Just how you assess the profitability of a property is not straightforward, there are various methods of assessing profitability, I will look at each in turn.
1. The traditional way.
This is the approach taken by investment books and the figures are also published in newspapers and magazines.
They take the average gross rental yield and compare it to the yield that would be received say by putting the money in the bank. Figures like 6% gross rental yield from property are stated and this is compared to other returns like bank interest and the stock market. Sometimes they also add the average capital appreciation so for example say if last year the average increase in house prices was 12% the overall return from property would be 18% (6% gross rental yield plus 12% capital appreciation).
For a property buyer these figures may give a guide to overall long term trends but for an individual investor almost meaningless as it fails to take into account expenses, the enormous variation between localities both in rent and property prices but above all the ability to borrow money and the cost of borrowing. It is far more difficult to borrow money to invest in other investments for example to buy shares, but borrowing money to buy properties is very easy.
2. You want Positive Cash Flow
This is the developers preferred method of presenting an investment and it does have some merit but needs to be treated with extreme caution. What you do is compare the expected or actual rental income and deduct the cost of mortgage interest. So for example a property has a rental income per month of £600 and the mortgage interest is, say £380, the property is said to have a positive cash flow of £220 per month.
You need to examine very carefully the figures, often the mortgage interest is based on what I consider to be an artificial interest rate e.g. a two year fixed or a two year discounted rate which after two years reverts to a standard rate which substantially reduces or eliminates any positive cash flow, nor is the excess arrangement fees these deals usually incur considered.
The second problem with this approach is that it ignores, underestimates or only considers some of the expenses. Service charges are the favourite, ‘they are yet to be decided’. The reason they are not ‘decided’ is that they would put off any investor. Usually these figures are used to sell flats and the high cost of service charges are ignored never mind the cost of management, maintenance, bad debts and voids. In every new build flat I have looked at the rents appear to be too high and when a sober assessment is made of all the costs there is a massive shortfall between the rent received and the expenses.
3. Calculate your Return on Investment (ROI)
This looks at what return you are making on the capital you have invested. If you buy a £100k property with a 90% mortgages then the capital you have had to put in is £10k plus costs. Assume you had invested £25k in a project and had a profit of £5k per annum the ROI would be 20%. Again you need to look at the figures very carefully and deduct all the costs from the profit and add all the costs to the input capital to give the real ROI.
The use of ROI is probably a much more useful tool than the ‘Traditional’ method used in (1) above as it takes into account the ability to borrow money and so gives an actual guide to your rate of return. However, for the sophisticated investors who always buy below market price (BMV) this tool is useless as they rarely invest any of their own money, or if they do, they quickly get it back out again. When you have no money invested in a property the ROI is said to be ‘infinite’ but how do you measure or compare ‘infinite’ returns? Most of these investors talk about the amount of ‘cash out’.
4. Your CORP’S
This stands for Cash Out and Rental Profit and it the method I use when comparing investments as it measure the cash out on an investment and the rental profit after deducting all expenses. I will only buy a property if I can get all my input capital back out and more if not immediately then within six months, by using bridging finance or quickly remortgaging my purchases. I calculation my rental profit after deducting all expenses including expected voids and bad debts and the full cost of the borrowing including renovation costs, but not the extra cash released. For examples see my manual. I do not deduct from my rental profit the extra interest from the cash release as I do not consider this to be an expense on operating that property.
By adopting this strategy you are able to go on buying as many properties as you want without using up your input capital either by having capital tied up in a deal or having to subsidies the expenses running a property or interest on the money borrowed to make the purchase.
Let’s sum it up!
The ‘Holly Grail’ of property investing is to buy property for nothing i.e. get all your costs and input capital out and make a profit out of the rental income. To get all your capital and cost out you need to buy the property at 20% or more BMV or be able to add 20% net to the value of the property by renovations, improvements or refinancing as a HMO. When doing improvements or renovations remember you need to add the cost of these to the purchase price to give the ‘net’ 20%. 20% BMV is the minimum discount you should be aiming for to ensure you have no cash left in the deal, assuming you are borrowing at 85% LTV or 35% BMV if you are borrowing at 70% LTV. What yield or rent to charge is more difficult to be exact about, it obviously has to cover the mortgage interest, but the other costs can vary considerable, I find I need a minimum of a 12% yield to cover the costs of running a HMO. NB Yield is calculated by dividing the rental income by the total cost of the building.