research before buying.
A seemingly profitable property bought based on numbers, including a cheap property management company, could become loss-making if you are later forced to pay more for an effective management company.
4. Financing
Financing costs are a key part of many property purchases. They are great ways of leveraging your buying power and potential return. However, you need to be aware of any hidden balloon payments in your mortgage.
Long-term fixed rate mortgages aren’t available in every country, and interest rates can rise.
You should also verify a developer’s claims that local bank financing is available if you require it and ask what loan-to-value ratios are available to foreigners.
5. HOA
Consider whether the homeowners association is financially sustainable in the long-term. If you live in a planned community, your HOA fees need to cover general maintenance and amass a renovation reserve fund to fix major future issues.
A few years back my parents were hit with a 32,000-euro bill for their share of the repair of a faulty condo-building roof in Croatia even though their unit was on the ground floor.
6. Taxes And Maintenance
Know what local taxes you will owe on rental income and ask for a copy of the property tax bill before buying to avoid any surprises.
Some thought should be given to the long-term maintenance costs of the type of building and finishes you want. Wooden houses in the tropics require regular upkeep. Thatch roofs are very romantic until you have to change them every 10 years or get them insured.
7. Insurance
Get property insurance quotes from the larger local insurance companies. Don’t skimp on full property insurance including hurricane and flood cover if they are a risk. Loss of business insurance isn’t cheap, but it might be a wise addition in today’s topsy-turvy world if you are heavily reliant on this rental cash flow.
8. Short-Term Rentals
If you are renting short term you will have to factor into your budget the higher-than-average usage of electricity and water by tourists and much higher cleaning and upkeep costs.
Once you are satisfied that you have accounted for all your costs, allowing for a little contingency, and the numbers still stack up, you can feel confident in making an investment.
Net profits for a rental should be 3% to 6% in old-world and major international cities and 6% to 12% in growing economies and tourist markets. In fast-developing tourist markets or boom-town markets, 12% to 16% can sometimes be found.
Formulaic Capital Appreciation Projections
This is another common hustle you get from fast-talking realtors trying to charge you more for possible future appreciation.
There is no realistic estimate of “8% per year appreciation for the next 10 years for an 80% profit.”
The truth is, capital appreciation is both hard to estimate and cyclical. There are many ways of making more-informed estimates. You can look at how the country is developing and what locations still offer value and appreciation potential.
You can even look at locations further up the path of progress and see how much they appreciated to put together matrixes of numbers to estimate your property’s possible price trajectory.
However, just picking 8% as a universal capital appreciation figure is both useless and unsustainable in most markets.
Locking In Quick Capital Gains
Buying a pre-construction investment property can be a great way of locking in large discounts and medium-term capital appreciation. Many people sell their off-plan property as soon as the development is fully built and never have to deal with rental management companies at all.
Here you can be nearly certain of capital appreciation, as the developer won’t sell their own inventory for less than the prices for finished units they set at groundbreaking.
A developer won’t undercut their own prices, and you have all the other units in the development to use as price comparisons when selling.
This can turn a 30% discount into a 30% profit in a couple of years. Even more profit is possible if the local property market appreciates over the construction period.
For these attractive returns you run the risk of the developer not completing the project.
This is why I do deep background research into any builder or developer that we work with. Track record is a huge consideration when talking to any developer.
Calculating Net ROI
Like calculating net rental yields, when you sell your property you need to be aware of any other expenses that will be deducted from your sales price.
These expenses commonly include legal fees, local capital gains tax, estate agent fees, waste disposal of old furniture, or upgrades required to sell the property.
Net rental yield = ((Gross yield – expenses)/purchase price of property) 100
Perks To Ownership
Inspection trips are one perk you can enjoy as property owner. If you rent short term, you can decide to use the property in between bookings. It’s a nice way of getting a tax-deductible holiday.
Even if your property is rented long term, the cost of your trip and cost of accommodation on your inspection trip is tax deductible.
Quality developments are available out there that because of prime positioning and early market entrance can offer high-net-rental-yielding properties with strong capital appreciation potential.
I never guarantee capital appreciation figures, but I will tell you when all the factors necessary for strong appreciation are present.
I vet all the property picks we bring you, and we build strong relationships with leading developers who have sterling track records in the industry.
By buying property that I have spent months and years monitoring, you can be certain that all the necessary considerations have been examined.
Con Murphy
Editor, Overseas Property Alert