What is it "Buy to return on investment" And how should I measure it?
The question most real estate investors ask me when they have found a property is “what is the return?” However, when I ask the investor if they are referring to the gross return or the return on capital to invest, many are not sure and do not really understand the question.
Many investment agents and real estate agents look at the gross return. It is easy to consult and can give good guidance on the overall financial performance of the potential investment, but it is far from the best way to select a property for investment.
Gross yield is the annual rent as a percentage of the total property value. For example;
- £ 7,200 annual rent: property price £ 100k: gross yield is 7.2%
The gross return measurement does not take into account the different ‘variables’ that each property may have. High-value ‘variables’ can turn what seems like a great investment into a bad one. The areas where the ‘variables’ vary most widely are:
- Gaps between leases
- Tenants who do not pay rent
- Property maintenance
- Lease charges
- Low energy efficiency rating
Clearly, the actual cost of running each property will be different and therefore using the gross return alone is not enough to make a decision to buy or not to buy.
I advise investors to look at what the projected annual net tax profit is as a proportion of their investment in cash. While this is not 100% accurate, it is a much more robust way to measure the projected financial performance of an investment. I call this income before taxes on capital employed.
To calculate income before taxes on capital employed, divide the net annual rent after deduction of all operating costs (the example is listed below) by the actual capital you plan to use for the deal (known as capital employed) .
Typical operating costs:
- Mortgage interest
- Property and building content insurance
- Lease Default Insurance
- Management and rental fees
- Periodic security tests
- Repairs and maintenance
- Accounting services
- Block administration and service charges
Using this method to evaluate the financial performance of an investment means that you are more likely to do so;
- Run your capital and produce a good yearly income
- Benefit from longer-term capital value growth
Free advice available
In order to produce reasonable estimates of the operating costs listed above, I encourage investors to consult with a local qualified leasing agent who will often offer their knowledge and experience of the local market for free.
By “qualified” I mean a leasing agent who is a member of the following; ARLA, Safe Agent, NALS and the Ombudsman. This will ensure that they are specialist in rentals and trade in a professional and reputable manner in their local area.