Keep It Simple
When I was at University the best lecturer I ever had was teaching me Economics.
Economics, like investing, is full of complicated sounding terms and theories..... that in practice are fancy ways of describing straightforwards ideas.
In a moment of clarity my lecturer was discussing "Economies of Scope" and summed it up saying, "Economies of Scope means "Choice". If you use the words "Economies of Scope" in the exam you get a point. If you use the word "Choice" you get nothing."
I am hoping to keep this guide to yields as simple.
What is a Yield?
How do we calculate it?!
A yield can sound a bit intimidating at first but it couldn't be simpler.
There are different types of yield but this article will discuss the most commonly used; Initial Yield.
The Initial Yield shows you what you can expect to get back on your investment based on the day 1 information.
It is literally your annual income divided by what it cost you to buy the investment.
In the case of property for example you would calculate your yield like this;
Annual Rental Income/(Price paid + costs)= Initial Yield
So, if you are buying a house for £100k plus costs (estate agent, legal, tax) of £10k, and you can rent it for £11k a year your initial yield would be 10%.....
Annual Rental Income = £11k
Price Paid = £100k
Costs of Purchase (Agent, Lawyer, Tax) = £10k
11,000/(100,000+10,000) = 10%
This is a useful Yield for many investments but it only shows day 1 return - so you need to keep this in mind if the income will change over the time you plan to hold the investment
For Example if I am buying the above property with its' rent per year of £11k but I have agreed with the tenant that the rent will increase (or revert) to £22k next year then we should also consider the Reversionary Yield for this investment...
This is calculated exactly like the Initial Yield but wth the new rent so;
Annual Rental Income = £22k
Price Paid = £100k
Cost of Purchase (Agent, Lawyer, Tax) = £10k
22,000/(100,000+10,000) = 20%
The Mechanics of a Yield
What makes a yield move up or down?!
In any market what makes a yield go up or down is perception of risk or what economists like to term "The Risk vs Return Ratio".
Again this is nothing to worry about - it is just a term to sum up what you already know! Basically if something is high risk you would want more money back (yield) on your initial stake.
Think of it like going to gamble on the horse racing - There are only 2 horses in the race;
Horse 1; hasn't lost a race in 3 years and is in great condtion - the favourite.
Horse 2; is 3 stone overweight, smoking a cigarette and was out drinking last night - the outsider!
If you had £10 to bet on the race you would need to get far more money back to bet on the outsider than to bet on the favourite... Well investing is the same, and the amount of money you get back is expressed through a yield.... If the risk goes up you would want a higher yield e.g. 10% but if the risk is lower you would accept a lower yield e.g. 5%.
To use property again to illustrate; If I could buy a shop let to Wal-Mart for 25 years I would consider this very low risk so would accept a lower yield e.g. 5%. But if I was buying the same shop let to Wal-Mart this time with only 2 months remaining on the lease my investment would be much higher risk (I don't know when rent will start again when the lease finishes and can't be sure how much it will be) so would want a higher yield to reflect this higher risk e.g. 10%.
It really is as simple as that - Once you master the mechanics of what makes a yield go up or down you have mastered yields.
A good exercise is to look at a range of investment opportunities and work out if the yield should be high or low, then change a variable and workout how that effects the yield.
In Property Investment the variables could include;
Is the current rent higher or lower than neighbouring properties?
When you get the hang of this there will be no stopping you!
Don't Tie Yourself Up!
Always remind yourself the concept is simple
There is no denying that to become fluent in how yields move takes some practice but always remind yourself the basic concept is simple. Everyone already understands the concept of risk vs return - they maybe just don't express it like an economist.
Hopefully now you have an understanding of how to calculate a yield and what variables go into making that yield good or bad value for the risk of the investment.
Good Luck and happy Investing!