Economics of Buy to let

Buy to let investment is just one of many forms of investment. Like with any investment it has its risks and rewards. Understanding the risks and rewards fully is essential when evaluating buy to let investment as an option. Only then can we compare different investment classes properly and make informal decisions regarding investment vehicle choice.

The buy to let investor hopes to 'profit' from two sources:

1. Income: The rent on the property provides an income which can be expressed as a percentage of the capital value of the property called the gross yield. This gross yield (often quoted) is quite unrealistic. It is the net income after all costs (maintenance, agent fees, accountancy, certification fees, insurance etc etc) which formulates the net yield which is the lower (less quoted) rear figure.
   
   Example: An apartment costs £300,000 and provides a rent of £15,000 per annum. Agent, maintenance, accountancy and other fees are estimated at £1500.
   
   Gross yield = 15000 / 300000 x 100 = 5.0%
   
   Net yield = (15000-1500) / 300000 x 100 = 4.5%
   
   Based on income alone the investor might compare this net yield with what percentage rate might be possible in an almost risk free bank account. Higher risks stocks and shares might be considered for a better rate but a higher risk.
    
2. Capital: Any rise (or fall) in the capital value of the property will result in a paper gain (or loss) in the capital value of the property.

A couple of examples to illustrate the economics of buy-to-let are:

Example 1:

The same property as in the example above in one year rises in value by 5% and so is now valued at 3000000 x 5% = 315,000.

In our example we can add the net yield to the capital value gain to give an annual performance of 4.5% + 5% = 9.5%.

Our example has clearly shown a good year but remember a 5% fall in property prices would have resulted in a £1,500 loss although it may not be 'felt' if the property is to be held for the longer term.

Finance options may also be seen as positive for the buy to let investor. It is usually possible to obtain mortgage finance to purchase a property which gives the investor exposure to a large asset without actually finding the cash to purchase the asset outright! This concept (called gearing) is not available to many other investment classes. Try asking the bank manage for a loan buy shares! Ask for a mortgage and the reply will be different.

Example 2:

Using our example the investor secures an 80% mortgage to aid the purchase of the £300,000 property. His deposit is therefore £60,000 and his mortgage £240,000. Of course he must pay interest on the mortgage (say 7%).

Mortgage interest: 240,000 x 7% = £16,800

However, the investor has exposure to the full £300,000 asset (i.e. he is over 4x geared) and in the example 'good year' takes net rent of £13,500 and asset capital appreciation of £15,000.

Annual return = 15,000 + 13,500 – 16,800 = £11,700

Again in our example, only £60,000 was invested so in that year the return can be calculated as:

Total return = 11,700 / 60,000 = 19.5%

But note that our investors’ cash flow is negative. His net rent less mortgage costs is £13,500 - £16,800 = -£2,300

This example illustrates that in this example year, where the property price rose by 5%, the investor saw an excellent return of 19.5%. It is the gearing (via the mortgage) that has allowed this!

BUT gearing can work both ways. Had property prices fallen by 5% in our example year:

Mortgage interest: 240,000 x 7% = £16,800

Asset has depreciated by 5% (£15,000), rent still £13,500

Annual return = 13,500 -15,000 = -£1500.00

So, again only £60,000 invested and the return is calculated as:

Total return = -1,500/60000 = - 2.5%

This example was clearly a poor year especially when we consider the £60,000 in the bank might have yielded 3% meaning we were worse off by 5.5.% investing in the property versus the bank. On the brighter side note how even in the bad year the rent has remained stable (acting as a hedge or insurance) and protected from further losses.

Inflation

Mild inflation is a friend of the buy to let investor. A compounded inflation rate of say 3% over 10 years means the real value of the mortgage has declined by more than a third Consequently, in an inflationary environment, we might expect rents and house prices to rise and the real value of the loan or mortgage to fall. The gearing effect (described above) magnifies the benefit (or loss in a deflationary environment). Thankfully deflation is quite rare but is a post “credit crunch” risk. Deflation has plagued Japan for some years so should be recognised as a real (although acceptable) risk.

Tax

A carefully planned and managed property portfolio can be very tax efficient when compared to other investment classes. Issues such as owning properties personally versus in a company, tax allowance are all quite complex but careful tax planning and integration within property maintenance strategies are very important. Buy2LetExpert can advise on this area to maximise returns although tax strategy should never guide investment decisions. Tax planning following investment decision taking is however prudent and fruitful.

Summary

Buy2LetExpert have been investing in property to let for almost 20 years. In the early 1990s we purchased houses requiring mild improvement prior to letting. In those days there tended to be a positive gap between funding costs and net return yields. Cash flow was therefore positive.

During the buy to let boom period, property price rises far exceeded rental growth. Yields fell and interest rates fell. However, today rental yields typically stand at a discount to mortgage funding costs. Cash flow is negative. In other words, the rent will hardly pay the mortgage! The buy to let became a pure 'punt' on rising house prices. This is TOTAL SPECULATION not investment for all but very long term investors.

However, buy to let is not dead. Purchasing property carefully with development potential allows for capital uplift prior to letting. Hence the capital part of the 'profit' is raised making the investment become more than just speculation. See our section on property development for some pointers. Buy2LetExpert can help with this complex but important area. Development is often a long term investment but the rewards can be enormous. It is not just for large corporations.

Buy to Let is clearly a long term investment. Short term speculation should be avoided. For short term speculation on capital values of properties why not buy a highly geared call option on house prices? City index and others can provide such services. The market for such derivatives is far more liquid than buying the underlying property asset directly itself.

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