ON THE FACE of it … there’s no apparent logic as to why doing that would make sense.
Unless of course, you intend to occupy the property when the lease expires; or it may adjoin the one you already own. In which case, the initial low rental is really of little (or no) importance.
However, not every such sale will have a special value to the purchaser. More often, the reason for accepting an initial low yield will be that …
- There is a pending review, to bring the rental in line with market level;
- You have a strong tenant and a long lease, and place some added value on having a secure cash flow; or
- The property has redevelopment potential, and a short-term lease.
When are you able to snare a Higher Yield?
Sometimes the remaining lease on a property may be short, with no certainty the tenant will continue on.
Therefore, despite the rental being appropriate … your passing yield may well end up higher than usual. And, in effect, you’re being compensated for the lack of security in cash flow.
However, there are several other reasons why you may obtain a higher passing yield …
- The rental is above market, and likely to fall when the lease expires;
- The property is purpose-built, and only suitable to a narrow range of alternate uses;
- The building itself is obsolete, and would soon in need of upgrading or replacement;
- The tenant could be considered financially weak; or perhaps …
- The property is currently occupied under a non-conforming-use permit.
And so, it’s important to users seek advice from your consulting team — to properly interpret the evidence you have available.
Bottom Line: You must not simply accept every passing yield as “reflecting the Market”, whenever you’re looking for comparable sales.
Instead, make sure you look behind each and every sale. And you need to discover whether … the rental was at market level; the tenant and lease period were secure; or if there may have been any hidden potential for further development.