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Q&A » Buying and selling property
ie, btl property bought for £118,000 at 25% ltv on ir of 1.5% is better return than the same at 15% ltv and 4%, but this not shown in rental yield.
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114You're right, this is not shown in the gross rental yield (annual rent/property price).
The reason for this is that 'return' (i.e. return on captal employed) is a profitability metric, whereas yield is a valuation metric.
Valuation metrics are generally used to ascertain the amount that should be paid for a certain asset, given the income it generates.
Profitability metrics are used to measure the percentage returns from an investment against similar investments or compared with previous years.
In your case, return on capital employed will be (as a rough guide) the net profit for the year divided by purchase price of the property (£118,000), where net profit is:
Rent received for 1 year
less: Any repairs/maintenance of property (NOT upgrades)
less: Mortgage interest paid (NOT capital repayments)
less: Taxes relating to the year rent was received
(In the interest of simplicity, I've assumed your BTL property is unfurnished and ignored accounting depreciation and capital allowances etc.)
Posted on 03 February 2009 |
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0Thanks for your response. Yes it is unfurnished. Still a bit confused on one point. If return is on net profit, should you use value of property or capital invested. ie mortgage payments are currently £113 pm, rent £550, capital £32,000. If I use your very helpful guide, the return appears to be about 4%, however, I am actually making a monthly profit of approx £300,(9%) which intuitively seems more accurate. Of course these are unusual times, and i doubt this is sustainable in the long term.
If interest rate is 4%, payments become 303, rent remains £550, after costs etc the profit is £200 and the return is 2% or 7.5%.
I freely admit I am not good at maths, CSE grade 3,many moons agO, SO May be missing the point but any further help or thoughts would be very gratefully received.
Thanks kazman6
Posted on 03 February 2009 | Love 0 loves
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0I would calculate it based
cash flow coming in per year divided by total money invested.
Example : invested £ 25K. £ 200/mo extra cash flow - yield 9 %.
In the past, people are banking on the value of property going up forever - some even came up with sth called negative gearing, but as it happens, the value doesnt always go up. and now they are in bankruptcy court.
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114To you, as owner of the property, you should use capital invested given that this is the actual amount of funds you have put into the business.
A potential investor however would use current valuation as they would have to pay current market rates to acquire a BTL property.
I should have mentioned earlier that you should include insurance costs if you have any.
Not sure how you got capital of £32k, it should be the entire £118k.
I'll give an example using your figures:
(1) Gross rental yield = annual rent / cost of property
= (12*550)/118,000
= 5.59%
(2) Net profit for the year (i've made some figures up and included them with asterisks so you get the idea)
Rent received = £6,600
less: mortgage interest = (£1,356)
less: annual insurance = (£250*)
less: repairs/maintenance = (£500*)
PROFIT BEFORE TAX = £4,494
less: Tax at 20%* = £899*
NET PROFIT = £3,595
(3) Post-tax return on invested capital = Net profit / capital invested
= 3,595/118,000
= 3.05%
Incidentally (and by pure blind luck!) this roughly corresponds to your monthly profit of £300. (£300 x 12 = £3,600)
I think you would benefit if you got a book that explained accounting in simple English - afraid I'm not aware of one I can recommend though. I'm hoping someone else can help with this?
Posted on 03 February 2009 | Love 0 loves
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114Pertmana >> I've no issue with your calculation, but what you are referring to is return on equity, which is slightly different.
The reason I chose not to use this metric is because it increases and decreases in proportion to the amount of leverage put into the business.
For example:
House A costs £100,000 and collects £10,000 annual rent and was bought with £1 deposit and £99,999 mortgage.
Return on invested capital = 10%
Return on equity = 1,000,000%
House B is identical to House A (same cost and rentals) but was bought with £90,000 deposit and a £10,000 mortgage
Return on invested capital = 10%
Return on equity = 11.1%
The two scenarios produce wildly different returns on equity despite being in all other ways identical.
I prefer return on invested capital in this situation because it enables direct comparison with other similar enterprises regardless of the amount of leverage they happen to be using, given that the total sum of money put into the business is always considered.
Posted on 03 February 2009 | Love 0 loves
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824TLG
If someone is trying to decide whether it is better to have one property with a larger equity and smaller mortgage or 2 properties each with half the equity and more mortgage, then it is the equity yield that is required. It is the profitability of the amount of capital that you are employing in the business that you want to know about. Borrowed capital is just a tool of the trade!
Posted on 03 February 2009 | Love 0 loves
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0thank you that lyndsay guy, much clearer, i thought capital was the amount i invested, not deposit and mortgage, how odd that the figures should be the same!
I definitely need that book if anyone can recommend one.
Thanks to you too Pertmana, much appreciated. (KISS) is my current approach, i do understand that its a better return than a saings account at present, thats for sure, even if more work. May not be true if property values fall much further though.
Regards
kazman6
Posted on 03 February 2009 | Love 0 loves
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114Kazman6... You're very welcome.
MikeGG
I agree with what you're saying. When looking at the return on your own funds, you should be using equity ratios. However when considering returns as generated by a particular business itself, you should use ratios based on total capital invested.
This is why I think kazman6 should look at the basic principles of accounting. Once those are understood, one can figure out the correct type of financial metric to use in each case.
Posted on 03 February 2009 | Love 0 loves
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0So to see if i have under
stood this, using my property as example
Gross yield 5.59% variable on gross rent and property value
net yield 3.05% based on net profit / total capital
this will vary acc to amount of maintenance, costs, tax etc, and could be used to compare other properties, with lower maintenance, or maint charges, or higher rent by value etc.
equity ratio 9% (approx). This is the return on my capital invested. Dependant on all above but also fluctuating mortgage rates if not fixed, and compares with the same amount invested in other things. Will also change according to ltv, useful as mikeGG points out when deciding to withdraw/or add equity.
Hope that is a simplistic precis of the complex ideas shared with me! I'm off for a restorative G & T.
Thank you all, and I've put a virtual drink in at the bar for you.
Cheers Kazman6
Posted on 03 February 2009 | Love 0 loves
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114Very good, Kazman although a small point on terminology. Return on equity is what you have calculated.
The equity ratio means something entirely different; it is the percentage of equity when compared with total assets.
In your case:
32,000/118,000 = 27%
This is a measure of how much leverage (i.e. debt) there is in your business - the higher the equity ratio, the less risky your business.
This is because interest on debts must be paid whether or not your business is profitable, meaning that businesses with low equity ratios (i.e. high leverage) are more susceptible to:
(1) Interest rates - if rates rise the interest expense rises with it
(2) Asset revaluation - if asset prices fall, the debt may become worth more than the asset (known as negative equity).
Posted on 03 February 2009 | Love 0 loves
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