The Polish Real Estate Management Act provides for four approaches to real estate valuation. On the retail, office and industrial investment markets, the use of the income approach is widespread – it is an investment method with simple capitalization. Such properties generate income which can be forecasted.
The following formula is used to estimate fixed income in the future, and thereby a property’s value:
property value = fixed annual income from the property / capitalization rate
The capitalization rate on the commercial real estate investment market is called yield. As income produced by a property is relatively stable, the final price of the property is determined largely by the yield. In fact, a property buyer acquires income generated by the property. For an investor, yield is actually the expected gross rate of return from an investment.
Whether yields are high or low and income ‘cheap’ or ‘expensive’ to buy depends on the investment risk of a property and the situation on the investment market, including profitability of alternative investments. Both the risk premium principle and the law of demand and supply play a role here.
Prime properties such as high-quality office towers in downtown Warsaw, dominant innovative shopping centres in Poland’s largest cities or modern industrial parks in top locations carry a low investment risk, and thereby offer low yields. Income generated by such properties appears ‘more expensive’, because the risk of it being lower in the coming years is low. Such assets will be targeted, for instance, by risk-averse insurance companies.
By contrast, outdated office buildings on the outskirts, shopping centres registering low footfalls and logistics parks that do not meet tenants’ requirements record high yields. Investors seeking to acquire such properties will offer lower prices to compensate for high investment risks associated, for instance, with problems with finding tenants which may push annual property income down.
Consider a prime office building that generates EUR 10m of annual income. An investor targeting this property estimates the investment risk and submits a bid with a 5% yield. This means that the investor will pay EUR 200m for the office building (EUR 10m / 5% = EUR 200m). If the bid is accepted, the property will generate annual income amounting to 5% of the price paid and, after twenty years, total income will be equivalent to the acquisition price, thereby the investment will pay for itself in twenty years.
The chart below shows prime property yields in Poland in the last 15 years. Yields have been moving in ever since 2003, driven by the maturing market, with investors considering Polish assets increasingly safe, and by quantitative easing. Despite this, yields in Poland remain higher compared with Western Europe (for instance, according to Cushman & Wakefield’s Global Investment Atlas 2019, office yields stand at 2.50% in Germany, 3.00% in France, and 3.50% in Spain) and the Polish commercial property investment market continues setting new highs.
Author: Aleksandra Sierocińska, Investment Surveyor, Capital Markets, Cushman & Wakefield