How do Landlords calculate their returns on their property investments?
Buying a residential investment property is very different to buying a home. For a start what landlords are really buying is a property investment and letting business. Therefore a key part of a landlord’s decision making process of whether to invest or not in a buy-to-let property will partly be made on the basis of what their likely investment returns will be.
What is involved in calculating property investment returns?
The process of calculating investment returns can be very complicated indeed. On commercial property investors will go to great lengths to use techniques which discount future cash-flows (DCF) from individual investments to work out the potential returns and in turn their value.
Luckily for residential landlords life doesn’t get anywhere near this complicated. The essence of calculating an investment return on property is to understand that there are two factors influencing what investment return is generated. Firstly; through income in the form of rent and secondly in the form of the capital appreciation resulting from rising house prices. Total returns to an investor are the sum of both.
Investment returns from a rental business
The other complication for a landlord is that buying a residential investment property is not just like buying a straight forward investment. It is actually running a business. Therefore what a landlord needs to include in their calculation are the associated costs of running that business.
The main revenue source for a landlords business is obviously the rental income.
The complication for landlords is that in calculating their net returns they need to include net income (after expenses) and add this to capital appreciation. This needs to be done for the entire investment period. A landlord will typically hold a residential investment property for approximately 15 years according to on going surveys from the Association of Residential Letting Agents (ARLA).
The final complication is that rent and other costs are likely to change over the investment period and this needs to be factored into the calculation of a landlords investment returns.
Set up & exit costs
Setting up a residential investment will mean that a landlord incurs certain set up or one off costs of bringing the investment into being. These costs include the initial costs involved in the purchase of the investment property such as the legal fees and stamp duty if it is payable. Other capital costs frequently incurred are where any appliances are purchased or if the residential investment property is improved. Finally, there is the cost of exiting the investment when it is sold. All these need to be factored into the overall calculation of a property investors returns.
Accounting for the long-term
One further complication to a landlord trying to calculate their likely returns from a potential residential investment is trying to account for the effect of inflation and the likely growth rate in house prices generally. The Halifax figure reveal that over the last 40 years house prices have been rising at an average rate of 10.3%. However the Barker Report produced by the Government on housing supply concludes that the real rate of growth (after inflation) over the last 30 years has only been 2.4%. Therefore in calculating a residential investment’s long-term returns a landlord will need to be able to predict both of these.
The return on capital
These calculations of returns all relate to the asset value of the investment property and the rental profit after expenses. However, this is not a true measure of the real returns made by a property investor. This is because unlike an investment in a building society a landlord is likely to have borrowed a significant proportion of their investment capital in the form of a mortgage. This means that they are likely to only have put in a proportion of the total capital into the investment.
For example on a £200,000 property they may have put down a 20% deposit or £40,000 into the investment. What this means is that any investment calculations needs to measure what the returns are on that £40,000 and any other additional capital costs not just the £200,000 in order to enable a potential property investor to measure whether the returns are good and likely to be better than investing that money in alternatives such as putting it in the building society.
What returns should Landlords be aiming for?
To some extent the investment returns required will depend on each landlord’s circumstances. For some landlords anything above that available on a building society deposit account would be OK. The real rate of interest from a building society account i.e. the gross rate (before tax) minus inflation is about 3% in real terms. This is pretty low as it reflects the fact that it is a risk free return. Property investment is not risk free and given that a landlord is investing a considerable amount of time, effort and capital it is reasonable to expect a return above this.
A property developer would look to receive a return of about 20% on capital invested. However, carrying out a development is far more risky than an investment. In addition, a development particularly a large one is likely to take place over several years; in which case the annualised returns could easily be halved to say 10%.
If we use these figures as a guide I would say that a long term real return of between 5-10% is OK although not stunning. A landlord has to appreciate that buying a property investment is not passive in the same way as holding a building society account is and running a rental business does involve small amounts of work to keep it on track. Therefore the returns that a landlord should expect from their investment should reflect this. A landlord should be aiming for at least a high single figure and preferably a double figure return on their capital. Anything above 20% is excellent.
Difficulty with predicting long-term returns
Off course, long-term predictions are notoriously difficult. Predicting things like the interest rate, the levels of inflation further out than a couple of years into the future was impossible up until recently. The independence granted to the Bank of England in the late 90′s has had a huge stabilising influence. Hopefully, the UK and the housing market will continue to benefit from this stable investment environment and enable all our property investments to continue to prosper.