Is a Buy-to-Let Residential Property a Good Investment?
Disclaimer: this article is not financial advice and should not be treated as such. It is a discussion based on personal circumstances and preferences and so should not be generalized to other situations without careful thought.
Like many people I have often dreamed of having a passive income stream and living my life on a beach somewhere. One of the more common recommendations to achieve this is to invest your money into a property which you can then rent out to other people. This is a tried and tested method but is it better than other forms of investment? Two answer this question, I need to answer two smaller questions:
- How to compare two investments.
- How to evaluate a house with respect to this metric.
The first question is easier to answer but more subjective. A variety of factors may affect what you consider a good investment. For my aim of having a passive income, at least one of them is that minimal effort is required in maintaining the investment. Given this constraint we are left with a smaller subset of available investments. There are also a host of other constraints most people will apply such as tax considerations and tolerance of risk but this is an article about numbers, not about financial planning, so I will leave it to the reader to consider those issues for themselves. Of the remaining investment opportunities, I will use return-on-investment (RoI) as the metric of quality to compare investments. The RoI is determined by the annual return divided by the cost of the investment. Now that question i) is answered, evaluating a house as an investment with respect to my chosen metric should be more objective. The bulk of this article discusses how to determine a buy-to-let property’s RoI.
1) First Approximation
The first approximation of the RoI of buy-to-let property is to sum the annual rental income of the property with the change in house value and then divide by the cost of the house. For this article, change in house value is ignored as the business model is not one of housing development and owners have little control over broader trends in the housing market.
For the purposes of this article, I will assume I am looking at student housing in the Kensington area of Liverpool. This choice is based upon previous research looking at housing prices and rental income in large cities on Zoopla, but it is not discussed as it will most likely form another blog. In this area a 4-bedroom house can be purchased for £150,000 and each room can be rented for £355 per calendar month (pcm). This works out to be an annual income of about £17,000. Thus, the naïve asset-level RoI on this property is 11.3%. This is a good return compared to the average annual return on stocks of about 7% over the last few decades (7.19% for the S&P 500 over the last 20 years and 6.4% of the FTSE 100 over the last 25 years). Stocks returns are just used as a benchmark and have other benefits such as tax treatment and involving little work after picking them which I will not discuss here.
This obviously is not the whole story. Anyone who has owned a property will quickly point out that there are a lot of costs associated with running a property, which mean that the nominal annual rental income can quickly be reduced. Equally, anyone who has invested in properties before will point out that you can reduce upfront capital by borrowing money. In our example, this means getting a mortgage. Thus, the actual equity return on investment is based upon the original cashdeposit plus any transaction costs incurred, such as stamp duty and lawyer fees. Evaluating these two factors will be essential to figuring out the RoI of our target buy-to-let property.
2) Cost of a Property
Buying a property involves interacting with a lot of different people and each person is liable to charge for the privilege. Table 1 provides a list of the key costs and an estimate of their cumulative value assuming a property is bought for £150,000 in the UK. The largest single cost when buying a property is the deposit. For a buy-to-let property in a reasonable condition the minimum deposit is around 25% of total property value. The second largest cost is the stamp duty which is the tax charged by the government on the transaction. This is a tiered tax that depends on the property value, but the main component is the 3% surcharge added when the buyer already owns a property. In total, we estimate that it costs us £47,450 in upfront cash to purchase our target property. The cost estimates described here are based on experience in buying past property.
Table 1: Illustrative costs associated with purchasing a buy-to-let property.
|Cost Item||Amount [£]|
3) Income from a Property
From our first approximation we already know the gross monthly income of our property, £1,420 pcm (assuming full occupancy). The important part is working out all the ongoing costs associated with renting a property, which can be split into three key areas.
- Maintenance costs – these are the costs associated with keeping the property up to date, insurance and repairing any damage done by tenants.
- Mortgage costs – these are the costs associated with servicing our debt on the property such as the monthly repayments on interest as well as the costs of renegotiating a new mortgage every few years.
- Percentage based costs – these are the costs of doing business such as hiring a property manager and accounting for any periods where the property is not let out which are best expressed as a percentage of the rent.
For easier comparison with the monthly gross income these costs are also calculated as monthly figures.
3.1) Maintenance Costs
Inside a house there are many things that need to be updated at regular intervals to keep the property in a fit state for tenants. It has been assumed that emergency repairs can be covered via insurance and damage done by tenants in a non-emergency manner will be covered by security deposits. This leaves update/replacement costs to be modelled. Table 2 breaks down the individual costs to provide as comprehensive a model as possible. For each cost I have provided a total cost estimate, a time between renewal cost and the resulting monthly cost. It is worth pointing out that these are best guesses on the actual costs and so have round values. With this caveat in mind, I estimate the monthly cost associated with maintenance and repairs to be £240.
Table 2: List of maintenance costs and update frequencies.
|Item||Cost [£]||Years Between Update||Cost Per Month [£]|
|Estate Agent Fees||350||1||29.17|
3.2 Mortgage Costs
The interest charged on an interest-only 75% loan-to-value (25% deposit) mortgage with a three-year fixed rate is about 3% (as of February 2020). This works out to be about £280pcm in interest payments. In addition to these interest payments banks typically also charge an upfront fee of £2,000 every time a mortgage is renewed and a mortgage broker will charge around £350 to find a new mortgage. Including these extra costs with the interest fees results in a monthly mortgage cost of £345.
3.3 On-going costs
In addition to the mortgage and maintenance there are on-going costs which are best expressed as a percentage of the rental income. There are two main line items here. The first is the cost of a property manager. As the properties will be in Liverpool it would be impractical to not have a property manager. Property managing services typically take a cut of the rental income and 10% is representative. A harder cost to model is not having tenants in the property (void periods) and so no rental income coming in. To make it easier to model, it is assumed one month a year is void and this loss is treated as a reduction in rent across all months. This works out to be the monthly rental income being reduced by 8%. Combined this means 18% of the rental income is lost before it ever hits our bank account which costs about £255 per month.
3.4 Summary of costs and incomes.
A summary of the costs and income can be seen in Table 3. It shows that per month £570 of the rental income can be treated as profit while the rest should be saved to pay for future costs. This roughly means that there is a 40% profit margin on the property which is a good amount of fat to have if some of the assumptions about costs are wrong. A £570pcm profit equates to an annual income of £6,840.
Table 3: Summary of property cash flow.
|Description||Cash Flow [£]|
Section 2 calculates that the equity cost of the assumed property is £47,450 and in section 3 the annual income is worked out to be £6,840. This gives a levered return-on-investment of 14.4%. This is almost twice that of investing in stocks. It is worth pointing out that this investigation does miss some important aspects. First, it looks at a property in isolation and does not consider the personal costs (e.g. time commitments) associated with running this property. It also ignores interest rate risk. We are in a period of unusually low interest rates and the profit from this venture would be eaten up quickly should they increase. Even with these caveats, this study covers enough of the key elements to suggest that purchasing a property is worth looking into more.