Let’s start by committing a modern heresy. No reputable economist would use the term ‘yield’ to express the financial viability on any residential property investment. It’s simply not an accurate enough term to cover the breadth of returns or potential losses on such a complex, long-term investment.

But why should I care about such nit-picky technicalities, or the answers?

• Because the devil’s in the detail in this game.
• Because you owe it to yourself not to let some simplistic headline figure be tapped out on a calculator by an agent or broker with axes to grind – particularly if you’re going to borrow money.

What you need is some understanding of the various returns that residential property offers – their pitfalls and advantages.

The difference between yield and return

First we need to break down the two financial rewards that can be available to investment landlords.

• Yield is the day-to-day cash received from an asset – like rent.
• Return is the total gain (however received, through rent surpluses and capital appreciation, etc.) expressed as a proportion of the purchase price. This means that the return will include the yield but not necessarily be the same figure.

Yield as a way to express investment returns is best used for assets that are:

• 1.Highly liquid.
• 2.Easily tradable.
• 3.Have low transaction costs (the costs of buying and disposing).
• 4.Where there’s little movement between purchase and sale prices.

Now, does this sound like the UK property market? I think not.

Yield is an incomplete measurement

Yield is a snapshot of, rather than the whole picture. An easy answer for agents with calculators. What’s more, as a replacement for a standard profit and loss calculation that reflects individual finances, its appropriateness diminishes.

Why the term causes such confusion

Originally, yield was designed to show the relationship between capital invested in certain types of investments and the likely annual return (which is what agents are trying to tell you, albeit somewhat inaccurately). This is virtually impossible with property, especially residential property where borrowings and different investment ratios are in play. (For those of you wanting a worthwhile equation, see the end of this lesson.)

The commodity aspect that no one mentions

What property investment does offer is a decent commodity aspect, not often available to straightforward armchair investors. Put simply, housing remains a commodity in permanent demand. So long as tenants, supply and costs remain broadly in balance you should never run out of customers, whereas commercial prices and rents depend on economic performance (positive or negative).

Why borrowers with no repayment strategy are asking for
trouble

Borrowers with no repayment strategy are playing a risky returns game, based on the myth of permanently soaring prices. With any other form of investment (or, bluntly, gambling with borrowed money) lenders would be slamming their doors.

Why yield alone is so incomplete

Residential property begins, rather than ends with the initial investment. Unlike a shares portfolio that you simply buy, watch and do nothing bar trade periodically, rental property requires you to do something all the time – or pay someone else to do that something. It’s a working investment requiring time and effort. It isn’t a straightforward ‘investment’ at all.

Farming isn’t a bad analogy

Growing crops produces a commodity. And so does owning a property, where rent is the product. Let’s imagine potatoes are the commodity crop. The market price includes seed, insecticide, mainly labour and somewhere in the fraction of a kilo on the supermarket shelf, the land price itself. The complete return for the farmer is not simply profit on his potatoes but also includes the rising land values of being good at what he does. He may take a risk, perhaps investing in asparagus crowns. Higher crop price feeds through to an increase in the value of the land. Yield is that year’s profit. Return is the complete financial benefit. Of course, not every farmer has the right conditions to grow asparagus. Location and climate are key. Besides, if everyone grew asparagus, there’d soon be a glut and prices would start to fall – along with the price of his land. Starting to see any similarities yet?

All investment relies on faith in the market

Plus, the investment side of residential property is starkly different from the commodity side of housing. Investments rely on faith. On a shared belief that certain items will retain or increase its current value (think, gold, stocks and shares, etc). Their value is also underpinned by a shared belief that the value of the purchase is likely to hold or potentially increase in value. The higher the likely increase, the higher the risk taken – and the further to fall if you miscalculate.

Investment landlords who’ve been in the market for decades don’t need telling that no market is more sustained by faith than UK property. Consumers are conditioned to expect year on year growth and complain of slumps when annual price increases so much as stall. Far too many landlords are dependent on rising value to bail them out of promiscuous borrowings.

Overall return is what really matters to private landlords

The overall return is what matters to any investor, including landlords. Those of you lucky enough to have been advised by genuine professionals, Chartered Surveyors (RICS), Architects (RIBA), Accountants (ACCA) or others with years of study supporting their opinions, will probably be aware of the full financial implications of property investments. Others with no more than agents or journalists to quote fat-sounding figures may not be so well prepared. Beyond the initial purchase, landlords pay down their capital while retaining their rental (usually increasing) income stream, meaning the two factors used to calculate yields continue moving apart.

Why yields appear to rise and fall

By now you’ll see that soaring property prices combined with stable rents will inevitably make yields fall. Just as falling prices make yield soar. That doesn’t mean that investors who can crunch their own numbers can’t find an investment which will make money. The real sums you need to get to grips with are costs out and rent in. Pretty simple, really.

How to do a simple yield calculation

Nevertheless, because they’re used so commonly, it’s best to know how the yield calculations in play are calculated by agents. Let’s take a property with a notional value of £100,000.

• Assume a rent £10,000 per year. Divide the annual rental income by the capital outlay and the ‘yield’ becomes 10 per cent.
• So, the exact same property, which has increased in value to say, £200,000 with the same assumed rent of £10,000 shows a yield of only 5 per cent.

Mmmm.

• Another scenario – the same property, falling in property price from your original £100,000 investment to say £75,000 with the same annual rent of £10,000. Your yield just shot up to 13 per cent.

Oh?

Let’s calculate that yield one final time

Purchased a property for £100,000 three or four years ago? Then watched its price skyrocket to over £250,000? Your yield has been slashed to a lamentable 4 per cent. But haven’t you made a packet overall – even after the taxman’s take?

Simple profit and loss accounts always show a truer
individual picture

Everyone’s circumstances vary. How much they borrowed (or didn’t) from whom and at what rate. The only thing that matters is what a particular property will yield to you. It’s called profit in old-fashioned parlance.

Learn how to factor in the true purchase costs

Using the same figures as before, let’s borrow £100,000. And let’s keep that loan running for 20 years. Then sell that building for, say, £250,000 and cash in. Because your interest payments are probably tax deductible – you’ll be charged Capital Gains Tax on the whole £150,000 profit (minus allowances and tapering, etc). However, you’ll have paid out at least £200,000 for that building once mortgage payments are included – tax relief didn’t exempt you from all interest. Give away thousands in fees and don’t keep generating maximum rent – then ask yourself how much you really made.

For the average landlord with a modest portfolio

Yield is thus reduced from something to rely on, to something worth throwing into the consideration pot. What the expressed yield can never be in the volatile UK housing market is a single good enough reason to buy any particular building unless everything else makes financial sense in your circumstances.

Here’s how to do a couple of more worthwhile calculations. Don’t forget to divide each result by the number of years you’ve held the asset to produce an accurate annual figure.

The whys and wherefores

How long did it take you to read this more complex of lessons, 20 minutes? To work out basic agency yield on a calculator? A minute or two? To try the complex calculations? To find the thirteenth month? Maybe a quarter of an hour. Like most aspects of property investment, the practicalities are quick. Will the income cover the outgoings and will there be a profit? If not – are you willing to fund the difference? And from where?

Further information

For further information check the internet. Avoid agency websites and go for the truly independent sites. I’d recommend a browse through www.yourmoney.com and head for the landlord section. The Royal Institute of Chartered Surveyors website www.rics.co.uk has some excellent features on finance. The Times and the Guardian and the Daily Mail have excellent archives on personal finance available online. Or pay a small charge and join the local Small Landlord Association which will give you a person to speak to direct, a monthly circular with loads of updated information plus stacks of freebies.

CHECKLIST/SUMMARY

• Yields can be tricky to apply to the private rental sector.
• Landlords need to consider the entire return which includes yield.
• A more worthwhile equation for working out genuine costs is included in the lesson.
• Landlords are not armchair investors. Once purchased, these investments need to work to earn their keep and that’s your job as the landlord.
• Property can be a volatile market. Be prepared. Keep a financial float.
• Yields as calculated by your local lettings agent show falls as property prices rise and vice versa.
• Always base your decisions on an income versus outgoings account. Never rely on rough yield sums.
• Make sure you crunch your own numbers with ruthless honesty.
• Experienced landlords use weekly rents for valuation psychology and slightly higher annual product.
• Read the whole of this lesson – not just this checklist.