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New Investment Appraiser

Landlords who have seen the recent headlines featuring ‘the king and queen of buy-to-let‘ who are in the process of unloading their portfolio of 700 properties may not know that these buy-to-let entrepreneurs started life as maths teachers.

Maybe this underlines the fact that residential property investment is all about the figures as we at Property Hawk have always said.

What landlords may not have been aware of is that Property Hawk has its own FREE investor appraiser software to work out long term investment returns.

With sentiment in the housing market turning more positive we have decided to look in detail at how to carry out an investment appraisal of a potential investment.

Investor Appraiser

I’ve recently discussed the importance of the rental yield in assessing a buy-to-let property.

However, rental yields assess only one aspect of the potential returns for landlords. They do and are meant to measure the income generating potential of capital asset. They don’t however take account of any gains that the investment may generate as a result of capital appreciation.

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In assessing a potential property investment it’s important to measure both.

This is why we developed our own development appraiser based on the principles of real returns over any given period of investment. It allows a landlord to work out how much the potential return is on their initial investment.

EXAMPLE

Let’s take an example of an investment in a £90,000 2 bed maisonette.

The starting point for any investment appraisal is deciding on the level of gearing of the investment.

As with any geared investment i.e. one that uses capital or equity to lever in loan finance, the higher the gearing the greater the potential rewards if the value of the investment goes up. The opposite is also true. If the value of the investment falls; the greater the gearing the higher the potential loss.

Have a go with the property investment appraisal calculator

Gearing

The maximum gearing now available to landlords with a buy-to-let mortgage is 75%, not the 85% available prior to the ‘credit crunch’.

Therefore we have for this example we have assumed that the landlord has opted for the highest level of gearing available, 75% of the purchase price of £90,000 or a loan of £67,500.

Investment assumptions
:

It’s important for a landlord to set our their expected investment parameters.

The important ones we have included in our investment appraiser are as follows:

Years invested, mortgage rate (rate payable), property growth rate, inflation rate and rental growth rate.

These are all difficult to predict for the long term as they will vary over time. But here are a few useful benchmarks that a landlord can use.

Years invested – The average time a landlord keeps their buy-to-let investment is 17 years.

Mortgage rate – Long term interest rates have been about 5%, and a buy-to-let mortgage averages around 2% above base. We think that long-term interest rates are likely to come down as a result of low inflation but still think long-term borrowing rates for a landlord are likely to be about 6%.

Property growth rate – The average growth rate in property prices has been 2.4% over the rate of inflation over the last 30 years, with the Barker Report on housing supply indicating that the trend rate up to 2004 had increased to 2.7%. Recent falls will obviously cast doubt on this so we will stick with the 2.4% long-term average.

Inflation rate – Inflation over the last 20 years has meant that prices have risen by 97%. We will assume a long –term average of 2.5%.

Rental growth rate – Rental growth has been less prestigious than the rise in house prices. It has largely tracked the rise in cost of living represented by inflation. We therefore have included it at 2.5%. Those landlords in areas such as central London are likely to have seen real growth in rents so could include a growth rate to reflect this.

Transactions

Whilst the above involves an element of educated guessing about the likely long term rates and returns, the transaction costs should be more straightforward. This is because the landlord can calculate these from their previous experiences or by obtaining a quote from companies.

We have included purchasers costs as a percentage of the purchase price because the costs are likely to vary depending on the costs of the buy-to-let property. In the case of the example we have allowed 2% to cover buy-to-let mortgage costs and solicitors fees.

Stamp duty is an increasing cost faced by landlords as a result of rises in the Stamp Duty Land Tax. The top rate of SDLT is now 4% for any transaction over £500,000 although the example investment comes below the transaction limit so that no SDLT is payable.

Sales costs will depend again on the value of the property that a landlord disposes of and the value of the buy-to-let investment at the end of the investment period. It is important to take this into account to allow a meaningful comparison of returns between buy-to-let against other forms of investment such as putting your money in the bank.

A landlord needs to extract their capital from the investment i.e. dispose of the property before being able to make this comparison. The actual sales cost at the end of an investment period will be higher than today’s price, but the investor appraiser takes this into account with the projected inflation rate. For the purpose of this example investment we have allowed £1500 to cover the sales costs.

We have allowed a category for disposal costs because in order to crystallise the investment it will have to be sold first and this will therefore impact on the landlords’ investment returns.


Capital costs

The capital costs refer to any investment that a landlord might need to make on capital items to go in their investment property. A couple of obvious ones are appliances in the property such as; a washing machine and cooker. We have allowed a £1000 to cover the cost of cooker, fridge freezer and washing machine. Where a landlord is going to rent out the property furnished then they should account for the cost of furnishing their investment. The assumption in this case is that the property is unfurnished.

Other capital costs that a landlord may incur could be for example: a lawn mover, carpet cleaner. They are all costs to the business and the investment and therefore need to be taken into account when calculating the overall investment returns.

Have a go with the property investment appraisal calculator

Revenue costs

The final set of figures required for the investment appraisement relates to the revenue figures. These are regular recurring costs or incomes generated by the investment property.

The most obvious revenue is rent. Other income that could be received by the landlord on a regular basis could be a service charge or a charge for regular services such as meals. In this case £500 is the estimation for the monthly rent level. The rent level is conservative and by doing this we have factored in an element of voids where the property remains unlet for a period in between tenancies.

The revenue costs other than mortgage costs which are accounted for in the appraiser are likely to be landlord insurance, service charges or management fees, gardening or maintenance fees. In this example we have assumed a monthly cost of £15 for insurance but because the property is a maisonette there are no management or gardening fees.

A landlord may also want to include depreciation costs such as redecoration and re-carpeting as an ongoing revenue costs as this is a regular charge that is likely to impact on the overall investment returns. In our worked example we have assumed a redecoration charge which equates to £50 a month. This should also cover minor repairs and replacement costs.


Results and returns and what it means

The results are very interesting.

What it reveals is the difference in returns that are generated by the two different types of buy-to-let mortgage. Using an interest only mortgage the long term rate of return works out at 4.61% on the total equity invested by a landlord of £25,300. However, if a landlord had used a repayment mortgage then the return jumps to 7.43%. The reason for this is that providing a landlord can afford the higher monthly payments they are gradually reducing the size of the loan and therefore the total amount of interest payable over the period of the investment which pushes up the overall returns.

Both returns are acceptable as a long-term return on an investment, however neither are stratospheric. Personally I would be looking at a return of nearer 20% before getting excited over the investment prospects.

It is worth a landlord playing around with some of the basic assumptions such as house price growth rates. If suddenly average growth rates increased from 2.4% to say 5% returns would leap to 15.55% and 14.5% respectively for an interest only mortgage and a repayment mortgage. These figures are much more attractive as an investment proposition. They also indicate an important relationship. Interest only mortgages are better where a landlord expects a high growth rate in house prices above say 5%. In a lower growth environment a repayment will produce higher returns.

These figures all go to prove what the Wilson’s have known all along that success in buy-to-let is a numbers game. Landlords looking in buying a buy-to-let investment need to understand the figures before committing to what inevitably will be a long-term investment.

Have a go with the property investment appraisal calculator

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