To what extent should
yield compression feature in underwriting your equity investment?
The question of to what extent yield compression should feature in underwriting your equity investment has been a frequent topic of discussion at Aprirose Real Estate Investment and something we have
been discussing with our investor base.
Rates are expected to fall and so an element of yield compression may be justified as tracking the market. However, investors should consider the specifics of the opportunity including the property location, tenant covenant, lease terms and where you are in the asset's lifecycle – is the asset still stabilising or stabilised?
These are all factors that will influence the extent of yield compression (if there is indeed any to be seen. It may of course go the other way and yields move out as a result of a shortening lease length etc.)
Another question that’s important is ‘have you bought well?’ If so, selling at a tighter yield may just be a case of exiting at market. But you got to be able to substantiate this.
The more you can do to the property to create value, the more a tighter exit yield can be justified. Traditional asset management such as improving the quality of tenants, upgrading the property and extending the leases all create value and support a stronger exit yield.
On the other hand, doing nothing to the property and still underwriting a sale at a few hundred basis points better than you bought it just isn’t acceptable to investors – as it shouldn’t be.
In 2025, with an uncertain market thanks to slower cuts in interest rates, expected rising in inflation together with post-budget rises tax changes we must create our own value, doing all we can to give us the best chance to benefit from yield compression.
A key metric we also consider is yield on cost. We may not be able to sell when we want to or for a price we would like. The market conditions may not allow for this. Therefore, creating value, resulting is an increased yield on cost is an important metric so that we maximise the return during the extended holding period. This, along with other factors to be considered (i.e. financing structure), will ensure that we can control as best we can when we sell and at what price.
We consider the exit upon our original acquisition. And while market scenarios may change in between, with a focus on asset management we should come out with a better return, than leaving the asset as is and hoping the market will result in yield compression.
There are a few examples that demonstrate this point.
One proposal we considered was buying a 20-year income stream with inflation linked reviews. The “opportunity” was to simply exit in five years with a 250 bps/35% yield compression. There was nothing to do with the property. Arguably the property may even become overrented which would also affect the yield compression. Not a deal for us.
We have an office refurbishment where we re-geared the anchor tenant lease to a new 10-year lease, and we are in the process of upgrading common parts and improving the ESG credentials. These will improve rental levels for the vacant space and has allowed us to negotiate new leases at elevated levels with the existing tenants who have shorter leases. The end product will be a newly refurbished, grade A office space with all tenants on longer leases. We will enjoy a strong yield on cost and should allow for profitable exit at the right time.
Another deal we are currently working on comprises a mixed used retail and residential scheme. There is the opportunity to asset manage the estate and improve the overall quality of tenants, drive footfall and ultimately improve the market rent and the valuation yields.
One final word - the opportunity is there but won’t always be obvious. As investment managers and investment partners who seek returns for Aprirose and our clients, we have an in-house asset management team for exactly this reason. Our investment strategy is clear – find the opportunity to add value or move on.
Rates are expected to fall and so an element of yield compression may be justified as tracking the market. However, investors should consider the specifics of the opportunity including the property location, tenant covenant, lease terms and where you are in the asset's lifecycle – is the asset still stabilising or stabilised?
These are all factors that will influence the extent of yield compression (if there is indeed any to be seen. It may of course go the other way and yields move out as a result of a shortening lease length etc.)
Another question that’s important is ‘have you bought well?’ If so, selling at a tighter yield may just be a case of exiting at market. But you got to be able to substantiate this.
The more you can do to the property to create value, the more a tighter exit yield can be justified. Traditional asset management such as improving the quality of tenants, upgrading the property and extending the leases all create value and support a stronger exit yield.
On the other hand, doing nothing to the property and still underwriting a sale at a few hundred basis points better than you bought it just isn’t acceptable to investors – as it shouldn’t be.
In 2025, with an uncertain market thanks to slower cuts in interest rates, expected rising in inflation together with post-budget rises tax changes we must create our own value, doing all we can to give us the best chance to benefit from yield compression.
A key metric we also consider is yield on cost. We may not be able to sell when we want to or for a price we would like. The market conditions may not allow for this. Therefore, creating value, resulting is an increased yield on cost is an important metric so that we maximise the return during the extended holding period. This, along with other factors to be considered (i.e. financing structure), will ensure that we can control as best we can when we sell and at what price.
We consider the exit upon our original acquisition. And while market scenarios may change in between, with a focus on asset management we should come out with a better return, than leaving the asset as is and hoping the market will result in yield compression.
There are a few examples that demonstrate this point.
One proposal we considered was buying a 20-year income stream with inflation linked reviews. The “opportunity” was to simply exit in five years with a 250 bps/35% yield compression. There was nothing to do with the property. Arguably the property may even become overrented which would also affect the yield compression. Not a deal for us.
We have an office refurbishment where we re-geared the anchor tenant lease to a new 10-year lease, and we are in the process of upgrading common parts and improving the ESG credentials. These will improve rental levels for the vacant space and has allowed us to negotiate new leases at elevated levels with the existing tenants who have shorter leases. The end product will be a newly refurbished, grade A office space with all tenants on longer leases. We will enjoy a strong yield on cost and should allow for profitable exit at the right time.
Another deal we are currently working on comprises a mixed used retail and residential scheme. There is the opportunity to asset manage the estate and improve the overall quality of tenants, drive footfall and ultimately improve the market rent and the valuation yields.
One final word - the opportunity is there but won’t always be obvious. As investment managers and investment partners who seek returns for Aprirose and our clients, we have an in-house asset management team for exactly this reason. Our investment strategy is clear – find the opportunity to add value or move on.
