High Yield Vs. High Liquidity

Is it possible to make a high yield real estate investment in Japan that is also highly liquid? The answer is probably, “no”. Understanding the relationship between yield and liquidity will equip you with the knowledge needed to make intelligent acquisitions that fit in with your own income objectives, and ensure your long-term investing success. Although there will always be exceptions to the rule, and the ‘deal of the century’ may come on the market every now and again, for the most part in real estate investment there is a negative correlation between yield and liquidity.

Why Picking High Yield Properties In Japan Isn’t Always The Safest Way To Invest

Many stock market investors have been surprised to lose money despite what seemed like a logical allocation strategy. When looking at stocks that pay income to their owners (dividends), it is possible to sort them from highest-paying to lowest paying- and many will make their picks starting at the top. Indeed, if an investor has a chance to choose between receiving 5% in dividends and receiving 6% in dividends what could compel him to forego the extra money by choosing the 5% yielding investment?

The answer is to be found in the nature of dividend paying companies. Companies that pay anything above a modest dividend often have lower prospects for growth (and as such, muted prospects for capital appreciation in their share price). This is because instead of using their money to expand and develop the business, that money gets paid out to stakeholders in the form of dividends. There is always a market for regular income, so there will always be an interest in companies that pay dividends. The more pessimistic view of dividend-paying companies (particularly the companies that pay what could be regarded comparatively as “high dividends” to shareholders) is that the dividend is deliberately high to make the company attractive to investors, despite a negative outlook for the company and its earnings. In short, investors will be paid and remunerated via the dividend to hold and own a bad business. The worse the outlook for the business, the higher the dividend has to be for it to be an acceptable risk for the investor.

The caveat here is that high-yield is great when you are receiving it, but when it stops being paid, it becomes the polar opposite of “high”. The companies that historically pay the highest dividends are in the mining, oil & gas industries and in the recent past there have been no shortage of investors whose “high yield” portfolio’s became “no-yield” exercises in bankruptcy. In short, there is no such thing as a free lunch, and no such thing as a risk-free return.

If an investment property has a high yield the risk is going to be one or both of the following:

1) high vacancy
2) lack of liquidity

High vacancy should be looked at as the amount of time that the property sits vacant and not producing rental income. Certain properties in locations with a weak rental market may sit un-occupied for extended periods of time. Usually, the acquisition cost of these properties is low and rents are high in relation to the value of the asset. This will result in a high-yield during periods of tenancy, but potentially long periods of vacancy with no rental income.

Liquidity in this instance should be the ease (or the difficulty) with which the owner can find a buyer for the property come the time that they wish to divest of the asset. There is a strong negative correlation between high-yield investments and their liquidity. This is true not just of real estate, but in capital markets also. Although the investor has the potential for higher returns during their period of ownership, they may not be able to sell the asset quickly, or may be forced to lower the sales price of the property to ensure a sale within a reasonable time frame. This too will ultimately effect the investor’s return when considering the investment return over the total period of their ownership.

An Example Of High Yield Being Low-Yield In Disguise

We start with two investment properties. Property [A] and property [B]. Their details are as follows:

[A]
purchase price: 8,000,000 JPY
net yield: 5%
location: 5 minutes to the nearest train station

[B]
purchase price: 5,000,000 JPY
net yield: 8%
location: 12 minutes to the nearest train station

We shall set aside the difference in purchase cost and look only at the return on investment.

Premise: 10% of the time (i.e of a holding period) an average property will be vacant and without a paying tenant. Vacancy will be prolonged, and in excess of the average for properties that are less marketable due to their individual characteristics that are below average. E,g age, condition of the property, distance to station, distance to amenities etc. On this basis, we can arguably make the following assumptions:

Assumption 1 – [B] may not be in as good a cosmetic condition as [A], inferred by the lower price. The price may also be a function of age, but the result is the same in either case- it is unlikely that B is the ‘newer’ or more cosmetically pleasing of the two
Assumption 2 – [B] is further from the train station so will be less attractive than [A] for renters considering convenience
Assumption 3 – [B] could conceivably experience periods of vacancy that are longer than [A] as a result of the above factors

Result: Objectively it is impossible to quantify the difference in the length of potential vacancy periods between two different properties in two different locations, that are presumably being rented out at different rents. However, looking at a range of vacancy periods will no doubt provide some insight.

Property A: net yield of 5% / 10% vacancy = 4.5% yield

Property B: net yield of 8% / 10% vacancy = 7.2% yield
/ 20% vacancy = 6.4% yield
/ 30% vacancy = 5.6% yield
/ 40% vacancy = 4.8% yield

Summary: Working on the assumption that Property [A] will be vacant 10% of the time -the average expectation for vacancy- the vacancy level at which [B] produces exactly the same annual return on investment as property [A] is where property [B] is vacant 43.5% of the time. This may sound extreme in isolation, but when thought of in the context of a calendar year that works out to 158.7 days or 5.2 months. In summary, if property [B] has 30% higher vacancy than property [A], they produce exactly the same annual return, despite property [B] having the higher yield.

Is it possible that because of the unfavourable conditions covered above (our ‘assumptions‘), property [B] could remain vacant for 5 months or more? Possibly. The point here is not to suggest that one is better than the other- the point is to illustrate that just because a property has a high or high-er yield than another one, does not necessarily mean that the ultimate return received by the investor will be higher than that received from another property which has a lower yield.

The Effect Of Liquidity (Or Lack Of…)

This time, lets assume that both of the properties are owned by an investor for 10 years. We shall also assume that they have been vacant for 10% of the time throughout the holding period. Accordingly, the annual return for the properties during the 10 year period is as follows:

[A] = 5% x 10% vacancy = 4.5% p.a (calculated as 0.05*.9 = 0.045)
[B] = 8% x 10% vacancy = 7.2% p.a

In this regard, property [B] has produced the better return for the investor.

However, if property [B] is in a location where there is less demand, and the market is illiquid (i.e there are not an equal number of buyers to do business with the sellers) then the owner of property [B] may be forced to lower his sales price to ensure that he can sell his asset. Selling his property at a discount would have the following effect on his total return:

– investor reduces the sales price by 10% and sells the property at the end of year 10 of his ownership for 4,500,000 JPY (the price that he bought the property for was 5,000,000 JPY)
– the investor received a return on investment of 7.2% each year during his ownership (accounting for vacancy), but then made a loss of 500,000 JPY on the sale (compared to his purchase price)
– as a result, the IRR –his annual return for his ownership period, including the proceeds from sale at the end– works out to 6.46% p.a
– this is still almost +2% higher than the returns for property [A]

But what about if the investor had to reduce the sales price by 20% and not 10%, selling the property for 4,000,000 JPY?
– in this scenario the IRR comes down to 5.66% p.a
– this is still higher than property [A]

What about, if during the ownership period, vacancy was actually 20% as the property was vacant for 2.4 months out of every year? Coupled with the 20% reduced sales price to combat the low market liquidity?
– the IRR for the ownership period works out to 4.8% p.a

Again, this is not to say that property [B] is better or worse than property [A]. The reality is that the affects of vacancy, and lack of liquidity can effectively reduce what appears initially to be a high annual yield.

Buying the cheapest assets does not always provide the most value and investors should remain aware that there is more than one component to returns in investment.