Rental properties aren’t exactly piping hot right now. To say they’re becoming more and more out of favour is an understatement. As interest rates rise the return on investment – better known as “ROI” on rental properties gets smaller.
Landlords aren’t all super-rich guys with bottomless pits of money! They’re trying to make a return on their investment and rising costs (with mortgages being the biggest of all) are not making things any easier.
The thing is, interest rates have been coming down for a while. Ever since ‘08, when the global financial crisis smacked us in the face with the force of a truck, rates have been glued to the ground.
This meant that it was practically a no-brainer to buy a rental property – take out a mortgage on it, pay ~2% on it and then sell it on for a hefty sum! The bulk of your expenses as a landlord will come from servicing your mortgage. The lower your mortgage bill, the more profit you can make.
But with inflation (and interest rates) at such depressed levels for over a decade now, rental growth has not been what it used to be. Rents didn’t experience the sort of growth in annual % increases like we’re seeing now. Here’s how inflation is forcing us to change the way we live and what we’re doing about it.
Then again, you can’t have it all! Low mortgage + high rates seem like a free lunch to me which as we all know doesn’t happen in finance (except for diversification!). This dangerous duo is squeezing renters across the country & what that means for you as a first-time buyer.
But holding properties for the very long term (20+ years) has done very well plus properties are an excellent hedge against inflation since rental income usually rises as inflation does. Consider holding some property whether that’s directly (with your own rental property) or indirectly (through real estate investment trusts that are listed on the stock market) as part of your overall portfolio.
Where does your ROI come from and which one should you focus on?
Your ROI from a rental property will come from 2 places: property income (“rental yield”) and/or a rise in property value (“capital appreciation”). Rental properties that have a high level of capital appreciation are unlikely to also have high levels of income.
Think of a company on the stock market. Your dividend players (aka offering a high yield) are not gonna also be your growth companies. And vice versa. Your growth companies are unlikely to be dishing our high dividend since they’re too busy focused on growing their biz to hand out precious profits.
Areas that have historically had high levels of capital growth will have seen lower levels of income growth. Not always but it’s a good rule of thumb.
What is your rental yield and how is it calculated?
A yield is basically the return each year that you can get from your rental property.
To get to this figure, you have to do have a bit of estimation: you’re predicting what you can expect to get each year in rental income but as ever nothing is ever guaranteed but it does give you a pretty good feel for the kind of return you can look to get.
As a rule of thumb, the higher the property value, the lower the rental yield and the lower the property value the higher the rental yield. This is because yield = income ÷ price.
Let’s look at a quick ex. Say your property is valued at £500k and your annual rental income is £15k. Your yield would come to 3%. (£15,000 ÷ £500,000 x 100).
If on the other hand your home had a current value of £300k and your annual rental income £12k well then your yield would be higher (due to lower property value) at 4%.
Higher yields are earned on the more affordable properties, even though rental income is usually less. That’s because the initial outlay is lower and, as a result, yields are less squeezed.
It goes without saying that the higher the yield your property can achieve, the better your return on investment will be (or “ROI”). Using this simple calculation is a great way of seeing what your annual return will be and that’ll help you decide whether the rental property is really worth your time, effort and energy!
Net versus gross yield – why it matters
We’ve looked at gross yield, i.e your base level of return before any costs are taken into account. But if you wanna see what your return will be after all that ugly stuff then you need to work out your net yield which is what you’ll actually get in your pocket.
To get to that figure you need to deduct all your expenses in letting the property from the annual rental figure. Expenses include insurance, maintenance, repairs as well as any letting agent fees/management costs if your property is being managed by a third party (less hassle but also lower returns! Just something to think about).
Capital gains – where does the growth actually come from?
The other place your returns will come from is through capital growth. This is when your property value goes up over the time you hold it for so you get to sell it for a way higher price than what you paid. And what makes properties such a special asset class is that you can take advantage of gearing – using debt to boost returns.
Say you put down a 5% deposit, you get to enjoy returns as though you owned the entire thing. You don’t get 5% of the rental income. You get the whole shebang. If you put down 5% deposit on a £200k house this means you invested £10k. If rental income per year is £12k your return will be £12 ÷ £10k (your initial investment) = £1.2k. You put down a £10k deposit and get 12% return. Pretty cool.
A family friend of mine owns a property in the south, near the sea. They’ve been lucky to have had strong rental growth over the past 10yrs or so but capital growth has been muted. But they were looking for that. They wanted some extra income to give them some wiggle room so that suited them well. It’s not often you get to have the best of both worlds.
Are you in it for the long run or not?
Before you even think of investing in a rental property, you gotta ask yourself whether you plan to hold it for the short term or the long term as this will help you decide if you should be prioritising rental income or capital growth.
If you’re thinking short-term, your focus will be rental income. You’ll want to buy in areas that are likely to give you strong rental income.
But if you’ve got a much longer horizon and are able to take that long term view, then capital growth will your big focus.
And you’ll turn to areas that have historically had steady levels of capital appreciation or up-and-coming areas that are likely to go up in price.
Of course you can end up having both – capital growth and strong rental yield but that’s obviously the best but not always guaranteed. And you will want to prioritise one over the other.
Other stuff to consider when buying your rental property
As a landlord, you should also be looking into some other indicators that will tell you how well your property will hold up.
Location is super important. Areas that are located near green space with great schools nearby as well as transport links with easy access to town and city centres will make your rental property way more appealing to prospective tenants. Tenant demand is key. Areas with great surrounding amenities are likely to hold up well.
It is usually the case that rental yields are at their optimum level in popular commuter towns, especially on the outskirts of big cities like London. That’s because homes in these locations are normally more affordable – making buy-in costs cheaper – while tenant demand remains very high.
As a result, there is an excellent chance to charge higher rents and find reliable, long-term tenants to keep your home in good hands.
If capital gains are your primary focus, you should focus on up-and-coming locations likely to enjoy rapidly increasing prices in the coming years. The added advantage of this is lower buy-in costs before the area becomes really popular.
There is always an element of risk here in backing the right horse – some up-and-coming regions end up being more popular than others – but if you get it right, the rewards can be high.
The bottom line
All in all, real estate is a really interesting asset class and it can give you some juicy returns but you have to know how long you plan to hold it for and be prepared for things to turn sour.
To protect yourself, always keep a stash of 6-12 months worth of your expenses so that if something nasty happens (cough cough, even higher interest rates) you’re able to cope and it doesn’t throw your entire investment under water.
Patience is underrated and with enough of it you can achieve a lot with this asset class. Just remember don’t over-leverage yourself. Debt works both ways. It multiplies the good – and the bad.
Disclaimer: This blog is not investment or financial advice. It is my opinion only. This blog is not a personal recommendation to buy/sell any security, or to adopt any such investment strategy. Always do your own research before you commit to any investment