How to work out if you should invest in property
In a recent article, I explained how to keep it simple with the property investment lifestyle ROI method. Today, I’m going to discuss the financial ROI of property investment, and why you must keep it high on the list of your investment considerations.
What is ROI on property investment?
ROI is the percentage return that your property produces. There are, in fact, three measurements of ROI that you should consider: total gross, total net, and totally real. I’ll explain in a few moments.
How do you calculate ROI?
Calculating ROI is very easy, though you will have to modernise your calculations for which type of ROI you wish to calculate. At its base level, the equation is:
(amount of return annually/value of the property) x 100
For example, if your rental income over one year is £12,000, and the property’s value is £200,000, your ROI is:
(£12,000/£200,000) x 100 = 6%
However, this calculation assumes that the property has not increased in value and that the rental income is your only return on the property investment.
Working out total gross ROI
To calculate a more realistic ROI, you must also consider the growth in its value. While this isn’t money in your pocket (until you sell the property), it is a component of wealth creation that you mustn’t neglect. So, let’s say that the property in the example above has increased in value by £10,000. Now your gross ROI is:
((annual rental income + capital gain)/property value at the start of the year) x 100
= ((£12,000 + £10,000)/£200,000) x 100 = 11%
Working out total net ROI
Now, the above calculation doesn’t account for the costs associated with holding your property. These might include items such as void periods, maintenance, and property management fees. Let’s say that:
- Your property is untenanted for one month, at a total cost of £1,300 (loss of rent + other costs you still pay)
- Maintenance costs you 5% of your remaining rental income over the year – £550 (5% of £11,000)
- Property management costs you 15% of rental income, or £1,650
Your total costs are £3,500, and your gross ROI now becomes:
(((annual rent – costs) + capital gain)/property value at start of year) x 100
= (((£12,000 – £3,500) + £10,000)/£200,000) x 100 = 9.5%
So, what is total real ROI?
As you can see from our example, the total net ROI is 9.5%. However, this assumes that you have paid for your property in cash. More likely, you will use a buy-to-let mortgage to finance your investment. By doing so, you’ll take advantage of the benefits of leveraging when you invest in property. Financing your investment boosts your real ROI. Here’s how:
Let’s say that you put down a deposit of £50,000 on the buy-to-let property, and borrowed £150,000 to finance the purchase. Let’s assume you pay 5% interest on the mortgage amount. Your mortgage, therefore, costs a total of £7,500 over the year:
- This increases your costs to £11,000
- So, your net return falls to £11,000 (£1,000 rental profit + £10,000 capital gain)
But, you have only committed £50,000 of your own capital, and so your total (net) real return is:
(£11,000/£50,000) x 100 = 22%
What does total real ROI tell the property investor?
Here’s the rub: total real ROI is probably the single most important ratio you will calculate as a property investor. It provides a way to directly compare property investment with other investment options, such as savings accounts, bonds, and shares.
Using ROI as an investment indicator
When you are considering investing money, you should always consider the total real return on your investment capital:
- If you have £50,000 of savings in a savings account paying 2%, you might be better to invest in a stock market fund promising 8%.
- Or, perhaps, invest in a property with a 15%, 20%, or higher potential total real return.
- Which is likely to better fund your lifestyle desires?
Whatever your investments, you should review them each year. When you do, always ask yourself which is the best investment to achieve the lifestyle you want today and in the future.
Kick off your property investment career on the right foot. Contact Gladfish today on +44 207 923 6100, and book your property investment consultation to discuss the total real ROI potential of your savings.
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