There are three rents: two you ignore, and one you calculate
When you’re investing in a property for its long-term potential, one of your main considerations will be the rental income you could receive. Your cash flow depends upon it. However, rental income doesn’t always meet with sales agents’ promises. There are plenty of horror stories of investors who bought property because of inflated rental potential, only to find they had to fund a shortfall between income and expenses.
In this article, you’ll learn how to properly assess the income potential of any property investment opportunity and prevent your thoroughbred investment from becoming a cash flow donkey.
Why is potential rental income so important?
Most beginner property investors think that mortgage interest rates are their biggest problem. But that isn’t the case. While lenders change their rates constantly, there is plenty you can do to control this expense. One of the benefits of using a buy-to-let mortgage broker is finding the best deal for you. Obtaining a fixed rate, for example, will give you the certainty of monthly mortgage expenses for years.
Nope – for me, the real value of a buy-to-let property is the rental income you are likely to achieve. While you have plenty of options with mortgages, the market rent is the market rent. If you try to let your property at too high a rental price, you won’t find tenants. Why would someone rent your property at, say, £1,000 per month when they can get the same property next door for £900 per month?
Your cash flow position hangs on your rental income. If you buy a property and base the investment on the wrong rental assessment, you could find that it becomes a real thorn in your side. You’ll have to shell out money from your pocket just to make it break even. Eventually, you may have to sell it just to stop the cash haemorrhage.
There are three types of rental prices
You’ll find that there are three types of rental prices. Only one of these is the one to trust.
1. The sales agent’s rental assessment
One of the most critical property investment lessons I teach is to never, ever, trust the rental assessment you are given. Especially if that assessment is provided by a sales agent working on commission.
The more desperate they are to sell, the more fanciful the rental income potential will become. Expect to hear blatant lies. These people are commission driven, and they’ll tell you anything to secure the sale. They’ll tell you a property is ‘guaranteed’ to be cash flow positive when it probably cost you £200 or £300 per month to keep above water.
If you trust a sales agent’s rental figure, then you are asking for trouble. Forget about your lifestyle plans – your current lifestyle will be in jeopardy.
2. The valuer’s rental price
This rental assessment should be more accurate, but the reality may also fall short of expectations. However, it will be the one that is used by lenders to calculate how much they are prepared to loan you.
It is made using a comparable valuation assessment and based on RICS guidelines. In my experience, this valuation is rarely met.
3. The realistic market rent
It is the true rental income potential of your proposed property investment. It is the figure that you should use to calculate your cash flow projections and ongoing viability of the investment. All you must do is uncover the realistic market rent.
How to discover the realistic market rent
To discover what your property will rent for, you must do a little legwork. You must also understand how letting agents work.
Letting agents ‘sell up and manage down’
Lettings agents depend on two sources for their income: property investors (landlords) and tenants. They know that the needs of these two sets of clients are polar opposites: landlords want to charge as much as they can; tenants want to pay as little as possible. Letting agents use this knowledge to their advantage when marketing their services.
When you speak to a letting agent as a landlord, they will ‘sell up’ the potential of your property. For example, one may tell you that you should be able to rent for £1,000 per month. Assuming that other agents offer an equal service level but a lower rental price, you’ll decide to put your property with this agent – the one offering the highest rent.
Simultaneously, the letting agent will be telling prospective tenants that they should be able to rent a property like yours for, say, £850 per month. The agent’s job now becomes one of managing down your expectations and manging up the tenant’s.
Meeting by meeting, they will reduce your expectations. Not all at once, but over time, during which your property remains empty. Eventually, they will get you to a price at which you are willing to let, and the tenant to a price that they are willing to pay. It will be somewhere between the high rental promised to you, and the low rental promised to the tenant. And this is the big clue as to how to assess the realistic market rent.
Step 1: Contact letting agents as a landlord
Phone a few letting agents up as the landlord you are. Tell them about your property, and ask them about the rental income it should achieve. Note down the prices they tell you.
Step 2: Contact letting agents as a tenant
Now, a few days later, contact the same agents again. This time, play the role of a prospective tenant. Tell them that you are looking for a property like the one you are proposing to buy. They will tell you what price they expect you will have to pay in monthly rent.
Step 3: Average your results out to discover the realistic market rent
You’ll find that the ‘landlord’ quotes are higher than the ‘tenant’ quotes. All you have to do now is calculate the average of the higher landlord quotes, and then calculate the average of the lower tenant quotes. The realistic market rent is somewhere between these two averages. Here’s an example:
Fred called five letting agents as a landlord, and received rental price quotes of £900, £900, £950, £1,000, and £1,000. The average of these is £950.
He then called the same letting agents, only this time with his tenant hat on. He received rental quotes of £825, £850, £900, £900, and £925. The average of these is £880.
The realist market rent will, therefore, fall between £880 and £950.
What rental value should you use for your cash flow projections?
When you are calculating your cash flow projections, you should always err on the side of caution. Underestimate your income and overestimate your expenses.
In the above example, you could expect to receive between £880 and £950 per month in rental income. Using the lower end of this range would be the cautious approach. If you want to be even more cautious, you could use the lowest of the tenant quotes (£825).
By forecasting your cash flow cautiously, if your income turns out higher and your expenses lower than expected, you’ll benefit from a good cash flow surprise rather than a nasty cash flow shock.
There are three takeaways that you should put in your knowledge locker:
- Never believe the BS that a sales agent tells you about potential rental income
- Always carry out your due diligence, and discover the realistic market rent
- When projecting cash flow and assessing the viability of a property investment opportunity, always err on the side of caution and calculate conservatively
To discuss how to calculate an accurate two-year cash flow forecast, get in touch with Gladfish on +44 207 923 6100. We want you to be successful in property investment, and enjoy the cash flow and profits that we’ve helped hundreds achieve to date.
Live with passion