Even after speaking to other property investors regularly for the better part of a decade, I haven't fully got over my surprise about how many people buy a property without doing any analysis into what that property will do for them financially.
In fact, I often come across investors who bought a property or two because “bricks and mortar are always a good investment”, then later read one of my books and were shocked by how naive they'd been.
(As it happens, because the property market has been so kind for the last 20 years, most of them had done very well – and being strict about the numbers now is just making their life more difficult. But still…)
Even if you're not a numbers person, working out whether any particular property is the right investment isn't at all difficult and doesn't require any elaborate spreadsheets. All you need, in fact, is three simple calculations…
Gross yield is the annual income generated by an asset, divided by its price.
Annual rent: £5,000
Purchase price: £100,000
Gross yield = 5%
Knowing the gross yield gives you a very general idea of whether a particular property is a good investment – and gives a quick and easy way to compare different properties to each other.
But it's not that helpful, because it doesn't take costs into account. That's where you need…
Net yield is the annual profit (income minus costs) generated by an asset, divided by its price.
Annual rent: £5,000
Annual costs: £1,000
Annual profit = £4,000
Purchase price: £1,000
Net yield = 4%
Costs could include:
- Managing agent fees
- An allowance for repairs
- An allowance for voids (the property being empty)
- Service charge and ground rent
That makes the net yield more accurate than gross yield, because it's based on the actual amount of money you'll end up with after costs. But there's still something missing…
Return on investment (ROI)
Return on Investment (ROI) is the annual profit (income minus costs) generated by an asset, divided by the cash you've put in.
(You might see ROI being referred to as Return On Cash (ROC) or Return On Capital Employed (ROCE) – they all mean the same thing.)
If you bought the property without a mortgage – using only your own cash – the net yield and ROI would be identical, because you're putting in the full purchase price.
But if you use a mortgage, ROI will look different:
Annual rent: £5,000
Annual costs: £2,000
Annual profit = £3,000
Purchase price: £100,000
Mortgage used: £75,000
Cash invested: £25,000
ROI = 12%
Note that the costs are higher because you now have mortgage payments to account for, and there for the profit is lower.
But you still end up with a dramatically higher ROI than net yield, because you're only putting in a quarter as much cash as you were before.
In other words, your return is a bit lower and your investment is a lot lower, so your ROI ends up being higher.
Which calculation should you use?
The most useful calculation, in my opinion, is ROI – because it tells you what's actually going to happen, considering the cash you're investing and the costs you expect.
But as gross yield is such a quick and easy calculation, it's handy to use it to directly compare different properties – as long as the costs associated with each property are likely to be similar.
What costs should you account for?
One of the more tedious debates in property is how you should properly calculate the ROI – in other words, what costs should you account for?
For example, everyone will have their own idea of what allowance for maintenance and voids should be included – or won't include one at all. Some investors will use a managing agent and factor in those fees, and others won't.
If you show exactly the same property to five different investors, you'll end up with five completely different ROI numbers. But that's fine: all that matters is that you're consistent.
By being consistent in terms of what you allow for repairs and voids, you can compare different properties to each other – including flats that have a service charge and houses that don't – and know which will give you the best return on your cash at the end.
(Of course, if you're looking at a house in your local area that you'd manage yourself compared to one hundreds of miles away that you'd use a managing agent for, you should include the agent's fee in just the latter case.)
Hang on…what about capital growth?
These calculations are all based around the rental income you'll receive from a property. But there's another benefit you get from owning a property: the capital growth you hope to experience over time as prices go up.
The key word there is “hope”: while capital growth is an enormous benefit of owning a property, you can never know for sure if or when it will happen. Just because property has increased in price by an average of 5% per year historically doesn't mean that it will continue to do so. Even if it does, you have no idea about the timing: a 5% average could mean -1% this year, 3% the following year and 13% the year after that.
So you're only kidding yourself if you project a certain amount of growth each year, and that growth doesn't do you any good until you sell anyway.
Hang on…what about tax?
These calculations are also all pre-tax: if you calculate an ROI of 12%, it will actually be less than that after tax.
Of course, you should make sure you know the effect that tax will have on your investments. But tax is so incredibly complicated (and depends on your personal circumstances outside property), it's impossible to factor it into calculations like these – and doesn't affect the main purpose, which is to compare different properties to each other.
While investors often get into all kinds of complication and debate about the finer points, you can actually work out how good an investment is using just two simple calculations:
- Gross yield to quickly compare similar properties to each other
- ROI to get an accurate measure of how hard your cash will be working
The next logical question after working out either of these numbers is: “well…is that good?”
The answer to that will be different for everyone: there's no cut-off where a good investment becomes a bad one. All that matters is whether a property is a good investment for you: and to know that, you'll need to work on your investment business plan.