Buy to Let properties make money from two sources that you need to understand if you are to be successful in this field.
- rental yield, and
- capital appreciation
Rental yield of buy to let properties
Rental yield is a measure of how much income you expect to make from a rental property. What’s known as the gross rental yield is simply the annual rent divided by the price of the house (and then expressed as a percentage). If for instance you bought a house for 100,000 and expected to receive and monthly rent of 500, you would calculate the gross yield as follows.
- multiply the monthly rent by 12 to make it annual (500 x 12 = 6,000)
- divide the result by the price of the house (6,000/100,000 = 0.06)
- turn it into a percentage by multiplying it by 100 (0.06 x 100 = 6%)
The gross rental yield is a useful starting figure as it allows you to calculate the potential profitability of different buy to let properties. But it is also an unrealistic figure because it does not take your costs into account. A more useful measure is the net rental yield. To get to that you do a similar calculation but you deduct your annual costs such as landlord insurance, management fees, estate agent fees, maintenance and the like from the annual rent before you divide it by the price of the house.
The beauty of this figure is that it provides a great comparison with other investment options. You can, for instance, compare the expected rental yield of a buy to let property against the earnings yield of shares (equities), the interest rate of a bank account or the yield on investing in bonds. It gives you a clear idea of how much cash you would receive, relative to your investment, if you were to buy a property for cash.
Yet few investors can afford to pay cash and most will need a buy to let mortgage. When assessing a property the more common calculation will therefore be to compare the net rental yield against the cost of servicing your mortgage. This gives an indication as to whether a property can be expected to generative cash or need cash put in every month to help cover the mortgage.
Just remember when doing these calculations to add in a margin of protection. Rents move around less than the prices of properties, but they can still fall quite sharply. Unexpected costs can also arise and your property may be empty from time to time while between tenants or in need of repairs. So always do your calculations conservatively to ensure you are not caught out.
Capital appreciation
This is the money that you will make if the price of your property rises when you own it. Over the years of the property boom capital appreciation provided the bulk of the profits that many property investors made. But many investors have lost everything in recent years by expecting this trend to continue. Many bought properties they couldn’t really afford at rental yields that did not make sense in the hope that they would make their money later by selling at a higher price. If you are making an investment decision that assumes that house prices only ever rise you are making a big mistake. Your final return will always be a blend of yield and capital appreciation and rental yield, but the first rule of property investing is not to rely only on house prices rising for you to make money. Instead long term success in buy to let property investing will come from properties that offer an attractive rental yield that allows them to pay for themselves many times over. The gain you make from selling eventually should just be the cherry on the top.
Some fabulous knowledge you’ve put up listed here.
There is a good book by Mark Temperley on amazon that goes into all of this in a lot of useful detail.