The Language of Property Investment

Following my article last month I have had a number of investors contacting me for clarification about how exactly I measure rental yield. I regularly get this kind of question, so I thought that it would be helpful to discuss the major terms and measures of success that we use in property investment.

 

Return on Investment (ROI)

Perhaps the most popular measure of how successful an investment is.

Example:
Suppose we purchase a property for £80,000 and sell 10 years later for £150,000. If we paid in cash for the property, then our ROI is calculated like this:

Profit (£70,000) divided by cost (£80,000) = 87.5% ROI

However, this 'top level' calculation is a little basic and may not reflect two important components of the deal. The first is any surplus rental income we have received over the time period. The total ROI should include this as well. Let's say that you averaged £3,000 a year net rental income. That's an extra £20,000 over the period.

So the new calculation is:

Profit (£70,000 + £30,000) divided by cost (£80,000) = 125% ROI

You can see from this that it's important to factor in anticipated rental profit to arrive at a realistic forecast of ROI.

But that's not the end of the story because you may have borrowed some money towards the purchase. We discuss leverage in detail below, but let's start with a simple example that illustrates the impact of leverage on your ROI.

We assume the same property and rental as above, but that you have borrowed 60% of the purchase price and put in 40% of the capital yourself. Of course you will have to pay the mortgage so your return from rental will reduce - in this example to £1,500 per year or £15,000 over the life of your investment.

The calculation this time is:

Profit (£70,000 + £15,000) divided by capital required (40% of £80,000) = 265% ROI

This illustrates the power of leverage to increase your ROI considerably. As we will see there are other ways to increase your ROI including the use of Velocity and BMV purchasing, which we will also discuss in this article.

What's an acceptable ROI for a property investment? That's pretty impossible to answer. As a comparison you are likely to get a ROI of about 20% over 5 years from a savings account. Many Axis investments would offer 200% - 400% ROI over the same period. Most property investments, even without leverage, would offer 100%+ over 5 years.

Key Points:

• Include rental returns in calculating ROI

• Leverage increases ROI

Rental Yield (RY)

Of all the measures of property investment the calculation of Rental Yield seems to cause the biggest problem and is open to many different interpretations. Let's clarify.

We need to differentiate between gross rental yield and net rental yield.

Gross Rental Yield

Take the annual gross rents and divide by the purchase price of the property.

Example:

Rental is £700 per month = £8,400 per year

Property cost £100,000. Gross rental yield is £8,400/£100,000 = 8.4%

Net Rental Yield

This is the rental income after expenses, divided by the property cost. The question here is what to include in 'expenses'. Different companies include different elements in their selection of what elements to include. There is also the added complication of an estimated rental yield, calculated before you purchase, and an actual rental yield based on your experience of ownership.

Here is a typical list of expenses that are often included to calculate net rental yield:
• Insurance
• Service charges (HOA fees in USA)
• Ground rent
• Management fees
• Local taxes (USA)
• Repairs and renewals (sometimes)
• Void periods (sometimes)
• Other costs payable such as water and garbage (USA)

What you will see is that we have NOT included mortgage or loan payments in calculating the net rental yield. The reason for this is that the net rental yield is a tool that allows you to compare different properties and indicates the amount of cash that is available to cover any loans. One investor may pay cash, another may take the maximum possible loan. That distinction does not impact the cash generating ability of the investment itself.

Example:

An investor purchases flat in the UK with these monthly figures.

Rent: £700; service charge £60; management fee £70; maintenance £20; ground rent £10. Total costs £160pm. Net income £540pm or £6,480 per year.

Assume, as in previous example, that the property cost £100,000.

Then the net rental yield is £6,480/£100,000 = 6.48%.

You will see that the costs have, in this example, reduced the gross rental yield by 2% pa. This is very typical.
What you will find in the USA is that the costs are a higher percentage of the costs, but the gross rental yield is very much higher than the UK, leading to much higher net rental yields.

Key Points

• Make sure you know what is included in a net rental yield calculation.
• In general you need a gross rental yield 2% higher than a mortgage loan rate to ensure that the property will have positive cashflow.
• Don't include mortgage payments in the rental yield calculations

CashFlow

Working out your cashflow is an extension of the rental yield calculation. The difference is that your cashflow calculation MUST include the cost of finance and the loan repayments.

In the example above we purchased a property for £100,000. Our net rental income after expenses was £6,480 a year.

Suppose we now decide to finance the purchase by paying a deposit of £25,000, and borrowing £75,000 at a mortgage rate of 5% pa, interest only.

Our annual payment would be £75,000 x 5%= £3,750.

Deduct this from the net income of £6,480 py and you are left with a surplus of £2,730 per year. This is your 'cashflow' from this investment.

Key Point

• Cashflow takes into account the cost of finance.

Return on Cash (ROC)

We have already discovered how to work out your overall return on investment. But there is another measure which is particularly important to investors who are buying for income, rather than longer term capital growth.

Investors seeking income want to know how their proposed property investment compares to other income producing investments. Here's how we work it out.

Take the annual cashflow (from previous calculation) and divide by capital committed to the deal.

Example:

Our cashflow in the previous example was £2,730 per year, after investing the deposit of £25,000.

So our Return on Cash (ROC) is £2,730/£25,000 = 10.92%

This is typically five times what an investor would receive in a savings account right now so it's a considerable improvement. And of course the property investment offers two additional advantages over a savings account:

1. The rental income rises over time and will generally keep pace with inflation

2. The property value increases over time leading to a healthy profit over the years

In one specific USA location we supply investors with property that is producing a ROC of around 20% pa!

Leverage

Leverage is simply the benefit from using finance from other sources to fund part of your purchase. We have already seen in the discussion about ROI how leverage improves significantly the ROI on your investment.

But leverage needs to be considered carefully. It isn't always the best way to go, and borrowing 100% of the property price is rarely the best option, even if it is possible.

The prime benefit of leverage is to stretch your cash and make your money go further. But borrowing money on which you pay interest will always reduce your cashflow. So if investing for income is your prime concern, it makes sense financially to use your own cash as much as possible unless you can borrow at a lower rate than you can obtain from savings.

Right now, in the UK, savers are typically getting between 1%-3% pa on their money. Mortgage loans for investment property are typically between 4%-6%. So if you have the cash, why borrow at a rate higher than you can achieve in your savings account?

At the other end of the extreme, maybe you have no cash at all and are seduced by the idea of 'no money down' - borrowing 100% or more of the property price. This is a high risk strategy because you are likely to be at best breakeven and very likely in negative cashflow when interest rates increase.

Between these two extremes are investors who are primarily focused on capital growth and have some capital resources but want to do the best possible to build a portfolio. Sensible borrowing, where available, can make a positive difference. Here's a table which sets out three different leverage options:

But leverage is not the only way to increase your ROI - as I will explain in the next section on velocity.

Velocity

In the UK we have been trained to think that leverage is the way to increase ROI. And it's true - see the table above. But it's not the only way and there is an alternative approach to increasing ROI called Velocity.

Velocity is our consideration of the speed in which we achieve our return. And it can have a major impact on your ROI.

Let's consider, as an example, our Maximum Profits investment strategy that we offer in Memphis, USA. At its best, we deliver a 50% ROI in 12 months. This is a cash only purchase with no leverage. Let's see how it compares to a typical leveraged investment that's growing at 4% a year.

I haven't taken buying and selling costs into account for the sake of simplicity. The key point to appreciate is that the benefit of Velocity beats leverage hands-down in this case.

For many investors the concept of velocity will be new, but in this property market it is vital to consider when making investments. At Axis our experience is that the USA offers many opportunities where the returns are exceptional because of velocity, even though they are cash only purchases. And with total investment costs for a house starting at less than £20,000 including fees the value for money is remarkable.

I hope that this article helps you to measure the value in potential investments and to ensure that you talk the same language as the people you negotiate with!

 

Live with Abundance

Rod Thomas FCA  

 

Posted in Investment Strategies

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