Money management for Landlords

Landlord Discussion
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I originally came to this forum asking about a technical issue, but have been drawn into a series of other topics.

The common theme seems to be that many landlords are pushing the boundaries of the law. The underlying cause of this illegality is a sense of threat. I find this curious from a business perspective. Many businesses also have legal responsibilities, and yet they mostly consider that breaking the law is a bigger threat to their survival than not exploiting a lack of supervision to lower standards for commercial gain. The reason for this is that you can insure against non-payment, but not against being sued.

I’m going to propose a way of looking at renting in the same way an investor looks at a business. I’m going to suggest that it is bad financial management that is creating the illusion that there is a constant threat, which in turn is leading to unlawful behavior.

When starting a business one of the initial decisions is how much capital you need and how much of that capital should be borrowed. This is known as gearing. I suspect most landlords start with a 10-25% deposit, thus making the gearing between 3-10.
You probably already know this, but the gearing dictates the risk/reward ratio of the business.

Then when the initial capital is raised, a decision is made as to how much capital is “employed” and how much is kept in reserve. Most businesses will not have guaranteed income. The owners of the business will want that business to survive a downturn. Beyond that, many will also want to be able to take money from a business, even when it is not doing well. Some money is kept to one side, to provide “cover”. Cover is expressed as the amount of cash reserves divided by the yearly dividend (profit paid to the owners). Typically this should be at least 1 year.

The two main levers to control risk are gearing and cover.

A high gearing will give you a high risk but high profit business. You can offset this with a high cover, that is use the profits to build a pool of money that allows you to ride out high losses, for a short period of time. You can think of this money as “self insurance” a premium the business can pay itself, in order to insure itself. After a period of time, the pool will be large enough you no longer need to add to it, and so you end up with a business that is insured for free. (A highly geared business that is effectively low risk/high profit)

In the same vain, a low geared business, that has low cover is still a high risk business. The losses involved are much smaller, but as there is no “coverage” for the loss, the business will fail the first time it happens. (A low geared business that is effectively high risk low profit)

Now, reading between the lines, it seems that a lot of landlords have fallen for the trap of the second scenario, high risk/low profit. I get the impression that many landlords would be shocked to hear that they should have reserves of at least a year. (To be clear, enough profit to give the landlord an income for year - if the business has to stop operating, not to cover a years operating expenses.)

This lack of knowledge of basic business sense seems to be driving a lot of insecurity, which they are attempting to pass on to their customers (tenants). Surprisingly, often by unlawful means.

So… Am I off base here?
If so, I would love to know what financial structure most landlords would advise?

(Seriously I’m not looking for troll-bait, simply to understand)

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Your basic proposition is not wrong in my opinion, but we should understand that it wasn’t always this way. In the past anyone could let out “the wife’s old flat” as the advert goes without needing 5 years of legal training. The world has changed and most people are not aware of it. There was no Govt information film warning people not to dabble in what has become a professional business where you can lose your shirt for an admin error. Consequently, most people see it neither as a business, where you have to learn the ropes, nor an investment, which can go up or down. I would suggest that for most people it’s an alternative to selling a former home that they are only counting on to cover its costs.

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@David122 :
Thanks for the input. I find your point very interesting. Essentially you are saying that because the financial position is inherited from a personal finance position, the balance is wrong right from the beginning.
The flaw in my reasoning, is that landlords make do with what they have, not plan it from the start.

I would presume, it’s not easy to fix too, because selling the “the wife’s old flat”, to swap for somewhere more suitable would incur the loss of tax advantages and extra transactions fees (Estate Agents fees, etc).

From this, maybe the core issue is that the same tax rules that make it easy for someone to rent a previously lived in property, make it hard to do so in a low-risk manner.
That might explain some things.

Thanks

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So I think you’re off base for a number of reasons.

  1. I don’t agree that most LLs do illegal things, rather our rights are so few that we must diligently uphold the few we have.

  2. Many, if not most, LLs are incidental whereby they buy a new property and don’t sell the old one. They often get NO income from their property as rent covers expenses basically. They hope for a return when selling.

  3. The “professional” LL has a bigger portfolio but makes a couple-three hundred pounds profit per month after expenses/repairs/interest per property. This means the margins are small and take into account return on investment (deposit) is small.

  4. The big problem is if a LL gets a non-paying tenant. It normally (now much longer!) takes 7 months to get them out (with court’s and bailiff’s waiting periods). In that time the lost income is £5-6k plus £2-3k in costs (that are unlikely to be recovered). So one bad tenant potentially wipes out 4 years of profit in one go! So after 4 years, given nothing else goes wrong, I might get a little profit again having worked for free for 4 years.

So your reasoning that a LL would pool money together for that bad tenant doesn’t work. It’s merely a financial construct that doesn’t work in the real world where a person’s real money is at stake.

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@Per
Interesting points.
I’m afraid, I could point at least a dozen posts encouraging illegal/unlawful behavior. As I say, there is a persecution complex at work here, and I’m trying to understand where it comes from.

If 2. is true, then this is very silly. The first time the property is empty, it will get repossessed. It’s hard to sympathise, as that is planning to fail, by failing to plan.

I would suggest anyone considering 2. should instead consider a REIT, according to this webiste the average REIT has cover of over 5, making it much safer investment (note: this website if for US REITs, but UK ones should be similar).

I cannot question your figures for the costs of eviction, as I have no experience at either end of it, but your calculation is wrong. It includes “expectation loss”, that is, treating a profit not made, as a loss. It also assumes that the property is always rented out. It is never empty?

Expected income = Rent * occupancy
Loss through non-payment = Expected income * (1-yield) * length + legal costs

Using guesses of 5% yield and occupancy of 80% and monthly rent of ÂŁ1000 and costs of ÂŁ2500, I get a loss of around ÂŁ7820, which is still a large amount of money, I grant you.

That said, if the property is worth £250,000, this is 3% of the capital. This means that it’s easily possible that the resale value of the property has risen by more than the cost of the eviction, during the time it takes to evict them.

Even without rising property prices, it still represents only 80% of the income for a year. Far less than the year’s worth of cover which would be considered minimum in business.

I guess, what I’m saying is that it still seems reasonable that anyone who structures their finances right, this should be completely survivable, just another “exceptional cost”. According to this website the chance of having to evict a tenant is around < 1/500 (London) and < 1/1000 for the rest of the UK, so on average it should cost around £8000/1000 or £8 a year (outside London).

Surely the landslide of illegality is not caused by something that on average is ÂŁ8/16 a year!

NOTE:
This website also uses the incorrect assumption that “expectation loss” = loss. Obviously it wants to sell insurance, but this is just misleading. Maybe a lot of this fear I’m sensing comes from insurance companies?

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Some professions have always been the object of ridicule and even hatred. There are such texts about landlords on ancient Egyptian papyry, ancient Greek scrolls and in every era since then. The persecution complex is not entirely imagined. The problem arises when landlords react to this and develop a seige mentality. If you think everyone is against you, it’s easier to believe ithat breaking the law is the only way to get justice.

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@David122
Good point well made. I cannot say that I have never encountered irrational hatred/mistrust of landlords too.

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Being more constructive, I would say that as a tenant, I would happily pay a £10 a year “eviction tax”, that compensated landlords for the some of the cost of evictions.

However, only if there is a requirement that landlords who get this compensation must show they have acted within a set of guidelines. Maybe this is a case where a carrot is better than a stick? A case where the market does not deliver, and a “nudge” is required?