by Rob Dix
I’m not going to bash you over the head about the importance of having goals, but consider yourself lucky that I’m in a pacifist kind of mood today because I really should: knowing what you want to achieve with a purchase is critical. Without knowing what you want to achieve, you can’t possibly know the maximum price you should be paying. If you do know what you’re ultimately aiming for and how you want to get there, you can see how each individual purchase fits into that picture and decide whether any given opportunity moves you closer to your goals or not.
For example, if your goal is to make £3,000 per month in rental profit, you might set the strategy of buying ten properties, each making a net profit of £300, and each property must offer the possibility to add value and refinance because otherwise you’d run out of cash before buying all ten. With that strategy firmly in mind, imagine if the opportunity comes along to buy a property below market value, but it only makes £150 profit. Or perhaps it makes £350, but there’s no potential to add value. That property won’t move you closer to achieving your goal, so you’ll say no.
Failing to take this approach means you could end up with a collection of perfectly well-bought properties, but still not end up where you want to be. There are worse fates in life of course, but surely you want to know that all this effort is going to pay off at some point?
OK, that probably counts as bashing you over the head – but it really is important.
Stacking the deal: buy-to-let
When you’re buying a property to rent out, your primary goal will be in some way related to the amount of money the property generates over and above its costs. Whether you express it in terms of net yield, ROI or a cash figure, it all amounts to the same thing: how much am I left with after the rent has come in and all my bills have been paid?
Clearly, answering that question involves knowing two things:
How much rent is going to come in?
What are the costs going to be?
You’ll probably have a rough idea of how much rent a property will achieve because you’ve been researching your area, but in the next section we’ll get into more detail on how to estimate both the rent and how much rental demand there’ll be.
That’s the easy bit. Pinning down the expenses is a little more tricky, because the only certainty is that you’ll be wrong: you can’t possibly know in advance exactly what every last expense will be. Some try really hard to know, however – and they write to me asking what the typical insurance is on a two-bed flat, or how often to replace the carpets so they can amortise it over the right number of years in their spreadsheet.
I admire these people’s spirit, because (a) spreadsheets rock, and (b) it’s vital to get the numbers right so you’re not disappointed by the returns you make. But given that life is short and the only certainty is that you’ll be at least somewhat wrong, I just aim to make sure I’m wrong in the right direction. In other words, I make broad but pessimistic estimates of all costs so it’s likely that the reality is going to be better than I expected.
Let’s have a quick run-through of what your major costs are likely to be in a buy-to-let scenario:
Mortgage repayments. This is almost always going to be your largest single cost. Luckily, determining what the repayment will be is easy: take the amount you’re borrowing, multiply it by the interest rate, and divide by 12 to get the monthly figure. (That’s for an interest-only mortgage. For repayment the maths is beyond me, so Google “repayment mortgage calculator” and you’ll find tools put together by people who did more than just scrape through their GCSE maths.)
The interest rate will probably change at some point during your ownership (even if you go for a fixed rate at first), so you’ll want to “stress test” the purchase against a higher rate. The long-term average base rate in the UK is 5%, and typical variable-rate mortgages are priced at 2% above base, so you may want to work off a 7% repayment rate. Of course, as a 5% base rate is the historical average, that means it can be higher – so you might want to stress test against even higher rates. Personally though, I anticipate mortgage rates being relatively low over the next decade (famous last words).
Service charge and ground rent. If you’re buying a flat, there’ll be a service charge and ground rent to pay. The service charge will be determined in part by the facilities that need to be maintained (so if there are lifts, extensive grounds or a swimming pool, the bill will be higher than a bog-standard block), but also by how tight a rein the management company keeps on their costs. Even service charges for blocks with identical facilities can vary widely, so find out what the current costs are before running your numbers – although remember they can change over time, of course.
With flats there are also cyclical “major works” bills to contend with (such as repairs to the roof), but we won’t worry about that for now.
Maintenance. This is the most unknowable expense of all. The only real “rule of thumb” I can give you is that maintenance costs are generally (very generally) lower in flats than houses. This is because many of the things that you might have to fork out for in a house (like replacing a cracked gutter) will be covered by your service charge in a flat. But, whether house or flat, there are plenty of impossible-to-estimate potential expenses. Will the boiler blow up on day one of your ownership or last for a decade? Will you have a leak in the bathroom that involves ripping everything apart and re-tiling at great expense? You just don’t know, although insurance (which we’ll talk about briefly later) can help to smooth out some of the bigger expenses somewhat.
Management. If you don’t want to manage the property yourself, a management fee will typically set you back 8–15% of your rent. Some landlords consider this tantamount to highway robbery, but I’m not one of them. If you ask me, £50 (on a £500 rent) is worth it if it saves even one hour of my time per month – which it almost always will. But I digress.
Insurance. Not a major expense, but you need to make a small monthly allowance for buildings insurance – unless it’s incorporated into the service charge of a flat.
Voids. At some point your property will be empty (even if it’s just a small gap to change over between tenants), and it makes sense to factor that into your figures. Again, it’s somewhat unknowable: even if demand is through the roof and you should in theory be able to just have a few days’ gap to clean and attend to some maintenance, you might get a difficult tenant who refuses access for viewings during their notice period and leaves you needing a month to get someone else moved in.
Bills. As a very general rule, bills tend to be included as part of the rent in HMOs (sometimes with a cap or fair use policy), and not in single lets. If you’re planning to include them, they (of course) need to be reflected in your calculations – not forgetting council tax, unless all occupants are students.
(I haven’t forgotten that tax is a cost, and we’ll be giving tax its own chapter later on.)
Knowing your anticipated rental income and having estimated your costs, you’re in a position to assess the deal based on your criteria.
My preferred measure, because it’s the most detailed, is ROI – the annual profit from holding an asset divided by the cost of acquiring the asset. The rent you can charge and the costs you incur are pretty much beyond your control (other than making improvements that allow you to increase the rent, or self-managing to cut out agency fees), which means it’s the price of acquiring the asset you need to manipulate if you want to hit a certain ROI figure.
For example, say your ROI target is 10%. By knowing the rental income and all your costs (including the percentage of the purchase price you’ll borrow and at what interest rate), you can pop everything into a simple spreadsheet and play with different purchase price figures until 10% ROI is the result. This way, you can determine the maximum amount you should pay for a property to make it work for you – and you don’t even need to know its market value.
The market value is a factor, of course, because you only want to be paying the low
er of the market value or the price that works for you. So even though you could afford to pay (say) £128,000 for a property and hit your ROI target, if you assessed the market value at £120,000 then you wouldn’t want to go any higher than that.
If, however, the market value was £150,000 and you had the chance to buy it for £135,000, in theory you’d turn down that opportunity because £135,000 is higher than the £128,000 that works for you – although in reality, you may relax your ROI criteria to get the benefit of £15,000 of instant equity.
Gauging rental demand
If you’re buying a property to rent it out, you’ll obviously have two critical questions in mind:
Will it rent?
If so, how much for?
Rental markets change over time and often move cyclically throughout the year (especially in towns with a large student population), but they don’t change that much or that fast. With a bit of research, you should be able to estimate the monthly rent you’ll achieve to within £50 (meaning that if you assume – for the purpose of your calculations – that the rent you achieve will be in the middle of that range, you’ll get nothing more than a nice £25 surprise or a philosophical £25 shrug of the shoulders).
Something of a side-note here, but rents are driven largely by wages (and also by local supply and demand). It makes sense: the amount each individual will be willing and able to spend on rent is going to be a proportion of their take-home pay. For that reason, rents are a lot less volatile than house prices, and will tend to drift up or down rather than spike suddenly. (House prices are driven by many different factors, which we’ll explore when we talk about the property cycle in Part 3.)
Just to be clear: rents are determined by wages and local supply and demand – not by landlords. You can’t decide to just stick the rent up by £100 a month because you feel like it or because your mortgage payments have increased. OK, you might have an exceptionally pliant tenant and there’s a degree of lock-in because moving is a pain, but wouldn’t you go elsewhere if you could get an equivalent product for £100 per month less?
In other words, you can try your luck with a rent at the high end of the market or try to get it let quickly by pricing at the low end, but demand isn’t elastic enough for you to just set whatever price you like. This is why I get annoyed when the response to anything that increases the cost-base of landlords is “They’ll just put up the rent and the tenant will end up paying for it”: it’s just not true, because the private rented sector is too fragmented for landlords to operate in a cartel in this way.
Anyway, where were we?
Ah yes: will it rent, and how much for?
Finding out the answer to both questions isn’t much different from determining a property’s market value – with the exception being that there is (unfortunately) no database of rental prices that have been achieved in the past. Instead, you have to work from the rents that are advertised – equivalent to working from an asking price – which isn’t ideal, but rents achieved tend not to deviate that much from rents sought.
The process is quite simple and the considerations are the same as we saw when assessing house prices: fire up Rightmove or Zoopla, and search for properties to rent that are nearby, equivalent in size and equivalent in quality. On both sites you can tick a box to also see properties marked as “let agreed”, which you should do to gather the most information possible.
My process isn’t as geeky as you might think: I just search within a 1/4 mile of the property I’m interested in, sort in price order, and eyeball the data to see what kind of price range there is. From there, I click into different results to see what seems to separate those at the high end from those at the low end.
With exceptions caused by landlords trying their luck or agents not really knowing the correct value, the patterns are pretty obvious: rents are higher for bigger properties than smaller, good condition than mediocre condition, furnished than unfurnished, facilities in the building than none (in the case of flats), and parking than none. There’s also a premium for locations that are well placed for transport links.
It’s worth noting that specific pros and cons of the property affect both the price and the time it takes to let. For example, in a block of identical flats, the one on the ground floor with a view of a brick wall or noise from people slamming the door of the main entrance will take longer to rent (or need to be done so at a lower price) than the others. Things like funky layouts or unusual room sizes will put people off too. This kind of factor is hard to determine when looking at comparables online (because the photos on rental listings are often somewhat lacking), but it’s important to take into account when you’re deciding what to buy. Basically, all else being equal, a property with some kind of oddity or drawback will cost you on the rent or take longer to find a tenant for.
While you can get a pretty good idea from looking online, the best way to find out what a property will rent for (and how quickly) is to call up and ask some local agents. Online, it’s hard to get an accurate idea of timescales: while you can see how many days ago a listing was added, you don’t know for sure that it’s truly still available. For example, sometimes agents leave one listing up for ages because they’ve got multiple units in that block with one listing counting for all of them, or they just plain forget to mark it as “let agreed”.
You might be dubious about whether agents will tell you the truth, but if you call a few you’ll probably find that there’s a fairly accurate consensus – and if you get one who’s particularly clueless or puffed-up and claims they can rent it in minutes for hundreds of pounds more than anyone else, they’ll quickly stand out as an outlier. Letting agents don’t have a great reputation, but they do see hundreds of properties each year. As a result, they’re all too aware of the ones where they struggle to get people through the door, compared to the ones where the phone never stops ringing the minute they put them up online.
Stacking the deal: buy-to-sell
How do you gauge whether a potential buy-to-sell project stacks up or not? We’ll discuss trading property in more detail in Part 3, but while we’re talking about assessing deals, it makes sense to touch on them here briefly too.
Just as with buy-to-lets, you’re going to be looking at two things: what price you should pay to give yourself a profit, and the demand for the final product. In this case though, of course, the “demand” you’re concerned with isn’t rental demand but people who’ll want to buy the property from you once it’s finished.
There are three main variables that you have some degree of control over:
The price you buy it for
The amount you spend on it
The price you sell it for
And naturally, you make a profit when the price you sell it for is greater than the price you buy it for plus the amount you spend on it. We’ll come back later to how much of a profit is “enough”, but professionals generally look for at least 20% (e.g. spend a total of £100,000, sell for at least £120,000). This is decent compensation for your hard work, and also means that if everything goes horribly wrong you should still at least break even.
The variable you have the most control over is the price you buy it for, so it makes sense to stack the deal by working back from the final selling price – something you have some degree of control over (by appointing the right agent and staging it well), but which is ultimately determined by the local market.
Calculating the final selling price is accomplished in the same way as working out the market value of a potential buy-to-let property – the only difference being that whatever the state of the property now, you’re interested in the price of comparable properties that are in mint condition. The same rules apply – only very nearby properties of the same size and with similar features are true comparables – and again, speaking to agents is very helpful indeed.
It’s extremely important at this point to be conservative with the final sale price you think you can achieve – because if you calculate you
r figures based on a price that’s £10,000 more than you can realistically achieve, that’s £10,000 of profit that vanishes. You should also bear in mind that you’re not in the position of an owner-occupier who can keep a property on the market for years until someone comes along, falls in love with it and is willing to pay an over-inflated price. You need to get your money out and move on, so ideally you want to be pricing it just below what’s being asked for similar properties to generate interest and shift it quickly.
The amount you spend on the property is the most difficult part to determine if you don’t have construction expertise yourself. I won’t get into how to work it out at this point, but getting a realistic/pessimistic figure is crucial. A contingency of at least 10%, preferably 20%, is always a good idea because you never know what unexpected problems you’ll discover until you start. Weirdly, the less work you’re doing, the more margin there is for error: if you know you’re going to have to rip the house back to brick and start again, there’s not much more that can go wrong.
In addition to the actual construction costs, there’ll be all the other expenses that go along with buying and selling houses: legal fees, borrowing costs (if you’re not using all your own cash), surveys, estate agents’ fees, and everything down to insurance, council tax and utility bills for the period that you own it. Everything needs to be factored in.
With all of this calculated, you can work out the price you should be paying for the property in the first place: the final sale price, minus your costs, minus your desired profit margin:
Price you’re willing to pay = final price you can sell it for - costs - desired profit margin
