Don’t follow the buy to let herd

The biggest mistake that most buy to let property investors make is in following the herd. In the boom years up to 2007 developers threw up thousands of small city centre apartments in areas where there was little demand. These weren’t aimed at the final market of home buyers or tenants but were deigned and built to be attractive to aspirant landlords. Walk through areas such as Woolwich in London or parts of Leeds or Birmingham at night and count how many of the flats in spanking new apartment buildings have any lights on. Don’t be surprised if you feel as if you’ve stepped onto the film set of a science fiction thriller in which all the people have disappeared overnight. In fact things are so bad in some areas that many of the new buildings are already starting to look shabby because there are too few occupants paying rent for the buildings to be cleaned and maintained.
These sorts of properties were actively sold at “investment workshops”, seminars and property presentations. Yet the only people to have made any money were the estate agents running the investment seminars and the developers who put the buildings up.

Think in terms of your target market

Are you looking to attract families with children for long-term rents, university students, single professionals working in the city center? Until you have an idea of your ideal tenant you shouldn’t even be thinking of looking at properties. Do your research first and decide on the sorts of tenants you want. And don’t be too hasty in ruling out large segments of the market. Young professionals might be seen as ideal but they will often want to live in areas with good transport, good nightlife and proximity to the city center. Buying an apartment that meets all these criteria will not be cheap and could lead to a lower rental yield (for an explanation of this please see the article on the economics of buy to let). And professionals don’t always stay put. Students, on the other hand, might seem to many to be the worst possible tenants because they will throw wild parties and destroy a property. Yet students are less fussy about where they are and have somewhat lower standards for what the neighbourhood should look like. They also don’t demand the highest quality of furniture. If you can find a cheap enough property close to a university that is still safe and habitable and wouldn’t take much investment to make cozy, then you might find a better investment return and higher yield than through buying a more expensive place.
Families on the other hand will want to be near good schools and may be quite stable as tenants for many years. Especially if you are able to buy within the catchment area of a school that is particularly sought after.

Research rents and property prices thoroughly before buying

These days there is a wealth of information out there on the Internet that will tell you want rents are in a specific area and what houses in the street or area have sold for in recent months. Try to figure out the average rents for a particular area for the size of property you are thinking of. You can do this by looking on popular estate agents sites to get a sense of going rents. It is often useful to work this back to a price per square foot so that you can compare similar properties that are slightly larger or smaller than one another (although in general the market looks at the number of rooms, not the floor area).
Call a couple of local estate agents in the area posing as a prospective tenant to ask what is available. Tell them you are only moving to the area in a few months and ask them when you should start seeing properties. That can give you an idea of how quickly properties turn over between tenants. Call a few others and be upfront with them about what you are looking for. They will also give an idea of rents in the area. If what they tell you stacks up you may want to see what properties they have for sale. If what they say doesn’t match with what you already know then scratch them off your list of potential agents that you will deal with in future. You don’t really want to be buying from someone who is already misleading you.

Compare rental yields of different buy to let properties and areas

Once you have an idea of prices and rents then you can start calculating yields for each buy to let property you are considering as well as averages for areas so that you can compare one neighbourhood  against another. The results may surprise you when, for instance, comparing student buy to let properties against buy to let family homes.

If one property is yielding much more than another look at it closely but ask why. Is the seller discounting it because they are in a hurry to sell? Or is the property going cheap because it will need a lot of maintenance or structural work? If the former, put it on your list of potential properties to buy. If the latter get a quick estimate (you’ll need a more thorough survey later anyway) of what it might cost, figure that into the price and then recalculate the yield. If it is still above average then add it to your list. Once you have a short list of properties go back to meet with some letting agents (as opposed to the ones trying to sell you a property) and ask their opinions. They’ll often be helpful as you may be a client in the future. A reliable and trustworthy rental agent may make your best advisor since they will know the rental market inside out and want to establish a long-term relationship with you so it is in their interest to help you find the right property.

Get structural survey of your shortlisted properties

Before taking another step make sure you have a proper high quality structural survey done. The few hundred pounds that a good survey will cost now could save you tens of thousands. In particular you want to look out for issues such as subsidence that make insuring a property expensive. Also be sure it isn’t in a flood zone. Check this with the environment agency and some insurers. The last thing you want is to buy a property and then find it can’t be insured or can only be insured at great expense.

All of this may seem an inordinate amount of work just to find a property. Yet hard work, market knowledge and proper research are the secrets of successful buy to let property investors.

The returns that a buy to let property investor makes depend mainly on three key factors. The first is the price you pay to buy a property. This is the one you have the most control over as you can always choose not to buy if the market is looking frothy. The second factor is interest rates on the mortgage you are paying. You have some control over this as you can pay a premium to get a fixed-rate buy to let mortgage. That means you won’t benefit if rates drop, but you won’t be caught out if they rise either.

The third factor is one that you have almost no control over and that is the prevailing market level of rents. In this regard you have to take what you can get. In 2009 quite a number of landlords were caught out by a glut of rental properties on the market the sent rents diving. I was one of them. A rental estimate from a good agent in mid-2008 told me I could expect £2,200-£2,400 per month for a particular property. By February 2009 when it went onto the market that estimate had dropped to £1,800, the rent that it did in fact obtain.

The biggest cause of this was a phenomenon known as the “unwilling landlord”. These were people who wanted to sell but their homes had dropped in value so instead they were renting them out. Many were, for instance, couples moving in together who would normally have sold one or both of their homes to buy a bigger one. Instead they created a flood of properties on the rental market.

There is some good news in recent months, however, in that the rental market seems to have turned up in the UK. The latest research from the Royal Institute of Chartered Surveyors, a reputable trade association of the people who do valuations, found that there had been a shortage of rental properties  in the third quarter of 2009.

This seemed to have mainly been the result of a decrease in the number of rental properties being made available as well as a small upturn in demand by tenants. The changes seem likely to have put the breaks on further falls in the rents that landlords were managing to attract. There is little fresher data than that from the third quarter, although a new survey should come out within the next few weeks giving a better idea of the performance of the rental market over the last quarter. This is traditionally a quieter period for the property and rental markets, so should be taken with a pinch of salt.  Still, RICS felt confident enough of the market to predict that rents might start rising again this year. If so, that will help lead to a real recovery in rental yields and vastly improve the returns that landlords can expect to make over the next few years.

In fact internationally worries about inflation have helped push up the price of gold to record highs and have been leading some investors to advise against buying bonds, which fall in value if inflation rises.

Property and inflation

The interesting thing about property investing is that over time it offers some protection against inflation. Normally investors look at commercial property, because there are deep and active markets in which one can buy chunks of big office buildings or shopping centers. Because these have to be renewed or replaced every 20 years or so, their prices must ultimately rise in line with the costs of replacing them, and it is safe to assume that replacement costs also rise over time with inflation.

The same isn’t quite true in the case of residential property. Often in big cities the price of a house will be many times higher than the cost of building it. In London, for instance, the insurance replacement costs of many houses is generally a third or a quarter of the market value. This is because residential house prices also reflect all sorts of factors beyond building costs such as the cost of land, proximity to good schools, whether the neighborhood is a good one, and so on.

Residential house prices

So the question then remains whether buy to let property investments offer any protection against inflation. Over the long run house prices would usually be expected to rise in relation to average wages, which usually rise slightly faster than inflation. In recent years that relationship has broken down and in the run up to the peak of the property market in 2007, house prices accelerated far faster than wages. That the grew so quickly was one of the signs of a bubble becoming overheated.  This means that over the very long run, the prices of real assets such as houses should keep pace with inflation. Over shorter runs, however, property prices can be extremely volatile. Thus over periods of up to 5 years, there is no certainty that prices will rise in line with inflation. If one take the recent drop in prices, house prices in some areas are down by 25%, even though inflation has steadily ticked upward.

The magic power of borrowing

Buy to let property investors do, however, have another trick up their sleeves when it comes to beating inflation. That is that many of them are buying houses using borrowed money. Inflation, simply defined, is the erosion of the buying power of money. If you have borrowed money to invest in a real asset you are letting the bank’s money erode in value while you, in exchange, have a real asset (an investment property) that should retain its value over time.

That idea is supported by figures produced by the Association of Residential Letting Agents  (Alra), a trade body in the UK, that has calculated the impact of inflation on the returns earned by typical buy to let property investors over five years. The following chart shows some of those numbers.

The impact of different rates of property inflation on returns from buy to let property investments. Source: Arla

The blue bars show the projected annual rate of return on an investment in a typical buy to let residential property that is bought for cash. The bar in the middle is based on house price inflation continuing at its average rate. The different graphs to the left or right show the impact of inflation being higher or lower on average over the next five years than it was over the past five.The orange bars show the expected return based on a  geared purchase where the investor puts down 25% of the purchase price and borrows the rest. As you can see the geared return is not only higher but is considerably more sensitive to house price inflation. Lower inflation will cut returns considerably (though in these cases they remain positive) and higher inflation leads to a huge jump in the return that is earned.

What does this mean for buy to let

For buy to let property investors the conclusion would be that when borrowing money from the bank, inflation is actually your friend as it can boost returns considerably. There are however two warnings that should be given. The first is that sharp falls in house prices can really hurt geared investors and put them into negative equity very quickly. They just have a thinner cushion of safety. The other is that when inflation goes up, so does the Bank of England’s rate and so too do mortgage interest rates. Higher mortgage rates can also be a killer if your rental yield is not high enough . If you are expecting a jump in inflation and want to profit from it be sure to fix your mortgage rate.

The first rule of buy to let property investing: Don’t assume house prices will keep rising forever

During the boom property years running up to 2007 many people made this fundamental mistake. They  figured that property prices would only ever keep going up so it didn’t matter if their net rental yield was less than the costs of covering their mortgage. They thought they could just top it up every month for a year or two and sell the property for bumper profits later. The lucky ones of these are now stuck with properties that they are having to subsidise every month that are worth less than what they paid for them. There is no easy way out for these people. Still, they are in a luckier position than many who couldn’t afford to keep subsidising properties and have now lost them and their own homes too. That is because they didn’t follow the second rule of buy to let property investing.

The second rule of buy to let property investing: Have a backup plan

Every year thousands of investors in buy to let properties end up losing everything. In the third quarter of 2009 alone some 1,600 buy to let properties were repossessed by banks. In the preceding three months 1,400 were taken back by banks. Many of these failed because their landlords had no way of covering their buy to let mortgage if rents fell or they encountered an unexpected vacancy. Before investing make sure you have a contingency plan. Do you have enough money in the bank to keep covering your mortgage for a couple of months if your tenants stop paying rent? Do you have rental insurance and legal insurance in case you have to evict tenants? Do you have enough income from other sources to keep covering the mortgage should rents fall by 10-15% or even more.

If you can’t say yes to all or most of those questions then you must be aware that you will be putting yourself at risk of losing everything if you invest in a buy to let property.

The third rule of buy to let property investing: have patience

Making money from buy to let properties is not a quick game. You need the patience to invest for the long term. You also need patience to wait for the right moment to invest. Many investors who bought at the top of the market in 2007 rushed into buying thinking they would miss their chance. The only chance many of them missed in the end was the chance to make some money. Markets always go in cycles. Don’t be rushed into buying when properties are expensive. If you have bought cheaply, don’t be stampeded into selling too soon. What you want to find are good properties at attractive valuations that will deliver a reasonable rental yield for many years that more than covers your mortgage and other costs. If you can find a property such as that it will make you money for a lifetime.

• rental yield, and
• capital appreciation

Rental yield of buy to let properties

Rental yield is a measure of how much income you expect to make from a rental property. What’s known as the gross rental yield is simply the annual rent divided by the price of the house (and then expressed as a percentage). If for instance you bought a house for 100,000 and expected to receive and monthly rent of 500, you would calculate the gross yield as follows.

1. multiply the monthly rent by 12 to make it annual (500 x 12 = 6,000)
2. divide the result by the price of the house (6,000/100,000 = 0.06)
3. turn it into a percentage by multiplying it by 100 (0.06 x 100 = 6%)

The gross rental yield is a useful starting figure as it allows you to calculate the potential profitability of different buy to let properties. But it is also an unrealistic figure because it does not take your costs into account. A more useful measure is the net rental yield. To get to that you do a similar calculation but you deduct your annual costs such as landlord insurance, management fees, estate agent fees, maintenance and the like from the annual rent before  you divide it by the price of the house.

The beauty of this figure is that it provides a great comparison with other investment options. You can, for instance, compare the expected rental yield of a buy to let property against the earnings yield of shares (equities), the interest rate of a bank account or the yield on investing in bonds. It gives you a clear idea of how much cash you would receive, relative to your investment, if you were to buy a property for cash.

Yet few investors can afford to pay cash and most will need a buy to let mortgage. When assessing a property the more common calculation will therefore be to compare the net rental yield against the cost of servicing your mortgage. This gives an indication as to whether a property can be expected to generative cash or need cash put in every month to help cover the mortgage.

Just remember when doing these calculations to add in a margin of protection. Rents move around less than the prices of properties, but they can still fall quite sharply. Unexpected costs can also arise and your property may be empty from time to time while between tenants or in need of repairs. So always do your calculations conservatively to ensure you are not caught out.

Capital appreciation

This is the money that you will make if the price of your property rises when you own it. Over the years of the property boom capital appreciation provided the bulk of the profits that many property investors made. But many investors have lost everything in recent years by expecting this trend to continue. Many bought properties they couldn’t really afford at rental yields that did not make sense in the hope that they would make their money later by selling at a higher price. If you are making an investment decision that assumes that house prices only ever  rise you are making a big mistake. Your final return will always be a blend of yield and capital appreciation and rental yield, but the first rule of property investing is not to rely only on house prices rising for you to make money.  Instead long term success in buy to let property investing will come from properties that offer an attractive rental yield that allows them to pay for themselves many times over. The gain you make from selling eventually should just be the cherry on the top.