Calculating The Rental Yield To Find The Best BTL Investment

Hello Colin:
I drafted a ludicrously long reply to your kind message, but it seems to have gone MIA. No loss, I say, because it repeated most of the points I've tried to make in previous nerve-racking posts. If it does appear, I apologize for appearing to wonk too loudly!
If it doesn't appear, I would like to make one point, again. Deep down, financial analysis is dead simple, the simpler the better. In a separate post, Emma praises the property investment calculator. I'm happy for her if she likes it, but she simply doesn't need all that clever-sounding stuff to know whether she's made a wise investment or not. It confuses simple issues when clear thinking based on reliable data is what's most needed.
You are right to be concerned about the risk/reward ratio of BTL. With many exceptions, the risks are usually underestimated and the rewards overestimated. We hear about BTL investors who crow about their successes but seldom hear from the many who lose their shirts!
Wishing you a happy and prosperous New Year, I must emphasize that I'm not qualified nor authorised to give investment advice. Please be especially wary of anyone who says they are, and never, ever, buy an investment asset from someone who's trying to sell one to you. If it's as good as they claim, why do they want to sell it?

I think that Emma's post (and it seems to have gone?) merely suggested a property investment calculator was an aid? Guy is perhaps over-cautious; there are many outlets of investment properties and good ones at that, property brokers market repossessed properties for example and take a commission or finder’s fee, developers sell ‘investment’ properties after completing any refurbishment, the key is due diligence -do your homework, and then do some more. If the numbers stack-up, why shouldn't you buy from someone who’s selling a good investment property?

Morning Mr T:
Yes, something weird took place on this website yesterday. Emma's message is lost and my long reply to Colin went MIA. I fancy you and I are on the same wave length, but I wonder if advising us all to be "wary" is also being "overcautious"?
In the City the joke used to be "never trust a broker trying to sell you a bond"! A nice play on the London SE's motto, at a time when HMG was selling the Consolidated Fund. In property, time share was a huge scam, and probably still is. There are plenty of dodgy estate agents and property brokers, one publicly-quoted London firm that I shouldn't name being a notorious example. Your condition of the "numbers stacking up" is a major condition: too often they don't stack up as well as unwary buyers think.
The risks of buying houses in the UK is best summarised, IMHO, by the jaw-dropping graph here: http://www.bbc.com/sport/cricket/35213969. Over 40 years the average UK house has been a sound investment but nothing spectacular: for owners the 2.9% real increase excludes repairs and maintenance, property taxes, and for landlords letting property can be a nightmare. Property is not a liquid asset: it is subject to losses and can take time to be realised.
It sounds as if you can cope with property's risk/reward ratio. That's great so stick at what you know and enjoy a prosperous 2016!

Thank you, Landlord. That's a sensible precaution which I hadn't thought of. Can you resurrect Emma's post, too? If I can have my say, shouldn't she -- and everyone else?
Best wishes for 2016.

interesting, i def posted it, erh, I had two people refer to it too, Guy & mr t! oh well, that's technology for you, stick with the property i think!!

Hi Guy
Thank you for your response and Happy New Year to you too! I greatly appreciate your candid and straightforward comments and concur with your thoughts on BTL property investment. The way that you have outlined it has clarified my thinking.
In the context of your caveat that you are 'absolutely not qualified to give you or anyone else investment advice' I would be very pleased to hear if you have any thoughts on how to assess the risks involved with investing elsewhere other than BTL property, in particular investing in the likes of BL shares (large established companies) or Schroders fund previously mentioned. I have dabbled in the past; a dalliance with FTSE options (was lucky not to loose my shirt) and some tech stocks in the 90's where I did loose money in the 2000 crash. I appreciate the thinking that investment is best spread along the risk/reward curve but I do not know where to begin in assessing risk with stocks and funds and my pot would need to yield more than the 2-3% that the safe bet government gilts offer. From earlier posts I understand that you 'enjoy the riskiness of the stockmarket' and I am aware that 'fortunes favour the brave' (like you, I am not looking for a fortune, just an income from investment) but for me I think that I am quite risk-adverse and lack the confidence to invest mainly due to lack of knowledge, experience and the feeling that 'I am too far away from the action' to know when a crash is just around the corner.
Kind regards
Colin

Morning Colin:
Thanks so much for your kind remarks on my posts.
Last night I drafted a reply to your recent message. On re-reading it, I decided I couldn't, and shouldn't, send it. I'm really not qualified to give investment advice, especially to someone whose circumstances I don't know. And, I don't live in the UK so there are lots of important things I don't know or master. In my favour, if any, I used to be a teacher -- MBA and all that -- so I may understand something about elementary economic and financial analysis. Like most teachers, my instinct is to help people with the basics and some clear, simple thinking on the subject.
So as not to frustrate you completely, I do have some suggestions. There are a few classics about investing that you may also like. A classic is "The Intelligent Investor" by Ben Graham, the teacher of Warren Buffett as a young man. My copy dates from 1976 so it's not new but still a classic. Another is "Where are the customer's yachts?" by Fred Schwed. It's a hilarious tale of home truths. The internet is full of helpful websites. I like Yahoo Finance: https://uk.finance.yahoo.com/. It's reliable, relatively easy to follow, and has some helpful things. For converting nominal values to real values, go here: https://www.measuringworth.com/ukcompare/. Beware of being fooled by this issue: always think real values! For some help with risk, from time to time consult the VIX index, aka the worry index: http://www.marketwatch.com/investing/index/vix/charts. It's available on Yahoo Finance, too. For good stuff on personal finance, especially for selecting suitable investment vehicles, Morningstar stands out: http://www.morningstar.co.uk/uk/. Lastly, for fun and a great education, please dip into Warren Buffet's letters to his shareholders: http://www.berkshirehathaway.com/letters/letters.html. They are outstanding and amusing, too.
Please don't invest a penny of your pot until you feel confident that you do understand what you're buying and why. This requires, alas, some real work and effort, for "a fool and his money are soon parted". (You know what I really mean by a fool:))
Please forgive my stubbornness. Your message just is a subtle invitation to give investment advice:) I'm not qualified to do so, trust me. If I did give any and you lost your shirt, I could never forgive myself. Please beware of any advice you get: even Warren Buffett, the second richest man in the world, cost his firm, Berkshire Hathaway, $444mn by buying Tesco in 2012 and selling in 2014!! Oops! My broker advised me to buy HMV and hold Glencore. Oh dear! I hope you see why I'm so stubborn. Best wishes!
PS I buy second-hand books: http://www.abebooks.com/.

Morning Guy
I think that you did answer my question!.....one needs to read up and become knowledgeable on the stock market if one is to invest in it, experience comes over time but even those with much experience get it wrong sometimes.
Thank you for the suggestions on reading material, that is very helpful and it looks like some of the books may be a fun read. Alas, I think that I may be a little to long in the tooth to become informed, experienced and confident enough to invest.
I must say that I would of loved to have seen your first reply, although I totally understand your reasons for not sending it, it would have been interesting, in light of the experience that you have, to have seen your approach to investing. I might be wrong (and often am!) but I suspect that it might come down to a simple and straightforward strategy or key pointers to look for.
I also appreciate you sage comment on advice which runs in line with my own thinking and brings us full circle because I originally came across this site whilst trying to understand more clearly the financial risks of BTL property and where your posts were most helpful.
Kind regards
Colin

Colin:
Thank you for your understanding despite some disappointment.
I fear I may be even longer in the tooth than you say you are, and you're right that, at my age, I do best what is simple and straightforward. I stress test, to use a modern term, every proposal I hear because one of my few certainties is that we have an irresistible urge to believe what we want to believe rather than what the facts are telling us. For example, I constantly hear that investment in property is gold at the end of the rainbow, which it's no such thing, but it is unquestionably a wise, even essential, component of any sound investment portfolio.
As for my simple approach, cash seems to be a poor investment so I only have available what I may need to cover an emergency or unforeseeable calls for cash. BTL is too much like hard work for too little reward, and property is too illiquid for me when, at my age, I may need cash quickly. I don't understand Gilts and other fixed interest stocks, or gold and currencies and stuff like that. So I'm left with the London SE. My modest portfolio of 21 shares, which consists of the usual suspects and a couple of more daring shares, pays me about 4%/year and its value broadly follows the FTSE 100 index. Over the long term I've done OK and kept my boat afloat. I'm not clever enough to speculate, so I trade seldom and BTH (buy to hold). This year I've lost money since May, as have most equity investors, but I don't care: I have faith in the longer-term future of the UK economy, which I expect to grow over this parliament above expectations.
In general, I use three main financial indicators to evaluate my equity portfolio or a particular share: the price/earnings ratio (P/E), the dividend yield and, for a particular share only, the sustainable growth rate. Lastly, I pray for a little luck without which few of us can succeed in any human endeavour.

Hi Guy
Thank you for your openness and the clear explanation of your approach to investing. It is much appreciated and refreshing to hear and receive when there is so much misinformation around (particularly online) and people tend to play their cards close to their chest (particularly when it comes to money!). I agree with you about luck and wish you much!
Best regards
Colin

At the risk of appearing to be an unbearable windbag, may I add a different point from BTL and turn to the issue of what other posters call their "pension pot"?
One potential component of any pension pot is some kind of insurance policy which, at a future date, reaching retirement age, say, pays an annuity. I have such an instrument and had another one that I cashed in. This post is a serious warning to take great, nay scrupulous, care before you choose to invest in any such instrument. The best assumption you can make is that the instrument is much more benefit to the vendor than it ever will be to you.
For eight years I have fought a large insurance company which tried to defraud me in several devious ways. With the help of an expert and recourse to an Ombudsman, I have won my case and the company has finally had to compensate me for its fraud with about £15K, a significant proportion of the capital sum. I'm not alone: I can name a handful of friends who have also been robbed in similar ways.
They can do this in all manner of ways: here are just a few. First, these instruments usually use a complicated suite of calculations to account for contributions and other credits. Then, the terminology used and the terms of the policy are often obscure and can be changed during the life of the instrument, often 20 years or more. They are a classic case of asymmetric knowledge: the vendor understands the instrument much better than the policy holder does. The vendor knows that the policy holder is unlikely to query the instrument until maturity by when he will be too old (or dead) to take the enormous trouble to check that the annuity paid is what is due. I can assure you that doing this is real work, and that even the regulators don't always understand the instruments, and are easily more on the side of the insurance companies than with the policy-holders. Lastly, the instruments are often sold by big, known-name "companies" registered in dodgy places, where controls are weak and legal redress out of practical reach.
As there is little reason why anyone should take any of my advice, for independent, humorous support I would like to quote Fred Schwed, who worked on Wall Street in the 1920s before becoming a writer. In his super book "Where are the Customers' Yachts?" (1960), he tells the apocryphal(?) tale of a visitor being shown round the Street and the Battery, with its many glossy yachts at anchor. "These are the bankers' and brokers' yachts," said the guide. "Where are the customers' yachts?" asked the naive visitor. Just so! We've all been warned:)

Some interesting comments ... as usual, some useful some misleading. Actually, one of the most acurate comments was from kaye (june-15). And I'm surprised he chose to not reply to the subsequent comment! So i will....

Using yield as defined by rent/purchase price is one measure but only one of many to consider. Kaye calls this measure 'asset turnover' and whilst he is technically correct, most people call this the yield. This common definition of yield is not misleading as long as you're clear on what the definition is. Personally, i don't like it because its too generic but its handy as a quick comparison between potential BTL investments (assuming you can predict rents to such accuracy).

Secondly ... kaye defines yield as what i would call Return on Capital Employed (does what it says on the tin). And no, equity is not used as the denominator (as guy assumes in his subsequent comment). ROCE uses Total capital cost (inc stamp duty and legal fees. Both cash equity and mortgage debt) ... however kaye did not mention that the numerator should exclude mortgage interest costs (because the ratio is compared to the weighted average cost of capital .. mainly the mortgage rate if highly geared).

Of course, if you really want to and if its relevant, you could also assess your Return on Equity (net profit, now including the interest cost of debt, divided by your cash outlay). This is kinda like an Earnings Per Share measure. But this measure gets silly when its all debt financed.

Oh, but what i actually wanted to comment was on guy's obsession with benchmarking against alternative investments (like UK gov gilts, bonds etc). Yeah, ok, in theory. However, assuming the investment is mortgaged, then the only investment available is in property (because the lender requires a property to secure the debt against). So there are no alternatives to consider! The alternative is to invest your cash deposit but the quantum £ growth on your 40% deposit is going to be a lot less than the quantum £ growth on your 100% capital invested (capital being equity plus mortgage)

Well, thats what i think. But open to criticism.

Qualifications? Accountancy degree, Chartered Accountant for 15 yrs, 6 yrs in Property Finance for FMCG FTSE100. BTL investor.

Dom: those are pretty impressive qualifications but I'm mystified that they lead you to such misleading conclusions.
In all economic analysis, of course there are alternative uses of resources whether our own or someone else's. Without a yardstick, how may we know how wise our choice of uses for those resources is? All investment analysis is based on the premium required over and above the risk-free rate, to compensate for the risk run by choosing to invest in A and not B. Eugene Fama, the 2013 Nobel Prize winner, and others devoted much of their working lives on this and no one now disputes their findings. Nor are their findings remotely theoretical (whatever that might mean).
You seem also to think that whether an investment includes a mortgage or not makes a difference to the rate of return on the investment. Franco Modigliani and Merton Miller dismissed that widespread belief in 1958, and they won the Prize in 1985. In the case of BTL decisions, the issue is the rate of return on the present realisable market value of a property not on what was paid to acquire and refurbish it.
Market rates of return change with every moment. On Bloomberg websites, we can see them change all day long: every morning in our newspapers. Wise, knowledgeable investors follow market rates for everything -- gilts, bonds, property, stocks and shares, currencies, and even the price of cornflakes -- and they continually evaluate what adjustments they might make to their investment portfolios and expenditure pattern mainly to protect themselves from losses but also to allow for risk.
As for your quantums story, I simply don't follow your point so I can safely dismiss it until you can say what you mean. I have a suspicion you may be misusing the true meaning of quantum, as many people do?
Keep polishing those qualifications. Best wishes, Guykguard

Guy, apologies for the length of this.

Can't say i disagree with any of that (except my misleading conclusions!!). It’s true that the forecasted Return On Capital Employed (ROCE) ratio of any potential investment should be compared to the risk free rate of return (one part of the wacc), and the ROCE of alternative investments being considered (if investments are mutually exclusive), and the weighted average cost of capital (wacc).

Neither do I disagree with Modigliani & Miller ... the ROCE ratio does not change with the financing or gearing (I did say that the interest cost of debt is excluded from the numerator in calculating the ROCE ratio!). I don't understand what i said that you think contradicts this.

And yep, use the present realisable market value (net of disposal costs of course) for any exit or continue decision of an existing investment (not the historic cost) when calculating that investments ROCE. In my earlier post where I defined the capital employed as the equity plus the mortgage I could have been clearer to say equity includes capital growth (as is normal).

All I was saying was that there are lots of measures to use in appraising a capital investment decision (future investments or existing investments) - yield %, ROCE %, even Return on Equity %(which includes interest costs as a deduction from the numerator) to name a few. But that ROCE is the best of these three. So I'm curious to know what I said that was interpreted contrary to above (or what i said that suggests I've come to wrong conclusions!). Nobody has even mentioned using a Net Present Value (NPV) calculation.

You say "yield is a measure of the balance between risk and reward" - comment #62. Really? How does the yield, using the most common definition of yield being the gross rental income divided by the property value as defined in the original article and the one I believe matt is refering to in comment #61, factor in risk??? Where is 'risk' in this equation?? I agree with matt that a lot of the market use yield for the reasons matt gives, but I couldn't say 99% do (he's just trying to make a point here. Don't take the 99% thing literally!). Yield is rubbish and is only good for making quick rough and ready comparisons of one property against another property.

With regard to quantums (meaning the growth expressed as an absolute £ figure) and theory vs practice. I can best illustrate this using an example ... lets say I've got £40k cash and i can either invest in a bond which returns 5% or i can go out and get a mortgage, and use my £40k as a deposit to buy a property of £240k, but the return is only 3% (lets say net of costs, net of interest costs and including capital growth - just to make it comparible). One might say that the bond is a better investment (5% vs 3%). But when i look at the hard cash profit I've made its £2k vs £7.2k!!! Thats what i mean by considering also the quantums involved. Quantum is latin for 'amount' ... add latin to my qualifications!!!! Maybe 'quantum' was a term local to where I've worked at, but we said quantum to be clear and distinct from when we were talking ratios. Of course, I'd love to invest £240k in the bond at 5% but I can't do that because banks don't lend money for that (theory vs practice!).

I'd like to know what your understanding of 'quantum' is? And what is the incorrect version that you assume most people apply?

Captain Hook understands the difference between theory and practice. He recognised in comment #29 that you can't invest the same amount of capital in halford shares as you can in property (because, generally, no one can get a mortgage to buy shares).

When I was being provocative (deliberately!) by saying you're obsessed with comparing to alternatives I was trying to highlight that its not simple to switch from property to something else (other than property) because invariable the property has a mortgage on it ... so to invest in something else means investing not £240k in something else but only £40k (to use my example). And maybe the ROCE ratio is better with the alternative £40k investment but the absolute £ profit number is not.

Oh, one last thing about those two guys you put in so high esteem – I certainly do agree that the ROCE ratio doesn’t change if financed by mortgage or not. I've not seen you say why this is so just to be clear, it’s because the ROCE ratio is generally compared to your weighted average cost of capital ratio. And any new investment with a ROCE % greater than your wacc % is a worthwhile investment. But your wacc DOES change according to your financing structure – so a really highly geared finance structure will have a high wacc (because debt is more expensive). And the mortgage interest rate will also affect your wacc. If your wacc is high then there will be fewer investments which are worthwhile. So financing is relevant! Put another way . . . if I can only borrow at 10% interest rate (extreme, I know) then there really isn’t going to be any point borrowing to invest because the interest paid will wipe out all the profits (the absolute £ profits!!!)

Hope this helps. I don't know, but it feels like you've got a clear understanding on some of the parts but not seeing the whole picture.

Morning Dom T:
At the risk of irritating other readers of these comments, I choose valour over discretion and reply to your main points above. I find them so misleading, even dangerous to the unsuspecting, that I can't resist setting things to rights. Your points sound so impressive but property investment analysis is so much simpler than you make out. I begin the quotes of your points with YOU; mine with ME.
YOU: All I was saying was that there are lots of measures to use in appraising a capital investment decision (future investments or existing investments) - yield %, ROCE %, even Return on Equity %(which includes interest costs as a deduction from the numerator) to name a few. But that ROCE is the best of these three.
ME: Best? Doesn't it depend on what use you're making of each ratio? ROCE was used in the Dupont analysis but is replaced by Return on Assets (ROA) which is simpler and means the same thing (double-entry bookkeeping, eh?).
YOU: You say "yield is a measure of the balance between risk and reward" - comment #62. Really? How does the yield, using the most common definition of yield being the gross rental income divided by the property value as defined in the original article and the one I believe matt is refering to in comment #61, factor in risk??? Where is 'risk' in this equation??
ME: The risk arises from the difference between the yield of the proposed investment and the risk-free yield. All economics is based on the net margin: all the marginal benefits minus all the marginal costs. That's an equation! Fama and others call the net margin the risk premium. Each investor will judge whether the risk premium of an investment meets the criteria set. Among these criteria will be all the benefits foregone by investing in A and not B.
YOU: With regard to quantums (meaning the growth expressed as an absolute £ figure) and theory vs practice. I can best illustrate this using an example ... lets say I've got £40k cash and i can either invest in a bond which returns 5% or i can go out and get a mortgage, and use my £40k as a deposit to buy a property of £240k, but the return is only 3% (lets say net of costs, net of interest costs and including capital growth - just to make it comparible). One might say that the bond is a better investment (5% vs 3%). But when i look at the hard cash profit I've made its £2k vs £7.2k!!! Thats what i mean by considering also the quantums involved.
ME: Oh dear! That is a serious schoolboy mistake. You are comparing investments of different size: 40K compared with 240K. And, you're applying different yields to each of your examples. To do both to prove what you want to believe and not what the facts are saying is little short of dishonest! In my MBA classes you would have got a failing grade for this! The bond is more profitable, of course, by 200 basis points! In the case of the property example and the 7,200 pound profit, 6,000 or 3% would go to your lender leaving you with 3% or 1,200 quid profit. So much for theory and practice!
A word about investments of different size, which may often be the case in property. There is a method of dealing with this: it's called the profitability index which you can find explained in any decent textbook on financial analysis.
On the question of your bond and property investments, trust Modigliani, please! How an investment is financed makes NO difference to the rate of return, with a few obscure qualifications. I can replace your mortgagor with my aged aunt who is desperate to lend me 200K. I invest the 240K in a bond at 5%: I hand over 10K of the yield to her, and keep the 2K balance. We've both earned 5%: the ROA is 5%. How an investment is financed only makes a difference to how the profits/losses (yield) are shared!
YOU: I'd like to know what your understanding of 'quantum' is? And what is the incorrect version that you assume most people apply?
ME: With pleasure! In Latin "quantum" does not mean "amount", but "how much". For about 100 years quantum has been a term in the study of quantum physics, which deals with stuff like atoms and quarks -- minute particles of matter. Read two greats on this: Richard Feynman and/or Murray Gell-Mann (both Nobel prize winners). If the common cliche "a quantum leap", presumably from the TV series, means anything at all, it means an infinitesimally small physical change that makes a big difference to the state of nature! In practice, the cliche mob use it to mean a big change:( If you meant to say "amount", why not say it and avoid being teased by evil people like me?!
If you really want to pursue our conversation, which I would be happy to do so if it were any help to you, please ask the webmaster for my email address, which I hereby authorise him/her to give you, Dom.

Hmmm. Your focus on theory is starting to make sense (you were an MBA lecturer?!).

I'm not sure I'm getting my points across. Will consider emailing if i think there is anything to be gained

It's amazing, jaw-dropping. I'm banging on again about how exaggerated the profits to be made from property can be and how misleading so much of what is written and said about it actually is. Before explaining briefly why, I repeat: property is a wise investment in a balanced portfolio of assets suitable for an individual investor.
This week, The Economist has published an interesting if worrying leading article about the consequences of the property boom in London. One of the worries is where the boom might lead to. A collapse of property prices may seem unlikely but it's not impossible. It's happened before, and when the tide did go out, we could see who was naked and who wasn't.
A pensioner I have time to dig around for interesting stuff. I came across an article in The Guardian dated 12th April 2016 entitled "Why younger people can't afford a house: money became too cheap" by one Dominic Frisby who is billed as a "financial writer". As the comments column was closed (with 1,116 comments) I could not see whether the following points had already been made, nor post my own. Instead, I posted on The Economist article on London property. Any A level student of Economics or Business who wrote what follows would be given a failing grade. Frisby earns real money by writing what I refer to below:
"A factor contributing significantly to increasing prices of property is frequent and reckless exaggeration by the media of such increases. It gives the unwary a wholly false picture of the profits to be made from buying and selling property.
In a recent article in the Guardian Dominic Frisby, a financial writer, wrote "Between 1997 and 2007... house prices...rose by more than 300%". They did no such thing: they rose by about 133%.
They did no such thing for two reasons. First, Mr Frisby seems not to understand the importance of real prices over nominal ones. For anyone writing about property, or any other asset class, this is reckless. Secondly, he doesn't know how to calculate a percentage increase accurately. For a financial writer, this is a schoolboy error.
Between 1997 and 2007, the percentage increase in the nominal price of the average house in the UK was about 206%. Mr Frisby divided the price for 2007 by the price for 1997, with a result of about 306. But that is not the percentage increase in the price! In real terms, based on the RPI, the percentage increase in the price of the average house in the UK was 133%.
The article was addressed to young people. Reading Frisby's utterly misleading
information, young people risk rushing headlong into the property market or wringing their hands in despair for having missed the boat.
Property is an attractive investment, especially as a means of providing shelter. As part of a portfolio of investments, it offers a good balance between risk and reward.
The main risks of property are liquidity. Despite the spectacular rises of property prices in London, in a downturn property can be hard to sell and prices can fall steeply. From 2010 Q2 to 2013 Q1, real prices of the average UK house fell by 13% and only recovered in 2015 Q3. Over a long period, say 30 years, the average annual yield on property ranges from 6% to 8%, with London likely to be consistently in the higher range.
The media should be careful not to fan the flames of property prices by misleading even reckless information about the true state of such an important influence on human welfare."

As the rental income continues to perpetuity and the rental income increases over these periods (say 10% in every 5 years), is it possible to aggregate or average the rental yield for these periods (say 10 years)?

Simeon, in theory, yes. But if you do want to include an assumption about rent increases then I think you should also include an assumption about capital (in general, the value of the property) and cost increases.

To do one without the other maybe a bit one-sided and lead to the wrong conclusions.

You may wish to read comment number 37 and the reply in comment number 39

Simeon:
Catching up on some emails, I read your post today. In case you have not already answered your own question, here it is.
The question you raise deals with a fundamental concept in all financial analysis, namely compound interest. You wish to know what the rent will be ten years from now if the rent increases by 10% every five years. In finance speak, you want to know the Future Value of an Annuity at the end of n periods, where n is the number of future periods. The formula is: FVIF(k,n)=[1+k]^n, where FVIF=future value interest factor; k=interest rate; and n=number of periods.
It is an axiom in finance that interest increasing, for example, by 10% every five years is the same as interest of 2%/year. For example, the monthly rate of interest on most mortgages is the annual rate of interest divided by 12. So, in your example the annual rate of interest is 2%.
Therefore, FVIF(.02,10)=[1+.02]^10=1.2190. What is FVIF? It is the number by which, in this case, the present rent must be multiplied to know how much the rent will be in ten years' time. Supposing the present is $520 pcm, the monthly rent in ten years will be $520*1.219=$633.88 (sorry, no pound symbols on this laptop).
If I may address Dom T's reply, there is nothing theoretical about this! Indeed, the simplest way of answering all such questions of compound interest is to buy, for little money, a set of interest tables. Any decent book on finance -- always buy these second-hand -- has all you will ever need, with good explanations, too. Any spreadsheet can do all this stuff, as can a finance calculator, but be sure you know what you're doing.
Where I can agree with Dom T is his point about capital, to which I would add alternative investments. In and of itself, the future value of the rent is just a number. It doesn't tell you anything interesting. The real question is, how well are you doing ten years from now? Dom T implies that you should estimate the future yield on your investment: I agree. I would add that you should compare the future value of the rent with the future value of interest on 10-year Gilts, the only risk-free investment available to sterling investors. In finance, it is essential to set one or more comparable benchmarks; there are always alternatives to investment. HTH, Guy K

Here is a perspective from the United States. You may find it interesting from a tax standpoint.
Started in the metro Portland Oregon rental game in the 97230 zip. Invested about 500K about 18 months ago. I have 5 rental homes and 1 I live in. Refinanced 3 of my first and received 152K to purchase 2 more in the 2017. I put down 25% on each house and my model is at 10% recovery on initial investment in the first year. I make about 50K for 2016 which is pretty close to my model.The big money is in 3-4 bedroom homes with at least 2 baths in a good neighborhood. I pay just about no tax on the passive profit, depreciation and purchase right offs are great as well as maintenance. The caveat is I’m a retired journey level tradesman that is big and strong. Most will not make this return, this is for me and enjoy the experience and the money.

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A flurry of comments on this website have induced me to visit the website for the first time since I last submitted a comment myself, in August 2016. Among other emotions, I was pleasantly surprised to read again so many generous reactions to my excessive contributions. If I may remind any of my previous readers, I overdid the contributions because I became aware of so many popular pitfalls surrounding the property game. I apologize for overdoing it then and I'm not yet cured, alas!
Much as I admire Martin Roberts and the HUTH presenters, I'm afraid they, or rather the programme makers, persist in misleading a large and enthusiastic audience. They persist in estimating the yield on the properties they feature by relating the rental income to the costs of acquisition and renovation. This is a schoolboy error. I duly wrote to Graham Penny, a knowledgeable and experienced auctioneer/estate agent who often appears on the programme. In his courteous reply, he agreed with the points I made and planned to discuss them with the programme makers. I wonder if he ever did?
What was paid to acquire an asset is not relevant. It is the current realisable value of the asset that is relevant, especially in estimating yield and premiums. Any investment has alternative uses. The yield on a property is the rental income -- of ten months, remember? yes ten not twelve -- divided by the estimated realisable value of the property (times 100 to make it look like a percentage). In HUTH, most broadcasts put the realisable value of a property higher than the costs of acquisition and renovation, sometimes much higher. Yet, the programme makers always estimate the annual yield on these latter costs! Barmy! In fact, I find it dishonest because the over-estimate may induce unsuspecting buyers to buy property on the assumption of annual yields that are simply wrong and misleading.
The basis of property finance is the property premium. This is the difference between the real annual yield on the property and the yield on risk-free 20-year Treasury Bonds. The yield on Treasuries is the reward for waiting 20 years to maturity. The property premium is the reward for the worrying time, that real property prices fall or that some unforeseen disaster overtakes you -- your tenant doesn't pay or your bijou sea-side property is expected to fall into the North Sea within ten years owing to changing currents.
Now let's bring real property prices and 20-year Treasury yields up to date. The Nationwide real house price index is in the doldrums. The UK average real house price in the first quarter of 2018 was about £211,800. This is a long way off the highest point of the index, in the third quarter of
2007, when it reached £247,000. Since 1975 the average annual real increase in UK house prices has been about 2.6%. Real prices have been falling since the third quarter of 2016. Assuming that rental income has remained unchanged since the third quarter of 2016, the yield on the average UK house will have risen proportionately to the price fall. This rise in yield offsets the fall in the real value of the average house!
There has been talk recently of rising BoE base rates. Owing to uncertainty surrounding Brexit, Trumpisms and the rest, UK interest rates have been behaving erratically in a narrow range. Today, the yield to maturity on 20-year Treasuries stood at about 1.82%. That is today's benchmark yield: a risk-free return.
So what should the property premium be? Aha, I can't tell you that: each property is different, as is each investor, and the data are for an "average UK house". In the long run, the yield on property has averaged about 8%. So my rule-of-thumb is that the property premium should be aimed at about 6% (8.00%-1.82% = about 6%).
Looking over my stuff of three years ago or so, I repeat here four pieces of advice I gave then. First, once a year get one or more reliable estimates of what the realisable value of your property is. Second, use that info to check how close your rental yield is to about 6%. If it isn't, you own a property that isn't average (which is quite likely!) or something doesn't add up, which is not unlikely! Third, follow Nationwide's Index of UK average house prices and compare the data with your property and personal circumstances. Lastly, keep track of the risk-free yield on 20-year Treasuries and the risky yield on the FTSE 100. You need to know what else is out there, so you can compare what you're doing with what other investors are up to.
Reading over this, I can hear the groans: that old dog'll never learn new tricks. Probably true, but there are many new dogs who could usefully learn some old tricks:) Best wishes!

Naughty, naughty Guy!

So many things not quite right there.
You've cherry-picked the worst possible time to buy (Q3 2017) and used that to base your argument.
Why not choose your 20 year bond timescale and go back to 1998?
London and south east is up around 300% -not to mention the rental income.
The original deposit could have been re-mortgaged out making the rate of return infinite.
Makes your nominal 1.82% look a bit grim.

Nice to see you're still around!

And the average annual rental void is about 2 weeks, not 2 months.

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To Benji:
My comments on yours:

Nice to see you're still around!
Thank you: every day feels like a bonus!

So many things not quite right there.
Not impossible.

You've cherry-picked the worst possible time to buy (Q3 2017) and used that to base your argument.
If I appeared to base any argument, it was unintended. I intended to take a new look at the property game after a lapse of three or so years. I found the fall in real house prices interesting but not surprising. I did not "choose" 2017: it happens to be the beginning of the most recent decline in average real house prices.

Why not choose your 20 year bond timescale and go back to 1998?
I can do easily but I was interested in understanding how the UK property market is faring now. From what you write I'm not sure you understand what a 20-year Treasury bond is nor how these investments work. If I'm right, rather than listen to more wonking by me I suggest you buy a decent finance textbook: in all investment analysis understanding the risk-free rate is basic.

London and south east is up around 300% -not to mention the rental income.
To convince me of this, you'd have to produce some reliable data and relate them to a period of time. Nationwide (NW) data are reliable. They do not produce real price data by region only nominal prices. Since 1998 average nominal house prices in London have ìncreased by about 383%. But we know that nominal prices mean nothing. Since 1998 average real house prices in London have increased by about 185%. In what NW call Outer SE, the rise has been about 128%. In the past 20 years London real average house prices have risen by about 5.4%/year. For the UK average real house prices have increased by 94%, an average annual rise of 3.4%/year. My apologies for being blunt but your figure of 300% is day-dreaming.
The original deposit could have been re-mortgaged out making the rate of return infinite.
I don't understand this. You'd have to show me the maths to prove your point. Till then, ...
Makes your nominal 1.82% look a bit grim.
This percentage figure was the annual yield to maturity of UK 20-year Treasuries on Monday afternoon, 30th April 2018. This morning the yield is 1.8%. Bond yields change every minute as buyers and sellers affect the price. Property yields behave similarly. Realisable values change over time but rental income tends to remain unchanged for a fixed period, sometimes for several years.

Like most people I know of who invest in property, you appear to overestimate its profitability. HUTH does so every weekday! Your comment about rental voids is the giveaway. Voids are not the only deduction from long-run annual rental income. There are many other potential deductions: agent/agency fees; repairs and maintenance; bad debts and litigation; insurance; general admin. Hence why large property companies budget on ten months annual rental income not twelve. They take the accountants' age-old advice: anticipate no profits and account for all possible losses.
Good luck with that portfolio of yours!

@Guy,

Good luck with that portfolio of yours!

Thanks Guy. Retired very early on it many years ago.

Too much to answer there and we're never going to agree, but here's what I mean about an infinite return;

Buy a property £100,000 with a 25% deposit.
Remortgage a year later for a higher amount taking back out the £25,000 invested.
I know own a £140,000 property with none of my money invested in it.
£0 invested giving a pre-tax rent profit of £5000 pa, hence an infinite return.

@ Guy,

Hence why large property companies budget on ten months annual rental income not twelve.

LOL. No they don't! There is far more to it than that. That was just an old skool, back of a fag packet, rule of thumb.

"Benji
LOL. No they don't! There is far more to it than that. That was just an old skool, back of a fag packet, rule of thumb.
You can laugh but that's how it's done. It's an elementary rule of investment analysis. All investment decisions must be weighed on similar assumptions or you can make any damned fool decisions. The word used for voids, tax, and similar variations is "notional". You may be right that big property companies are old skool but they are wrong.
As for your infinite return, I don't like to be so blunt but you understand nothing about investment analysis. For one thing, how an asset is financed has nothing to do with its profitability. The long-run (20 years) annual rental yield of your property, which you say is worth £140,000 -- that is, how much you could sell it for -- is [((£5,000/12)*10)/£140,000]=2.98%. This estimate is valid whether you have £140,000 invested in it or none. Neither the realisable value of the property or the rental income are affected by how it is financed! An infinite return is absurd.
May I just end by saying that if the case of your present property is true, the annual rental yield is surprisingly modest. You could invest the £140,000 in 20-year Treasuries today to earn 1.8% with no risk: and Treasuries don't need painting every five years! (This is not investment advice: I'm not authorised to give any.) FWIW, by comparison with your property my FTSE 100 portfolio's yield today is 4.94%: this doesn't need painting either.

To: The Landlord
cc. Dr Mehak Nagpal

Through you, I would like to thank Dr Nagpal for his kind words about my comment. I do not wish, therefore, to be seen as ungrateful in also taking exception to him using your website to advertise his services on your website. AFAIK, sexology has nothing to do with property so part of the comment is also wildly off-message. I do not think that the web should be used indiscriminately and free of charge for commercial purposes. I would therefore be pleased to see the message in question removed.
Yours truly, Guy K

@The Landlord
Sorry, I forgot to remind you that there are a couple of other similar commercial comments that could do with your red pencil!

@Guy,

Sorry to also be blunt but you understand nothing about property investment.
Large property companies do not work out their budget decisions simply on "ten months annual rental income not twelve". It is a very complex calculation decided on a myriad of individual factors.

Your calculations are nonsense. The property example I gave you increased 40% in one year. I buy trade, not retail. Heaven knows what it would sell for in 20 years time. The rent will probably also be a lot higher in 20 years.

Oh, and no bank will lend you money to buy 1.8% treasury bonds, even if you were fool enough to want to.

@Benji
Writing cheeky comments and pulling rank on me don't wash. Sorry! Facts speak for themselves but opinions are, well, just opinions.
If you knew anything about the "complex calculations" which you claim large property companies make, why don't you use them to calculate the rate of return on your example? With some relevant information, I think I could do a decent job in about 20 minutes. Investment analysis is a financial procedure for asset allocation so, as long as any assumptions (read opinions) made are similar for all candidates, the allocation will be logical. Trouble is that non-quantitative considerations necessarily outweigh quantitative ones.
By trade I presume you mean commercial property? In Chester over Easter I was shocked: the handsome old City centre is derelict, abandoned, with vacant premises everywhere, some boarded up for some time. The Rows are in a deplorable state. I see that Doncaster is in a similar bad state, mainly due to pedestrianisation, it seems. In the SE Haywards Heath is a disaster -- all charity shops and cheap specs -- as are most of the south-coast seaside towns: Hastings, even Brighton. Don't tell me that commercial tenancies earn, over 20 years, all 240 months rent. No chance!
Your capital gain -- if you had the courage to realise it and pay any tax -- is cool. Congratulations! For every roulette winner, on average there are about 36 who lose their shirt. I'm not sure I yet know the full facts on your apparent gain, but please keep them to yourself, or the spell might be broken. Stick at what you know and can do well.
Banks might not lend you and me to buy Treasuries but they buy squillions for themselves. At 31 December 2017 Barclays, for example, reported holding £58.4bn (net) of "Government and Government-sponsored debt". Are they so stupid? No, but I don't know how to trade them so I don't have any. When interest rates were falling, I wish I had: profits everywhere, all risk-free!

@Guy,

Ha ha! Yes, I suppose I am pulling rank. I've been doing this day in, day out for decades. It seems the closest you've got to the property industry is a spreadsheet and your missus telling you when to get your chequebook out.

Thought it was obvious that by 'trade', I don't mean commercial, (although I do dabble).
I mean buying residential, building, converting, developing, restoring, renovating, getting your hands dirty -and then flogging or renting them off to such as yourself at 'retail'.

Your capital gain -- if you had the courage to realise it and pay any tax -- is cool. Congratulations!

Thanks! I have been doing and paying a lot of tax.

And I'll throw you a bone here;
Look up 'section 24', have a good laugh. Take a few days to think it through. Then use your financial intelligence to work out the unintended consequences of taxing turnover.

-But don't worry about me, I'll be alright!

@Benji
Your reference to turnover tax is the one bright spot in your previous message, and an interesting one, too. An expat for almost 50 years, I'm not expert on UK tax or on UK property. I only claim to know about investment analysis. Such "financial intelligence as I may have is not mine: I just stand on the shoulders of giants like Modigliani and Fama.
As Hayek wrote, "the power to tax is the power to destroy", so any decision to tax or to change tax rules is, as you correctly imply, potentially dangerous. I understand your concern.
From what I know and read, the UK property market is in a serious mess and has been so for many years. The very idea that an essential of life, shelter, is beyond the means of the average citizen or couple is simply absurd. Add to that the certainty that UK food prices (and many others) will begin to rise from March 2019 and the UK is going mad!
On the countries which I know and where I've lived, the property market is far more orderly and, with exceptions, property prices are reasonable for owners and tenants. In general, property law in Germany, for example, is tilted in favour of the tenant so home ownership is low because rents are also reasonable, though rising in thriving cities like Berlin and Düsseldorf, which is one of the richest cities in Europe. UK tenancy law is unthinkable in Germany or Belgium or the Netherlands. Yet, new builds of every kind are visible everywhere and city centres like Chester or Barrow are unknown! The seaside towns of the channel cost of France are among the most prosperous places anywhere. I've yet to understand the causes of these significant differences. Maybe you do?
Taxes are the fair price we all, landlords included, must pay for a civilised society. As my contribution to such an important debate, I choose to argue the investment analysts' corner. This is that the tax regime should not favour one investment over another. In other words, I want to be able to choose how I invest my assets without any consideration of the taxes due. I do not want to be induced to invest in A rather than B because the tax man makes A more attractive than B. I want to invest in A rather than B because, all things considered, for me it's a wiser use of my funds.
In all important respects, BTL is a business. So are investments in stocks and shares. There should also be fair treatment of any such business undertaking so that we may make wise choices.
In the multinational corporation where I worked for 20 years, our investment analysis procedure paid no attention to differences in national profits taxes. The differences were wide and the rates changed frequently. To overcome this and to compare all investment proposals on a consistent, equivalent basis, to all investment proposals we applied a notional tax rate of 35% so that the appraisal was based on the intrinsic business merit of the proposal and not on the whims of governments.
In addition, tax only affects the distribution of operating profits/losses to the shareholders. The investments were in the USA, Argentina or Italy or wherever: the shareholders of the investment were often based in tax havens like Delaware or Luxembourg!
In the UK I read of a continual imbalance of supply and demand for housing. I don't know why supply seems always to be lower than demand. Presumably, one reason is that UK property is not sufficiently attractive compared with alternative investments? What are they? What are the impediments to investors like you to investing more in property? You know: I don't, I can only speculate.
What I think I know is that it will take a brave person to invest in Chester city centre (and dozens of others). With the spectacular fall in sterling, and further surely to come, is the UK a wise choice of destination for property investment which is not liquid? Are bricks and mortar, or inflammable cladding on luxury Thames-side blocks, a wise investment? Will the High Street survive? In my case, when it comes to property I -- only just! -- prefer to add to my holding in British Land. They yield 4.49% today and I'm 70% up but over several years, so not spectacular.
As I say, tax is not my strong point. Your Landlord association and the government seem to be having a grown-up debate on what is an important issue. I hope it will be resolved fairly and sensibly so that the UK property market is a lot more efficient in the future than it has been in the past. I'm not that optimistic, alas.

@Guy,

The seaside towns of the channel coast of France are among the most prosperous places anywhere. I've yet to understand the causes of these significant differences. Maybe you do?

If you mean seaside towns like Le Touquet and Deauville, then I think it is due to being Paris-on-sea, horse racing, casinos and a hangover from the English heyday. A bit like Brighton being London-on-sea. Proximity also to Benelux.
I wouldn't describe Le Havre or Calais as particularly prosperous.

(Just looked up Le Touquet on wiki and the above could be a cut and paste, but it was based on having property in the area)

@Guy,
Taxation and legislation are the biggest barriers to UK residential property IMHO.
The big institutional investors are dipping their toes in but will need a lot more incentives if they are to provide accommodation on the scale needed.

@Benji
They won't get them.
One way or another, taxes are one of life's inevitabilities. As for UK legislation, I don't know the details. What I do know is that UK tenancy legislation makes no sense whatsoever to German lawyers (my wife is a German lawyer who practised in real estate for several years) or in Belgium. With the prospect of a Corbyn government and more Labour local councils, I would expect more, more restrictive legislation not less.
In my classes I used to preach that it's no use business people wishing or hoping for less uncertainty, less risk. They'll never get it. The future is not risky, it's unknowable, so we must keep going in the hope that, in retrospect, we shall have made more wise decisions than unwise ones. As Churchill was keen on saying, "KBO: keep buggering on". Hoping for lower taxes and less legislation is hoping to find a crock of gold, so KBO.

@Guy,

Germany have the opposite problem to Britain; a declining population. Around 30% of the population is over 60. And the size of the country is a lot bigger. Their housing market is a different kettle of fish.

They won't get them.

So if they just keep buggering on, tightening the screws, what will be the financial result?
Obvious answer is less rental properties and increased rents. Or do you foresee something else?

@Benji
Three remarks before we leave for ten days in the Périgord:
1. Chester is a former Roman town with a distinguished history; near a major, moneyed big city; and surrounded by posh places like Altrincham. When I was a kid, Brighton and Bournemouth were grand places. Now? Down at heel. My old (Irish) mother used to say that, when the Jews left them, that was the end. Yes, like most port cities, Le Havre and Calais are in trouble.
2. You tempt me to get my crystal ball out. Sorry, I don't have one. What I do know is that the property market in the UK is inefficient and has been so for about a generation. As long as supply and demand are in such chronic imbalance, no matter what the causes of it, the chaos will continue. One cause may demographic changes, but the differences in population-by-age between most large EU Member states seem to me not to be significant. The German property market (and others) in some cities, Berlin for example, is under pressure from the arrival of a large number of immigrants.
3. As for WSC's wartime remark, property dealers like you or British Land just have to KBO. It's what you know and understand, so why change unless you take a view that the property business is, like tinkering, over. The point I was making is that, for 47 years, I heard business people wishing for "better times ahead". Dream on: they rarely come and, even when they do, they're not obviously recognisable! Successful people are able to adapt to whatever conditions arise: they have effective coping capabilities. Brexit will test to the limit the British people's ability to adapt as well as their coping capabilities. The forthcoming changes from being a Member State on 29th March 2019 to a third country the following day will be dramatic, no matter what any citizen voted for. What the effect of those changes will be on you property portfolio, I'm unable to foresee but you personally better be paying careful attention to them. By October 2018, the EU die will be cast and it's not looking promising for the UK.

Loving the banta on here! My phone started pinging with emails from this website about a week ago . . ignored them at first . . then was curious to see why I was getting all these notifications! hahah . . this old chestnut. The "recent" tax introductions in the UK market is a political debate (section 24 and other introductions) ... but I think it's an important aspect which I'd consider relevant to an investment decision

Owing to a flood of tiresome notifications from spammers from the Indian sub-continent -- I'm pretty sure -- I'm checking out of what is an interesting website.
Before doing so, I wish to answer Dom T's message of 5th May. Of course tax is important. Without knowing the details, I'm sure that Section 24 has important consequences for property owners.
What I also know is that tax is not relevant to investment decisions. Interest rates are quoted gross; yields on all stocks and bonds are quoted gross; bookmakers' odds and rates of return on all possible investments quoted gross.
Of course, those -- and there seem to be some -- who deny that there are alternatives to any investment may fail to allocate their resources as efficiently in the long run as those who choose to follow my suggestions in previous posts.
At the risk of irritating Benji, I repeat: over a 20-year lease, a landlord cannot reasonably expect 240 monthly rents. There will be voids; repairs and maintenance; fees, litigation and bad debts. Ten months rent a year over 20 years is a prudent estimate to account for the future financial risks of investment in property.
May I end my participation in this debate by pointing out an important mistake in the first page of the website. The Landlord's ambitious formula for the annual yield on a rented property should read:
Annual gross yield = [mrr*12/i]*100
Good luck to all landlords!

Thank you for your understanding despite some disappointment.
I fear I may be even longer in the tooth than you say you are, and you're right that, at my age, I do best what is simple and straightforward. I stress test, to use a modern term, every proposal I hear because one of my few certainties is that we have an irresistible urge to believe what we want to believe rather than what the facts are telling us. For example, I constantly hear that investment in property is gold at the end of the rainbow, which it's no such thing, but it is unquestionably a wise, even essential, component of any sound investment portfolio.
As for my simple approach, cash seems to be a poor investment so I only have available what I may need to cover an emergency or unforeseeable calls for cash. BTL is too much like hard work for too little reward, and property is too illiquid for me when, at my age, I may need cash quickly. I don't understand Gilts and other fixed interest stocks, or gold and currencies and stuff like that. So I'm left with the London SE. My modest portfolio of 21 shares, which consists of the usual suspects and a couple of more daring shares, pays me about 4%/year and its value broadly follows the FTSE 100 index. Over the long term I've done OK and kept my boat afloat. I'm not clever enough to speculate, so I trade seldom and BTH (buy to hold). This year I've lost money since May, as have most equity investors, but I don't care: I have faith in the longer-term future of the UK economy, which I expect to grow over this parliament above expectations.
In general, I use three main financial indicators to evaluate my equity portfolio or a particular share: the price/earnings ratio (P/E), the dividend yield and, for a particular share only, the sustainable growth rate. Lastly, I pray for a little luck without which few of us can succeed in any human endeavour.

Hi there, please excuse my ignorance or lack of knowledge, as I’m new to BTL or Property investing.

I’m recently soon to realise my late Mother’s inheritance money, and I wanted to use a majority of it to buy an investment property.

Now, if I buy a ‘flat’ outright as a cash buyer, do I still need a Buy to let Mortgage to ‘interface’ between a tenant and myself?

Or do I simply draw up an agreement or contract with an Estate Agent to do this?

As I understand I don’t really need a ‘mortgage’ as such as I’d have bought the place outright.

I understand I’d still pay stamp duty, ground rent and all those charges, but the monthly ‘mechanism’ for me to realise any rental income - how do I set this up????

Thanks very much for any information, and sorry if this is schoolboy obvious or basic - it isn’t to me !!!!

Thank you very much for this amazing post. Really helpful.

merely suggested a property investment calculator was an aid? Guy is perhaps over-cautious; there are many outlets of investment properties and good ones at that, property brokers market repossessed properties for example and take a commission or finder’s fee, developers sell ‘investment’ properties after completing any refurbishment, the key is due diligence -do your homework, and then do some more. If the numbers stack-up, why shouldn't you buy from someone who’s selling a good investment property?

Thank you for this excellent blog