by Rob Dix
Lessons
Other than demonstrating the power of time on leveraged property investment (and giving capital growth some attention after we’d ignored it in previous strategies), the purpose of this example was to get you thinking about where and what you buy.
Let’s start with “where”. I said that historically, prices in the UK have doubled on average every nine years. But you’re not going to approximate the “average” unless you own hundreds of properties in every part of the UK – so if you’re interested in capital growth, location matters.
I don’t necessarily mean that you should search for the elusive “hotspot” where prices will outperform everywhere else in the UK. Instead, you just need to look out for parts of the UK where you can take a reasonable punt on growth being stronger overall than other areas. For example, cities will as a rule experience more growth than more sparsely populated areas because they’re the economic hubs where jobs are created as the economy expands. And in terms of industry and investment, you’d bet that parts of the country like the North East are going to struggle more than the South East or North West. (A decade or two is a long time to turn things around, of course, but all we can really work from is what we know today.)
I chose Southampton pretty much at random when I was trying to think of an economically strong city that’s likely to continue doing well – but there are any number of other cities I could have chosen. In fact, I’d prefer to choose more of them and (in the previous example) own one flat in six different cities: it reduces the odds of finding a massive winner, but I’m also less likely to have put all my eggs in a basket that underperforms.
“Where to buy” goes down to the location within cities too, and intersects with “what to buy”. As a rule, growth happens first and fastest in prime and central areas. That’s why I chose in my example to use a modern, relatively new flat in a popular area. The monthly return would have been a lot higher if I’d chosen a house on the fringes (there wouldn’t have been a service charge, and the purchase price would have been lower relative to the rent), but the intention was to maximise capital growth potential. When the economy is in full swing and growth is in the air, demand is always going to be highest (and therefore push up the price more) for the best properties in the best locations.
This is the yield/growth trade-off that we often see: as a general rule, properties that yield highly (relative to the area in general) will experience capital growth later and less strongly. This is somewhat simplified, because if a property’s yield is temporarily higher than one would expect for that kind of property, buyers will be attracted and prices will rise to remove the discrepancy. We’ll come back to this when we discuss the property cycle in Part 3, but for now just be aware that you’ll generally need to choose a property with some kind of yield/growth compromise in mind.
Finally, I’ve not mentioned “when to buy”. When property prices double, they don’t just drift upwards in a nice predictable way. The majority of that growth happens in just a few years, and is immediately followed by some of the gains being rapidly lost. This is the phenomenon of the property cycle, which we’ll cover in a lot of detail in Part 3 – because if capital growth is your objective, it’s a big part of the picture. You should never truly put the blinkers on for 20 years (as in our example) because then you’re just leaving to chance whether you end up selling at a good time or a bad time. I’d love to get into the property cycle in more detail now, but I’ll restrain myself. Trust me, it’s exciting stuff – think of it as your reward for trudging through some of the drearier bits about accounting that we need to get into later.
Chapter 4
Replace your wage with rental income – fast
Aim: Turn cash in the bank into an income stream that allows you to quit your job as quickly as possible.
In a nutshell: Buy a small number of properties that generate a lot of cash immediately.
Upfront capital required: High
Effort involved: High, if self-managing
Ongoing investment required: Low
Payoff: Short term
All of the strategies we’ve looked at so far have had a relatively long-term payoff. That’s all well and good (and time is where a lot of the magic of property happens), but what if you’re thoroughly sick of your job and want to quit RIGHT NOW? Well, with this strategy (and the next one) we’ll look at ways to create that instant income you need.
Both work best when you have a decent amount of capital to start with. This makes sense: if you have the luxury of time, you can put in more cash over the years or allow equity to build up. That’s not an option if you need to generate a return on your money from day one.
This particular strategy is all about accumulating rental income fast – which puts us squarely in the territory of multi-lets rather than single lets. When a property is rented out room by room, the total income generated by that property is generally higher – and of course, the more lettable rooms you can squeeze in (by converting reception rooms into bedrooms or sub-dividing large rooms), the more income you generate.
(A multi-let is also known as a House in Multiple Occupation (HMO), and we’ll use the term HMO from here onwards. “HMO” is actually defined in several different ways for different purposes, and it’s possible to have a multi-let that isn’t an HMO… but that isn’t important right now.)
The downside is that HMOs involve more management (in terms of keeping all the rooms occupied and making sure everyone is happy), and there will generally be higher maintenance costs as the house is being used more intensively. Let’s look at a couple of examples that demonstrate all of these points. Just like in the previous strategy, we’ll imagine that we’ve got £250,000 to invest.
Example 1
We’ll start with an example of an investment I know pretty well, because I own one: a mini-HMO in Liverpool, aimed at students.
It’s in the student-y L7 postcode, and has two bedrooms and two reception rooms. By converting one of the reception rooms into a bedroom, it can be let to three students. I bought mine a while a ago now, but looking at Rightmove it seems like you’d need to spend somewhere in the region of £60,000–£65,000 to cover the cost of buying and refurbishing a property like this. In fact, here’s one for £60,000 that has apparently just been fully refurbished – so nothing needs to be done: propgk.uk/liverpool-buy (the area isn’t ideal for students, but it’s passable).
To be pessimistic, I’m going to assume you need to buy for £60,000 and spend £10,000 on refurbishment. So the cash investment needed is:
25% deposit on £60,000 purchase price: £15,000
Stamp duty: £1,800
Refurbishment: £10,000
Purchase fees (solicitor, broker, survey, etc.): £1,500
For a total investment of £28,300.
The house will have three lettable rooms, each of which will command a rent of £82 per week, for a monthly total rent roll of £1,065. That’s a gross yield (dividing the annual rent by the total purchase price and refurbishment cost) of 18.2% – more than double the typical yield of a single family home.
But before you get too excited, it’s worth remembering that HMOs come with more than their fair share of expenses too – which is why gross yield is only a meaningful calculation for comparing investments that have similar cost profiles.
One big extra expense is bills, which are usually included as part of the rent: £20 per room per week is a fairly standard estimate for rooms let to professionals, although it may be lower for students because they’re exempt from council tax and might not expect Sky TV with all the trimmings. Management fees (if you don’t plan to self-manage) are also generally higher, as more work is involved than a single let.
So from our gross monthly rent of £1,065 I’m going to deduct:
Mortgage (£45,000 borrowed interest only at 5%): £187.50
Insurance: £20
Bills (£20 per room per week): £259.80
Repairs allowance of 10%: £106.
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Management at 12.5% (typically higher than for single lets): £133.15
That gets us to a monthly profit of £358.49, or an ROI of 15.2%. In fact though, student lets tend to run for a period of 11 months – so by the time you allow for a month without income and average that out over the year, the monthly profit reduces to £328.64 and the ROI to 13.94%.
(And to show just how cautious my assumptions are, the one I own actually has a real-life ROI of around 30% because my mortgage interest rate is lower and I’ve been lucky with repairs over the last few years.)
With our £250,000, we could buy nine of these (OK, we’d need to negotiate a discount of £5,000 across all nine properties to hit our budget), for a total monthly pre-tax income of fractionally under £3,000. Enough to quit your job? It might be a pay cut, but even after factoring in time for admin and phone calls from your letting agent, you’d still have plenty of time on your hands to pursue other sources of income. If your thumbs started to hurt from all the twiddling and you wanted to self-manage, you’d save £1,200 per month and take your monthly income to over £4,000.
Clearly this is a strategy I quite like because I’ve done it. I don’t have my entire portfolio in these investments, however, because there are downsides that are worth exploring.
Firstly, terraced houses in student areas tend not to be the most desirable, so (in accordance with what we’ve seen in previous examples) they’re unlikely to give much in the way of capital growth. If you consider “total profit” (rental profit plus equity gain) over the entire time that you own the property, it could end up lower than a single let even though the month-to-month income is higher. This becomes even more marked when you divide your total profit by the number of hours you put in over the duration of the investment. Capital growth is never any kind of certainty, but you could end up making less money for more work, even though the ROI appears to be higher.
Another downside, when it comes to student HMOs at least, is concentration of risk. What you’ve basically got here are cheap, not-that-great houses that students happen to be willing to pay a good chunk of cash to live in right now. If trends shift (as they’re doing in many student areas towards purpose-built accommodation), you could suddenly be the proud owner of nine unexciting houses where your yield has just been cut in half and your tenants have recurring cameos on Crimewatch.
Example 2
The “trend-shift risk” we saw in the previous example is specific to a particular type of student property, though. The HMO sector in general is thriving and should continue to do so, because young people aren’t going to find it any easier to afford their own flats – even to rent. So in the professional market you’ve got people living in rented accommodation well into their 30s, and in the housing benefit market you’ve got people who are only given enough to cover a room rather than a flat until they’re 35 (unless they have dependents).
Let’s take another example then, because owning nine houses seems like a lot of work and there are risks involved. Could you quit your job by just owning a handful of more upmarket professional house shares that are less at risk of a drop in rental demand?
Here’s a real-life example from a friend in Milton Keynes:
Purchase price: £190,000
Stamp duty: £7,000
Refurb and set-up: £10,000
Number of rooms: 6
Rent per room per month: £370
Total income: £2,220
Total bills: £500 (including insurance – just under the £20 per room per week figure that I estimated earlier)
Mortgage: £593 (£142,500 borrowed interest only at 5%)
Repairs allowance of 10%: £220
This gives an ROI of 16.84% and a monthly profit after costs of £905. £250,000 would just about buy four of these (with a fractional discount or saving on a refurb), giving an income of £3,620 per month.
You can’t tell from the example, but it wasn’t easy to pack six bedrooms into that house. The chap who gave me the case study is a dab hand at reconfiguring houses to squeeze in as many rooms as possible without making it overly pokey or breaching any regulations. This is where expertise comes in: if you thought it was only possible to get five bedrooms out of that house, your returns would have been cut dramatically.
The takeaway lesson from this scenario? That you can buy four houses, generate £3,620 per month and quit your job. However, you’ve just given yourself multiple new jobs: you’re now a letting agent, general dogsbody, referee in fights over who got crumbs in the butter, and so on. While HMOs seem more profitable than single lets, some of that profit has a time cost attached to it – and while being a full-time landlord might sound more glamorous than the job you’ve got now, you could be pining for a nice easy office job after a few months of running around after multiple tenants.
The alternative is, of course, to use a managing agent – but doing so reduces the ROI to not far off what you’d expect from a single let. In the example above, adding in management at 12.5% would add £277.50 in costs for each house, or £1,110 in total. This reduces the monthly income to £2,518, and the ROI to 11.67%.
Actually, your costs of using an agent will be even higher because most agents will charge a letting fee every time they rent a room on top of the management fee. If six rooms are turning over once per year and the agent charges £150 each time, that’s another £75 monthly cost on average.
This example, therefore, brings out another truth of property investment: outsized returns are generally earned, through hard work and hard-won expertise. In the scenario above, if you do the management yourself (hard work) and know how to maximise the amount of rent you can generate from any given house (hard-won expertise), you’ll do very well. Otherwise you’ll have to settle for lower returns.
Not that there’s anything wrong with either approach. You might be happy with making a lower return if you want to spend your time on other things and would rather outsource the management. Alternatively, you might prefer the job of being a part-time HMO manager to the job you’ve got right now – and you might even be able to systemise it, take on other people’s properties and eventually employ someone to do the job for you.
Chapter 5
Flip your way out of the day job
Aim: Embark on a new career as a property trader – bringing in enough money to replace your wage.
In a nutshell: Buy, fix up, and sell on for a profit
Upfront capital required: High for best results, but moderate can work too
Effort involved: High
Ongoing investment required: Low
Payoff: Short term
In the last strategy we looked at how to use a lump sum to create an income right now, so that you can get out of your job pronto. What if you still want to tell your boss where to stick it, but don’t have that much cash to put to work?
To demonstrate this strategy, we’ll use £50,000 as the amount of starting capital. This £50,000 won’t be enough to buy a decent chunk of rental income, even with HMOs. Realistically then, the only way to get an immediate income is to look at trading in property (rather than investing in property): buying, refurbishing, and selling on at a higher price. “Trading”, “buy-to-sell” and “flipping” are all used pretty much synonymously to refer to this process.
As you don’t have enough to buy a property purely with cash, you can use bridging finance – which, as we saw earlier, is a handy but costly form of short-term lending. Alternatively, you could approach a friend or a family member who has cash in the bank and offer them a fixed percentage return on their money for the duration of the project. (You could instead offer to go in 50/50 with them and split the profits, but that’s a worse deal for you unless they bring skills to the table too.)
Example
For this example we’ll look at a property that we can buy for £90,000, and needs £18,000 spending on it in order to bring it into tip-top condition. Once it’s gone from tired and unappealing to shiny and desirable, we reck
on we can sell it for £140,000.
With bridging you can typically borrow 70% of the property’s value, so we’ll borrow £63,000 and put in £27,000 as a deposit. That means the upfront costs are:
Deposit: £27,000 (30% of £90,000 purchase price)
Stamp duty: £2,700
Refurbishment budget: £18,000
Purchase fees (solicitor, valuation, etc.): £1,500
So that’s £49,200 of the £50,000 cash pot spent.
There will also be costs associated with the bridging loan of £63,000. It’s usually possible to structure the loan so that these fees (or at least the majority of them) are paid at the end of the project, but in case of any upfront fees there’s £800 left in the budget to cover them. I’m going to assume that we borrow the money for eight months, at an interest rate of 1% per month and with fees totalling 2% of the amount borrowed. That leaves total borrowing costs of £6,300 to pay back.
Because we’re professionals, we run the project like a military operation and finish on time and on budget, finally achieving the anticipated sale price of £140,000. With the property sold, it’s time to calculate the profit. The difference between the purchase price (£90,000) and sale price (£140,000) is £50,000 – from which we need to deduct:
Refurbishment: £18,000
Stamp duty: £2,700
Bridging interest and fees: £6,300
Legal fees and other transaction costs (for both purchase and sale): £3,000
That leaves a profit of £20,000.
I said I was going to leave tax aside for these models, but it’s more straightforward to calculate with property trading: if the property was bought within a limited company (generally a good idea for buy-to-sell projects, as we’ll see later), we’ll pay corporation tax (currently 20%) on the profits. That would leave a post-tax profit from this project of £16,000.
