Yield
As well as being a buy-to-let multi-millionaire, Ajay Ahuja is a chartered accountant. He is founder and owner of Accountants Direct which provides references for the self-employed for mortgaging purposes. He advises various local councils and accommodation projects and works to provide innovative solutions to problems facing the homeless. He also consults with corporations and private clients to help build property portfolios for maximum gain.
Calculating yield
So how does a professional investor know that a property purchase is going to put money in their pocket? It’s called yield. Yield is defined as:
Let’s look at this in more detail. Yield really has only two key variables:
- 1.What you get out.
- 2.What you put in.
So to calculate yield you simply divide what you get out by what you put in and express it as a percentage. In mathematical terms:
1. What you get out of the property
Can you guess what you get from a property? Well I’ll help you – RENT! This is the only thing you can be assured of getting from a property with any real certainty. We’re not facing an undersupply of housing in the UK so it is safe to assume that you can expect a steady stream of cash, in the form of rent, as a direct result of owning a property.
Capital growth you can never be sure of. So NEVER factor it in to your calculations as its impossible to calculate! Professional property investors do invest for capital growth, that’s for sure, but there is no point factoring it in to your calculations as it can only ever be a predicted figure. Incorporating predictions introduces errors in to the calculations and I hate errors!
So the output for a professional investor is:
What you get out |
Term |
Definition |
Annual rent – annual interest cost – expenses – tax |
Annual rent |
This is the amount of money you can expect to receive from renting out your property. Any other money received from the tenant such as electricity or gas bills is excluded as these receipts should just be covering the cost of the bills anyway. |
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You assume a full 12 month rent without void. Voids are factored in as an expense below. |
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Annual interest cost |
This is the amount of money you will expect to pay in interest costs as a result of making the property purchase. You do not include any of the repayment part of the cost as this is not a cost. |
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To calculate the annual cost you simply multiply the amount you need to borrow to buy the property by the interest rate being offered by the lender. |
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Expenses |
Typical expenses will be: Service charges and ground rent – This is applicable to leasehold flats in England and Wales. Under the terms of any long lease in England and Wales you have to pay ground rent (usually never more than £500 per year) and then a maintenance charge called a service charge to cover such things as gardening, repairs, insurance and management of the block. |
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Look into these service charges as they vary widely. I have two similar flats in differing parts of the country where one charges £5 a month and the other charges £90 a month service charges. Not knowing the potential service charges can result in you making an unexpected loss after all other costs are deducted. |
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Insurances – You may want all or some of the following insurances: Building, Contents, Rent Guarantee, Boiler, Plumbing and Electric Insurances. Whatever you decide to go for get quotes so you know what these insurances cost and you can factor them in. Some areas can be expensive to insure without you realising it. This could be due to historic flooding, common subsidence or regular burglaries. |
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Letting agent fees – If you’re going to use the services of a letting agent get a breakdown of their fees. Ring them up and ask them to send you their fees list. Be very careful – do not go with the agent with the lowest headline rate. They have hidden costs such as marketing fees, tenancy renewal fees, inventory fees and whatever fees they can come up with! Try to get an idea of total costs for a year’s letting. |
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Repairs – This has to be an estimate. I would tend to over estimate to ensure you don’t get caught out. Repairs do even out over time so try to factor in replacement of boilers, carpets, kitchens etc. and then annualise these total costs. £1,000 a year is a good figure to start off with ... unless you are thinking of letting out a 10 bedroomed mansion! |
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Void periods and bad debts – Sometimes tenants do not pay the rent! You have to factor in tenants losing their job, deciding not to pay or absconding. If you’ve got insurance then this does not have to be factored in as it’s covered by the insurance. |
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One thing insurances cannot cover you for is voids. So it is prudent to allow 1 to 2 months for remarketing and finding the right tenant for the property. |
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Admin costs – This is usually a small amount but you have to factor in property licences, postage, paper, phone, computer and whatever costs you incur administering your portfolio. |
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Other costs – This will be specific to the property. If you’re thinking of buying a riverside apartment in the city and renting it out to city professionals then your advertising costs may be that little bit higher than a studio flat up north! |
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Now taking all of the above in to consideration you should come up with a figure. Hopefully this should be a positive figure as this will mean it’s potentially profitable. If it isn’t then stay away! Don’t try to tweak it to make it positive. You’ll find your initial figures will be closer to the true figure rather than your recalculated figures trying to make it work. |
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Tax |
Unless you live in a tax haven such as Jersey or Monaco you will have to pay tax. You need to be aware of the following when determining how much taxable profit you have made for the Inland Revenue to tax: |
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Allowable expenditure – Some expenses are disallowable when it comes to tax. This means you cannot charge these expenses against your profit. The Inland Revenue have this rule about expenses: expenses have to be incurred necessarily, wholly and exclusively to the business for them to be fully deductible against your taxable profits. |
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If expenses are not allowable then they may be partially allowable, such as mobile phone charges and the use of a private car. |
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Allowable reliefs – You will be entitled to ‘non-cash’ expenses called reliefs where they allow a percentage of costs or income to be charged against your taxable profit. Reliefs include Wear and Tear Allowances and Capital Allowances. |
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Basic or Higher rate tax payer – if you are a higher rate tax payer then you are taxed at 40% compared to 20% for a basic rate tax payer. This will mean a reduced net profit after tax figure. There is an argument that if you were a higher rate tax payer it could be more beneficial for you to invest in other tax friendly investments such as VCTs (Venture Capital Trusts). I do not agree with this as I think property investments are an essential part of anyone’s investment portfolio, but you have to consider all points. |
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ISAs and pension investments can look attractive as they have so many tax benefits but the ISA allowances are very small and the pension benefits seem too far away where the benefits may never be realised. However, look at the yields of these investments and compare them to property. This should steer you towards property! |
What you get out should only ever be assessed by what you put in. So let’s look at what you put in.
2. What you put in
There can only ever be two sources available to buy properties – your money and borrowed money. Decide which one of the three types of investors you are, then decide which yield calculation is applicable to you.
Look at the following table.
Investor |
What you put in |
Your money |
Borrowed money |
Description |
High risk investor |
Nil |
None |
Purchase price + Acquisition costs = Total cost of investment |
This investor is either a future multi-millionaire or the one that goes bust big style! |
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The return on their cash is infinity as the investor had nothing in the first place. If they pull it off they would have made money out of nothing. |
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This is what I did 10 years ago. I put virtually nothing into my property business and I’ve got a whole lot out. |
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Yield is very important here as you need rent to cover the costs of borrowing over the whole investment. |
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If you do follow this strategy be very careful and do your maths before you do the buying! |
Medium risk investor |
Some |
Deposit + Acquisition costs |
Purchase price – Deposit = Mortgage |
This is the normal way people invest in property. You put a bit in and the bank puts the rest in. |
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You can get a better return the less you put in IF the market goes your way. Yield is still important as it needs to cover your borrowing costs. The more you put down the less you have to rely on yield. |
Low risk investor |
All |
Purchase price + Acquisition costs |
None |
This type of investor would be typically looking for a return greater than their bank is offering. |
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They would have used all their money in the bank, forgone the interest they would have earned from the bank and hoped for a return greater than the bank’s in the form of capital growth and rents received. |
So to calculate yield, as mentioned above, you simply divide what you get out by what you put in and express it as a percentage:
So the magic calculations that need to be computed, based on what you put in and get out detailed above, are:
Investor |
Calculation |
Description |
High risk investor |
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Even though you borrowed everything you still need to see if you’re getting a return relative to some basis figure. I consider the unsecured loan taken out to pay for the deposit and acquisition costs as a good basis. |
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The money that’s come in will take into account the interest costs of the unsecured loan. |
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Therefore you can get a yield calculation based on what you got out based on what you theoretically put in. |
Medium risk investor |
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Unlike the high risk investor there is no unsecured loan to service so there is no interest cost on the unsecured loan taken off what you get out from the property. You then need to compare this calculated yield to alternative investments. |
Low risk investor |
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Unlike both investors above there is no borrowing cost as there are no borrowings. |
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You then need to compare this calculated yield to alternative investments. |
An example
Let’s look at an example to calculate the yields.
Tom |
High risk investor |
Tom will borrow £27,000 on an unsecured basis to raise the deposit of £25,000 and £2,000 acquisition costs. He will then obtain the other £75,000 by way of a mortgage to purchase the property. |
Dick |
Medium risk investor |
Dick will fund the deposit and acquisition costs from his savings. He will then obtain the other £75,000 by way of a mortgage to purchase the property. |
Harry |
Low risk investor |
Harry will fund the property price and acquisition costs with his savings. |
Tom, Dick and Harry are all higher rate tax payers but they have very different risk profiles. They see a property advertised for £100,000 but all have very different strategies to buy the property.
They estimate that it can rent out for £1,000 per calendar month. They also estimate the following annual expenses to derive a profit and loss account.
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Tom |
Dick |
Harry |
Rent |
£12,000 |
£12,000 |
£12,000 |
Unsecured borrowing costs (interest only) |
£1,750 |
N/A |
N/A |
Mortgage costs (interest only) |
£4,500 |
£4,500 |
N/A |
Void periods |
£1,500 |
£1,500 |
£1,500 |
Service charges and ground rent |
£1,000 |
£1,000 |
£1,000 |
Repairs |
£500 |
£500 |
£500 |
Agents’ fees |
£1,050 |
£1,050 |
£1,050 |
Sundry |
£450 |
£450 |
£450 |
Profit |
£1,250 |
£3,000 |
£7,500 |
Tax @ 40% |
£500 |
£1,200 |
£3,000 |
Net profit |
£750 |
£1,800 |
£4,500 |
So the yields for each investor are as follows.
Investor |
Calculation |
Result |
Tom – High risk investor |
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2.8% |
Dick – Medium risk investor |
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6.7% |
Harry – Low risk investor |
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4.4% |
Now all these yields are positive so the property purchase is expected to put money in the investor’s pocket. What each of Tom, Dick and Harry’s thresholds for investment are will determine whether they will buy. So for example if Tom’s threshold is 4% to buy then he will not do so as the investment is below his 4% threshold. If Harry’s threshold is 4% then Harry will buy as his yield is above his threshold. All of their thresholds will be based on their own personal criteria and alternative investments. But you can be assured that if the yields were negative then the professional investor would not be interested. This is because the investment will take money out of his pocket.
Understanding +/- yield
It’s obvious to see that when the clock strikes 12 noon you are winning on both counts. That is to say that:
- the yield is positive and at its highest point;
- the capital growth is positive and at its highest point.
Looking at 12 noon graphically:
So we can see that at 12 noon the price of the property is at its lowest real price. As a result of this the yield is at its highest. Now due to the fact that rental prices are directly proportional to wages, which rise religiously with inflation, we can show that it’s the property price alone that drives the yield. In other words the yield is only high due to the property purchase price being artificially low due to market conditions.
You have to draw on your own experiences to really believe what I’m saying. Just because house prices have risen by 20% in a year – do you ever see rental prices rising accordingly? Probably not. Rental prices are directionally proportional to wages. This makes sense. If you had volatile rental prices you would find that people would be on the streets! If interest rates rose dramatically, landlords would raise their rents to meet their mortgage payments and then ‘forget’ to reduce them as their mortgage payments fell. So as we have eliminated inflationary influences from this model we would have the rent vs time graph looking like this.
So we can see that rents do not change over time. Another great thing about rents are that they are:
- known and
- predictable.
They are known as it is very easy to gather the market rental value for a one, two or three bed property as there should be plenty of these types of properties to rent on the market. As long as the property you are thinking of buying is not unique in any way then the market rental value will be easily comparable with similar properties on the market. The rental market will not entertain a property that is overpriced on rent as the tenant will simply go elsewhere. So the market rent of a property will fall within a small range.
Rents are predictable as rental values only ever increase with wage inflation. So we can assume that the rents will rise but only modestly. Since we are ignoring inflation we can predict that rents will remain the same in real terms.
So using the graphs above we can see that over the four key points on the clock the yield is the inverse to the property purchase price, in other words, as property prices increase yields decrease:
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12 noon |
3pm |
6pm |
9pm |
Property price |
£50,000 |
£116,667 |
£233,333 |
£116,667 |
Annual rent |
£10,000 |
£10,000 |
£10,000 |
£10,000 |
Annual mortgage cost @ 6% interest of property price |
£3,000 |
£7,000 |
£14,000 |
£7,000 |
Other costs |
£3,000 |
£3,000 |
£3,000 |
£3,000 |
Net yield |
£7,000 |
£nil |
(£7,000) |
£nil |
So we can see that it’s property prices that drive yield. In other words:
The property price is everything!
So knowing that the property price is everything we theoretically can ignore the yield curve as it is simply a result of the property price curve. An analysis of the property prices is essential if we want to gain heavily – so read on!
