Calculate and compare to other investments
When you invest in residential property, you’ll be doing so with the aim of profiting either from capital appreciation or rental income. The biggest mistake that beginner investors make is not being targeted enough in their objectives. Instead of working out their investment return and understanding their cash flow, they fall in love with a property and end up hoping to get some income from rent and make some money from capital appreciation.
In this post I’ll explain why investing for capital appreciation alone is a fool’s game. You’ll also learn the basic method of calculating your real rental investment return.
Why rental income should be the driver of your property investment decision
Property prices go up and down in a cycle. If you read the national press, you’d believe that the whole property market moves up and down at the same time. Nothing could be further from the truth. Not only will one area be in a different part of the property cycle to another, within that area different types of property will be at different points of the cycle.
For example, since 2009, property prices in Hull have flatlined. But if you compare semi-detached properties to the average of all properties, you’ll see that semi-detached have underperformed by quite some way:
Meanwhile, in London, prices have been much more aligned across all property types, and since 2009 average prices have increased by around 50%:
The property market cycle moves at different rates, even varying from street-by-street. For sure, over a long period, the chances are that property prices will rise; but you can’t be sure of it. That’s why the best property investments are made for the potential of long-term rentability.
And get this: if you buy a property that will rent easily, and it continues to do so, the value to another investor is more likely to hold. That’s because of the investment return it can give. So it’s a double whammy: investing for rental income means you steer towards the investment properties that are more likely to hold and increase their value.
Even in a recession, people need somewhere to live. Investors need income to sustain their investment. If you invest in the right property, you’ll satisfy both needs.
What do you need to know before you invest?
Before you invest, you’ll need to do a lot of research. You’ll need to assess the property’s rentability. You’ll need to pay attention to factors such as proximity to amenities, local infrastructure, regeneration projects, and local transport. Think about who your potential tenants are and the type of property that is most suited to them.
We use an 89-point checklist to run due diligence on an investment opportunity. This disciplined approach takes the emotion out of an investment decision and makes sure that you consider every pertinent fact associated with the property on offer. (You can see how this works by watching this video, which details the Gladfish 89-point due diligence checklist.)
Part of this due diligence process is the calculation of your cash flow and investment return. If this doesn’t stack up, then the investment is a bust. Don’t even consider signing on the dotted line and exchanging contracts.
Calculating your income and investment return
What I’m going to show you now is a ‘back-of-the-envelope’ calculation, which I use before drilling deeply into the numbers using the Gladfish 2-year cash flow worksheet. It is a quick and easy method of making one of the most important calculations in property investment: what annual return will your property pay you?
Step 1: Find out the expected rental income
I know this sounds counter-intuitive, but you could start here before you even know the price of the property you’re considering as a buy-to-let investment. Research rental prices of similar properties in the close vicinity to where you are investing by calling letting agents and searching online.
Spend some time posing as a tenant and as a landlord. If you get four or five ‘tenant quotes’ and a similar number of ‘landlord quotes’, you’ll find the realistic market rent is approximately the average of them all.
Step 2: Estimate your costs of owning the property
It is where your calculations get a little trickier. You’ll need to allow for expenses such as:
- Void periods
- Repair and maintenance cost
- Property management fee
Step 3: Calculate your net income
Simply deduct your annual costs from your rental income. So, let’s say that the projected rental income from a two-bedroom apartment is £900 per month (or £10,800) per year. You’re going to allow for one month when you have no tenants and a property management fee of 10% of rental income.
Your costs are:
- Insurances of £400
- Void periods of £900
- Repair and maintenance cost of £1,000
- Property management fees of £990
Your total costs are £3,290, and your net income is £7,510.
Step 4: Work out your annual return
Now that you know your annual net income, you can work out your annual return.
Let’s say that the cost of the apartment is £180,000. By dividing your net income by this value and then multiplying by 100, you’ll arrive at your annual return in percentage terms. In this example, your annual return is 4.17% (£7,510/£180,000).
You can use this figure to compare with other investment vehicles, savings accounts, and ISAs. Don’t forget that the above calculation doesn’t include any rise in the value of your buy-to-let property, either. It purely calculates the income potential of your investment.
Of course, if you increase the rent or avoid void periods the annual return rises, too. This annual return ratio is sometimes known as the ‘capitalisation rate’, and in my next post, I’ll look at how to use the capitalisation rate to invest in property for income.
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