How can I use the capitalisation rate to invest in property for income?

Brett Alegre-Wood
October 22, 2016

Working out how much to bid for your investment property

One of the questions that we get asked most often is how you can invest in property for a certain amount of income. If you’re putting your cash in the bank, you’ll know exactly how much income you’ll get.

With the Bank of England base rate at just 0.25%, if you’re prepared to lock your savings away for three years you might be lucky and get around 3% (although you might also find that the maximum you can save in this type of ‘high interest’ account is limited to around £20,000).

When you’re investing in property, the capitalisation rate tells you how your annual rental income compares to other investments and savings accounts. In this post, I’m going to show you how to use the capitalisation rate to calculate the price you are willing to pay for a buy-to-let investment property, based on the percentage annual return you want.

Recapping the capitalisation rate

As a quick recap, the capitalisation rate is calculated by deducting the costs of owning and maintaining your buy-to-let from the rental income. In my last post What return should I expect from my investment property?  I explained this more fully, using an example of property valued at £180,000.

In that example we calculated the capitalisation rate as follows:

example_of_calculated_capitalisation_rate_.pngCalculating capitalisation rate you pay for your investment property

You’ll notice that the above income and costs are ‘fixed’. You’ve researched the rental potential of the property, and so know that it will rent for £900 per month.

The repair and maintenance costs have been estimated and might be above or below the amount shown. If you have a major central heating failure, the cost could be higher. On the other hand, if you go a year without any need for major repairs, then your expense here could be near zero. (This is one of the advantages of investing in new build properties off-plan – your repair and maintenance costs should be almost zero.)

Property management fees should be around 10% of your rental income.

In other words, you should be confident in your net income figure of £7,510.

Let’s say that you want to make 5% on your investment. Here’s how you calculate what maximum price you can bid:

(Net income/required capitalisation rate) x 100

= (£7,510/5) x 100 = £150,200

A basis for bidding, not a rule

This method should be used as a basis for bidding, but not a rule. For example, if your investment benefits from guaranteed rental during the first years of ownership, you’ll be able to increase your bid.

Similarly, if you’re already benefiting from a discount to market value (as we negotiate for our clients on our off-market, off-plan properties), you’ll probably find that the potential to discount further is severely limited.

You may have to take a view on future rental potential, too. If you think that you’ll be able to ask for premium rental prices because of a particular aspect of development, for example (or a larger balcony, car parking space, etc.), then you may be willing to pay more now for the better future rents you’ll receive. This is one reason why off-market investment provides such great investment potential. You have the potential double bonus of an extra discount for earliest investment and the opportunity to cherry-pick the best lots.

As a starting point for further cash flow considerations, the capitalisation rate calculation gives you a solid foundation on which to build your investment portfolio. You’ll know from the off that the investment is valuable compared to others, and can use it as a guide to price when negotiating discounts.

Above all else, never make the mistake of paying no attention to your costs, rental, and net income. As a buy-to-let investor, cash flow will probably be your most important consideration. It’s what is going to keep you in business and help you use leverage to grow a property portfolio.

You’ll notice that I haven’t mentioned mortgage interest payments. In my next post, I’ll show you how using a mortgage to invest powers you own personal capitalisation rate.

In the meantime, if you’d like to discuss investment opportunities with above average capitalisation rates, please contact the team at Gladfish on +44 (0)207 923 6100.

Live with passion,

Brett Alegre-Wood


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