When delving into any investment venture, understanding the concept of yield compression is essential. This article aims to shed light on what yield compression is, its significance, and how it impacts the capital value of investments over time.
What is Yield Compression?
Yield compression refers to the shifting perception of risk associated with an investment. It reflects the market’s assessment that the income stream generated by an investment has become more secure and promising. Essentially, yield compression results in a lower risk profile for an investment, leading to a decrease in the yield or return expected by investors.
Illustrative Example:
Consider two investments: both are student buy-to-let properties generating a net rental return of £15,000 per annum. One property is located in a relatively unproven area and has only maintained this rental level for a year, while the other property is situated in a well-established area with a five-year track record of full occupancy. The latter investment is perceived as lower risk due to its stability and reliability, making it more attractive to investors.
Leveraging Yield Compression: Investors can capitalise on yield compression by identifying areas poised for strong demand in the future and acquiring properties at competitive prices. A prime example of this strategy is demonstrated by our clients at Fresh Invest:
Several years ago, we collaborated with a developer to introduce nine six-bedroom HMO houses in Liverpool. Despite lacking rental assurances, these properties were sold to investors at a net yield of approximately 11% based on anticipated rental income. Subsequently, all properties were fully occupied upon completion, validating the investors’ trust in our assessment. Over time, as these properties maintained high occupancy rates, the perceived risk decreased, leading to yield compression.
Impact on Capital Value:
Yield compression inherently results in capital growth for investors. Consider the following scenario:
Initial investment: Net income of £20,000 at an 11% net yield = Property value of £180,000 Post-yield compression: Net income of £20,000 at a 9% net yield = Property value of £222,000 Furthermore, assuming rental growth of 10%: Net income of £22,000 at a 9% net yield = Property value of £244,000
Understanding yield compression is crucial for investors seeking to maximise returns and mitigate risks in property investment. By strategically leveraging this concept, investors can capitalise on opportunities for capital growth while safeguarding their investments against potential downturns in the market.
