The first question of any professional property investor when considering a purchase is – what is the yield?  This should only ever be the starting point.  If the yield is good then go for it.  If its not then forget it!  But first we need to know what yield is and then what is a good yield.  Yield in its purest form is:

‘what you get out relative to what you put in’

Lets 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:

What you get out  x 100.

What you put in

1.What You Get Out

So what do you get out from property? – RENT!  But its not just as simple as that.  Do you consider the rent received, rent received less mortgage costs or the amount of cash you receive after all expenses including tax?  Do you include capital growth?  Do you consider it on a weekly, monthly or annual basis?  Well I have come up with the key outputs you should only ever be interested in if you are considering purchasing a property.  The key outputs from property investment are:

BuyerOutputDefinition
CASH BUYER – a buyer that is using only their own savings to purchase the property and not borrowing any funds at all.Annual RentThis is the amount you expect to receive from your tenant for use of your property only.    You do not include any payments from your tenant that are considered expenses such as water rates or council tax if you do include this in your rent.  You calculate it on an annual basis as returns are always calculated annually – its industry standard.  You assume a full year with no void periods.  Void periods are dealt with below.
Annual Rent - ExpensesThis is what you expect to receive back in your hand before tax.  So this is the annual rent less the annual expenses.  Typical expenses will be:

  • Service charges & ground rent – if you rent out a flat you are responsible for all the service charges and ground rent due.  These are the costs to maintain the block and to keep the freeholder happy!  These expenses can never be the responsibility of your tenant as non-payment of these charges can result in the loss of your flat as it is leasehold.  These costs need to be considered before you buy a flat as some service charges can be extortionate.
  • Insurances – You need buildings insurance to cover the property against damage or vandalism.  Some areas are expensive to insure so if you can get an idea of insurance premiums for the area before buying so you can see how much it will affect the overall output.  You may want rent guarantees and maintenance insurances so these premiums will need to be accounted for.
  • Letting agent fees – You may need to use a letting agent as you have a full-time job or simply do not want to deal with the hassle of renting out the property.  Some letting agents charge 7% of the rent others charge 17%!  So the cost can vary widely.  Get an idea first as the charge is applied to the rent so it hits the top line.
  • Repairs – This is a cost that has to be estimated but you are in the hands of the gods!  This expense alone can make the difference between making a profit or a loss.  Over the long term repairs even out through the life of the property but if you get hit for large repair bills early on it can leave you out of pocket for a while.
  • Void Periods & Bad Debts – If you are investing in a high demand area then voids will be minimal but its always good practice to assume 1 month to be prudent.  I invest in medium demand areas and I assume 2 months for some areas.  Remember also that sometimes tenants do not pay!  So the non-payment of rent is as good as a void. I charge 1 month as standard.  So in total I charge 3 months worth of rent to this expense which is equivalent to 25% of the annual rent.
  • Admin costs – There will be letters, tenancy agreements, postage and other office costs involved with running a property which need to be estimated.  The more properties you have the less the overall cost as the cost is split between the properties.
  • Other costs – This will be specific to the property.  If you are considering buying a flat in Chelsea then your marketing costs may require an advert in The Times and a glossy brochure being produced – this will be a lot!  However if you’re buying a small bedsit up North then only minimal costs for advertising will be needed but extra security costs for the property during void periods will have to be budgeted for.

Its good to calculate this output as it will determine whether it is a good investment.  If the output is not what was expected then you can walk away from the deal.  If it meets your expectation or even surpasses it then its worth considering.  This output is commonly called the expected net profit of an investment.  We would hope that this figure is positive!

Annual Rent - Expenses - TaxThis is another important output.  This is what you expect to get back in your hand after everything – including tax.  Things to consider when taking into account the amount of tax you’ll have to pay are:

  • Allowable expenditure – you have to check that the expenses above are tax deductible.  Expenses have to be incurred necessarily, wholly and exclusively to the business for them to be deductible.  If they’re not then they will have to added back when calculating your tax liability which will result in a higher tax charge.
  • Allowable reliefs – there will be certain reliefs available to you such as Wear&Tear allowance and capital allowances which the Inland Revenue allow you to apply to the profit.  Even though these are not out of pocket expenses i.e. no money has passed hands, you still can claim these reliefs to lower your overall profit thus reducing your tax charge.
  • 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 means you receive less of the profit.  It may be more beneficial to invest in other more tax efficient investments geared towards higher rate tax payers.

Tax free investments benefit the higher rate tax payers the most.  Tax free investments such as ISAs and Private Pensions are out there as alternatives to property investments.  You have to look at the yields from these investments and compare them to property.  I can tell you now that property yields way in excess of any other of these investments but ultimately its up to you where you invest!

(Annual Rent – Expenses) + Annual Capital GrowthThis is the expected net profit before tax plus capital growth for the year.  Not only do you receive a rental profit but hopefully there should be an appreciation of your property.  There are many investors that invest in property solely for the growth.  They are not concerned with making a rental profit (sometimes happy to make a rental loss!) but making an above average gain on their initial investment.  Annual Capital Growth (ACG) can be determined by:Current Market Value after 1 year of purchase(CMV1) - Purchase Price (PP) = Annual Capital Growth (AGC1)

Basically its how much your property has gone up by in a year of ownership.  For future years ACG is:

CMVn – CMVn-1 = ACGn

In simple terms it’s the difference between the value of the property now and one year ago.

MORTGAGED BUYER – a buyer that uses their own savings and borrows funds to purchase the property.Annual Rent – Annual Interest CostThis is the same as Annual Rent above but the costs of borrowing are deducted.  This will be the interest cost applied to the loan.  This gives a quick approximation of what you’ll get back after you’ve met the immediate payment of the mortgage as the mortgage payment has to be met without fail.
Annual Rent – Annual Interest Cost – Other ExpensesThis will be the same as above but also deducting the expenses detailed above.  This gives an expected profit figure before tax.
Annual Rent – Annual Interest Cost – Other Expenses - TaxThis will be the same as above but deducting tax also under the same rules and reasons above.
Annual Rent – Annual Interest Cost – Other Expenses + Annual Capital GrowthThis will be the same as above and including growth calculated as above.

What you get out should only ever be assessed by what you put in.  So lets look at what you put in.

2.What You Put In

Well you can be assured that you’ll have to put in some of your hard earned cash!  But how much depends on what you’ve got and how much you’re willing to borrow.  There can only ever be two sources for investment – your cash and borrowed cash.  Lets look at the following table:

What you put inYour CashBorrowed CashDescription
NilNoneNoneHere you put in nothing!  This scenario would occur if you were an employee as an employee never puts any cash in to a venture – they only take out.  The yield of an investment is of less interest as the employee is not assessing the risk of an investment.  An employee will only be interested in what pay packet they are going to receive and the possibility of it going up in the future.  This situation can be ignored as I am assuming you are an investor.  If you were to calculate the yield the yield would be infinity as you have put nothing in and got something out!The only other way this could occur would be if you took on a financial partner.  Here the financial partner would put in their cash and borrow the cash but would rely on your expertise to make the investment work.  If this is the case then yield is important and hence all the calculations below are valid.
NilNonePurchase price + Acquisition costs = Total cost of investmentHere you still put in nothing!  The difference is that you borrow the whole of the cost of the investment.  That is the deposit, the mortgage amount, solicitor costs, arrangement fees and valuation fees.  On the surface the yield would again be infinity.  However because you have borrowed all the money your ability to service the debt will be dependent on the yield so yield becomes very important.  In fact out of all these four classes the yield of the investment is the most important as it has to be compared to the average interest rate you’re borrowing at.  If the yield is lower than the average rate then the investment will lose money.  See further below.
SomeDeposit + Acquisition costsPurchase price – deposit = MortgageThis is the normal way people invest in property.  You put in some but the bank put in the lion share.  Typical ratios of your money to the bank’s money are anywhere between 15:85 to 40:60.  So ultimately you want to know what return you expect to get on your own money invested.  This is called Return On Capital Employed (ROCE).  Capital being another name for your own personal contribution to the investment.
AllPurchase Price + Acquisition costsNoneIf only!  This investor is rich enough to fund the whole purchase price and acquisition costs from their own savings.  There are no borrowings.  This investor needs to calculate the yield so he or she can make a direct comparison with other investments.

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:

What you get out  x 100.

What you put in

So the magic calculations that need to be computed, based on what you put in and get out detailed above, are:

BuyerNameCalculationWhy it’s a key performance indicator
CASH BUYER – a buyer that is using only their own savings to purchase the property and not borrowing any funds at all.Gross Yield (GY)Annual Rent x 100.Property Purchase Price + Acquisition Costs

 

This is a quick calculation to compute.  It can give you a quick idea if the investment is worth pursuing.  If you calculate the gross yield to be 2% then you quickly know that it wont be too long before that 2% yield diminishes to below a 0% yield and hence make a loss.  Armed with this calculation you can quickly walk away from an investment or on the flipside get very excited!
Net Yield (NY)(Annual Rent – Expenses) x 100.Property Purchase Price + Acquisition Costs

 

This calculation gives us a figure to compare directly with a bond yield or bank deposit account.
Net Yield After Tax (NYAT)(Annual Rent - Expenses - Tax) x 100.Property Purchase Price + Acquisition Costs

 

This is the real cashflow inward to you after everything including tax based on what you put in.
Net Yield Including Capital Growth (NYICG)(Annual Rent – Expenses) + Annual Capital Growth x 100.Property Purchase Price + Acquisition Costs

 

This is the return on the investment including any appreciation the property may have experienced in the year.  This return can be directly compared to a stock or equity investment on the stock market.
MORTGAGED BUYER – a buyer that uses their own savings and borrows funds to purchase the property.Gross ROCE (GR)(Annual Rent – Annual Interest Cost) x 100.Deposit + Acquisition Costs

 

This is a relatively quick calculation to compute.  You can get an idea of the return you’ll get on the money you have personally invested.
Net ROCE (NR)(Annual Rent – Annual Interest Cost – Other Expenses) x 100.Deposit + Acquisition Costs

 

This calculation will give you the net profit figure for the investment based on what you put in.  A true measure of the profitability of the investment.
Net ROCE After Tax (NRAT)(Annual Rent – Annual Interest Cost – Other Expenses - Tax) x 100.Deposit + Acquisition CostsThis is the real cashflow inward to you after everything including tax based on what you put in.
Net ROCE Including Capital Growth (NRICG)(Annual Rent – Annual Interest Cost – Other Expenses) + Annual Capital Growth x 100.Deposit + Acquisition Costs

 

This is the true return on your money after taking in to account any appreciation on the property.  This return can be directly compared to a stock or equity investment on the stock market.

An Example

So lets look at an example to calculate the yields:

David buys a property for £100,000 and funds the purchase with £25,000 of his own money and £75,000 of the bank’s money.  He also pays out £2,000 for acquisition costs from his own savings.

He estimates that he can rent it out for £1,000 per calendar month.  He also estimates the following annual expenses:

Mortgage Costs                               £4,500

Void Periods                         £1,500

Service Charges&Ground Rent    £1,000

Repairs                                              £500

Agents Fees                         £1,050

Sundry                                               £450

Total                                       £9,000

He’s a higher tax rate payer so his profit gets taxed at 40% so he estimates a tax charge of:

With Borrowings                  Without Borrowings

Rental Income                                  £12,000                                             £12,000

Expenses                              (£9,000)                                             (£4,500)

Profit                                       £3,000                                                           £7,500

Tax@40%                             £1,200                                                           £3,000

He estimates 10% growth of £10,000 of the property price after one year of ownership.

So we have all the figures to calculate the yields:

NameCalculationFiguresResult
Gross Yield (GY)Annual Rent x 100.Property Purchase Price + Acquisition Costs(12 x £1000 x100)/(£100,000+£2,000)11.8%
Net Yield (NY)(Annual Rent – Expenses) x 100.Property Purchase Price + Acquisition Costs(12x£1000 - £4,500)x100/ (£100,000+£2,000)7.4%
Net Yield After Tax (NYAT)(Annual Rent - Expenses - Tax) x 100.Property Purchase Price + Acquisition Costs(12x£1000 - £4,500-£3,000)x100/ (£100,000+£2,000)4.4%
Net Yield Including Capital Growth (NYICG)(Annual Rent – Expenses) + Annual Capital Growth x 100.Property Purchase Price + Acquisition Costs(12x£1000 - £4,500+£10,000)x100/ (£100,000+£2,000)17.1%
Gross ROCE (GR)(Annual Rent – Annual Interest Cost) x 100.Deposit + Acquisition Costs(12 x £1000 - £4,500) x100/ (£25,000+£2,000)27.8%
Net ROCE (NR)(Annual Rent – Annual Interest Cost – Other Expenses) x 100.Deposit + Acquisition Costs(12 x £1000 - £4,500 - £4,500) x100/ (£25,000+£2,000)11.1%
Net ROCE After Tax (NRAT)(Annual Rent – Annual Interest Cost – Other Expenses - Tax) x 100.Deposit + Acquisition Costs(12 x £1000 - £4,500 - £4,500 - £1,200) x100/ (£25,000+£2,000)6.7%
Net ROCE Including Capital Growth (NRICG)(Annual Rent – Annual Interest Cost – Other Expenses) + Annual Capital Growth x 100.Deposit + Acquisition Costs(12 x £1000 - £4,500 - £4,500 + £10,000) x100/ (£25,000+£2,000)48.1%

So what do we do with these yield calculations?  Well we should compare them with alternative investments.  Alternative investments being other non property investments and other property investments.  Once compared you can make a judgement.  So a comparison table may look like this:

NameResultsNon-property investmentsAnother property investment being considered
Gross Yield (GY)11.8%2.2% - dividend from a stock or equity holding10.4%
Net Yield (NY)7.4%4.2% - from a bank6.5%
Net Yield After Tax (NYAT)4.4%3.3% - from a bank after tax4.6%
Net Yield Including Capital Growth (NYICG)17.1%6.8% - from FTSE Fund19.3%
Gross ROCE (GR)27.8%2.2% - dividend from a stock or equity holding22.6%
Net ROCE (NR)11.1%4.2% - from a bank12%
Net ROCE After Tax (NRAT)6.7%3.3% - from a bank after tax6.3%
Net ROCE Including Capital Growth (NRICG)48.1%6.8% - from FTSE Fund44%

You have to compare the yields from property with every other investment to be sure that your money is not better invested elsewhere and this includes other properties, stocks, bonds, managed funds, banks or other businesses that you can invest in.  Be sure to ask the proposer of any investment whether their return is stated before expenses, interest charges, their management charges, tax, capital growth etc, so you can really compare the investment directly with your proposed property purchase.

Assuming property is your chosen investment then you should set yourself some thresholds.  You should set desired yield figures to be met and then go out and get them.  Once you are sure of what you want then acquiring them will be mere formality – as long as your demands are within reason!

My Policy

I adopt the following policy:  If Gross Yield is in excess of 12% and the Gross ROCE is in excess of 20% then BUY!   This will mean you will have sufficient rental income to cover the mortgage costs and you are being cash efficient with your capital.   The threshold of 12% & 20% is purposely set high to counteract the risk of borrowing (see chapter 6 – Risk).

If only one of the thresholds are met then tread carefully.  If yield is in excess of 12% but ROCE is below 20% then you are not borrowing enough to maximise your overall return.  This in itself is not a problem if you have chosen not to borrow so much.  It is a problem if your borrowing is restricted by the lender due to the lender requiring a high deposit.

If the yield is below 12% but ROCE is in excess of 20% again tread carefully.  As long as the yield is not too far off 12% (I would say 10% being the lowest) and the likelihood of voids is minimal (due to the property being near a train station, shops or in a desirable area) then buy – otherwise stay away.

If neither threshold is met then walk away - no matter how pretty the property is!

One tip in using all these calculations above is - be prudent.  Do not over estimate the likely rent achievable, capital gains and estimated profit and do include all the costs associated with buying the property within your acquisition costs.

To find out all the yields, ROCEs and capital growth indices for over 330 areas in the UK then visit www.propertyhotspots.net.

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