Buy-to-let investment is, fundamentally, all about yield. Capital gains may be nice, but, at the end of the day, it’s yield which pays an investor’s bills from one month to the next. The question then becomes how to calculate yield. Here is a quick guide to help.
The basics of rental yield
The basic calculation for rental yield is as follows.
(Annual income – annual costs)/price paid by investor = Net yield
A key point to note here is that the same property can generate a very different net yield depending on how you finance it. For example, let’s assume that two identical properties are purchased for £100,000 and that each generates £10,000 per year in rental income. Let’s also assume that it costs £2,000 per year to maintain each property.
Investor A buys their property outright while investor B puts down a £25,000 deposit and has a mortgage for the remaining £75,000, which costs him £3000 per year to service.
£10,000 annual income – £2000 annual charges = £8000
£8000/£100,000 = 0.08 or 8%
£10,000 annual income – £5000 annual charges = £5000
£5000/£25000 = 0.2 or 20%
In other words, even though Investor B has more than double the annual charges of Investor A, they are making double the profit on their buy-to-let investment. Of course, this is all before tax; however, the complexities of tax are well outside the scope of this blog post.
The importance of details
While the basic calculation is school-level maths, making it work in practice can be rather more complicated (even before you factor in tax). Basically, it is crucial to factor in all possible costs and to ensure that you can charge a rent which not only covers them but also provides you with an acceptable return.
In fact, ideally, you would like to be in a situation where you are earning an acceptable return plus a bit extra so that you will have some room to manoeuvre should circumstances change.
There are two basic keys to making this work. The first is to make sure that you really do factor in all possible costs. It is now illegal to charge tenants anything other than the agreed rent (and a few permitted exceptions, none of which are likely to apply if a landlord simply gets their sums wrong when calculating the rent).
The second is to keep a close eye on the financial news to see what changes are likely to be heading your way in the near future and what, if anything, you need to do about them. Again, an investor’s level of exposure to unwelcome changes may depend on the extent, if any, to which they use financing.
For example, Investor A can ignore changes to interest rates while Investor B might find that they significantly impact his net yield. Similarly, Investor B could be much more exposed in the event of Section 21 being abolished without major improvements to Section 8 as he might find it difficult to remortgage if a lender feels they might struggle to repossess the property if he defaults.