Calculating Property Investment Returns
How do Landlords calculate their investment returns?
Property Hawk has provided its’ own Investor Appraiser to enable the whole process of calculating a landlord’s long-term returns from a potential investment easy.
What is involved in calculating property investment returns?
The process of calculating property investment returns can be very complicated indeed. On commercial property investors will go to great lengths to use techniques which discount future cashflows (DCF) from individual investments to work out the potential returns and in turn their value.
For residential landlords life doesn’t need to be so complicated. The focus for calculating potential returns on property should be on the two main factors.
Firstly the income, ie, rent, and secondly, the capital appreciation resulting from the potential rise in property’s price. An iinvestors total returns are the sum of both.
Returns from a rental business
Buying a residential investment property is not just like buying a straight forward investment. An investor is actually perceived as running a business, and therefore needs to include any associated costs of running that business in their calculations.
In the Property Hawk Investor Appraiser the standard costs are catergorised as: mortgage, decoration, gardening, decoration, management, cleaning although landlords are able to enter additional ones.
The main revenue source is obviously the rental income, so when calculating their net returns a landlord needs to include net income (after expenses) and add this to capital appreciation. This needs to be done for the entirity of the 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).
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. Other capital costs might be any developement/ refurbishment costs required. Finally, there is the cost of exiting the investment, ie selling the property. 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 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.
Our Property Investment Appraiser
The Property Hawk Investor Appraiser allows a landlord to account for all these factors and will automatically calculate the likely investment returns from an investment over the chosen investment period. This is useful because it immediately gives a landlord some indication of the potential long-term investment returns. It should enable a landlord to take a view on whether to go ahead with an investment or not.
What returns should Landlords be aiming from a property investment?
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.
The difficulty with predicting long-term property investment returns
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 housing market will continue to benefit from this stable investment environment and enable all our property investments to continue to prosper.