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What Is a Good Return on Investment (ROI) for a Buy-to-Let Property in the UK?

Originally published at: https://blog.openrent.co.uk/what-is-a-good-return-on-investment-roi-for-a-buy-to-let-property-in-the-uk/

The answer is, it depends how much of your own cash you use to purchase the property. And the more cash you use, the worse your return will be. Working out your return on investment (ROI) for a rental property is essential to making financial decisions. This calculation tells investors if buying, letting and selling…

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always assuming no void periods and no bad payers

Not sure I agree with this bit…" For those of you looking at a long-term investment, maybe hoping a rental will contribute towards a future pension, you will be okay with a lower ROI in the short-term. Perhaps you have a repayment buy-to-let mortgage which will be paid off within 15 years when you hope to retire. When you come to work out your ROI then, it will be considerably improved. When we look at your new ROI calculation, the figures change because mortgage costs are no longer a factor".

You have paid the mortgage off, albeit with funds from the rental, so your capital invested is still £150,000 because you could have spent that money on something else (eg another property).

For investment comparison you should also look at it based on the current value (less tax) too because you need to compare it to what else you could do with the money (the opportunity cost). If your profit is, say, £10,000 pa, the return based on the Openrent calcs would be 20% Let’s say you’d net 250k after tax if you sold it, that calc would give you a 4% return. Obviously, there is the potential for capital growth to take into account too, but, at that stage, £250k is what you actually have invested in the property, regardless of what you put in to start with.

This is totally wrong.
The answer misses out a massive, fundamental aspect of the roi; owning the house as the mortgage is paid off. This will increase the roi substantially.
Not to mention that the initial investment of 50k will likely increase by 5% per year as a result of rising house prices.
Also I don’t think receiving twice as much rent as mortgage and fees is anywhere near realistic.

Ummm, no it won’t

To put some simple figures on it…

Say I have a house worth £100,000 with a £75,000 mortgage and make a profit of £1,000.

I have £25,000 invested in the house so the ROI on that is 1000/25000 = 4%

Now say I pay the mortgage off and my mortgage interest was £150 per month. I now have a profit of £2,800, but my capital invested is £100,000. So my ROI is now 2800/100000 = 2.8%

I would only be better off paying off the mortgage if my mortgage rate was higher than the the ROI - in which case, you’d probably have to question whether you had a viable rental property anyway.

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I should really stop posting, as this entire forum seems to be a troll-training ground!
But, I love maths problems…

Essentially RoI/RoC calculations are simple…

  • RoI = Profit / investment_cost
  • Profit = change_in_assets - change_in_debts

There are two assets

  • The house
  • A cash balance

There is one debt

  • The mortgage

Change in debts
Calculating the debt in the mortgage is easy, as it is simply the amount of money it would take to cancel the mortgage (including early repayment costs). This cost and arrangement fees will mean that you will generally start with a “debt” greater than the cost of the house.

Change in assets
Estimating the value of the house is harder (obviously), but you could make some assumptions

  • It will increase due to natural tendency to rise. Possibly the rate of pay-rises, say 3% a year.
  • It will decrease due to depreciation (wear and tear).

Depreciation
Accounting for depreciation is an art-form, and is covered by many different accounting principles. All of which I’m ignoring… As an example, I will keep it simple.

  • “I will fit a new kitchen costing £10,000 every 10 years”. I expect to spend £2000, maintaining the kitchen per year" … 12,000/10 = £1,200
  • “I will fit a new bathroom costing £5,000 every 10 years”. I expect to spend £4000, maintaining the bathroom per year" … 9,000/10 = £900
  • and so on…

If you do this per room, and include things like electrical-items, etc, you can come up with a realistic figure for depreciation.

Cash assets
In essence simple, money in - money out.

  • As maintenance costs are included in the depreciation, you don’t include maintenance here.
  • Remember your property will not be rented 100% of the time.
  • Include insurance/agency fees.
  • You should include the interest cost of your mortgage offset by any current account interest.

NOTE: Treat maintenance costs as “purchasing depreciation”.

A simple example over 25 years : using fake figures
Assumes …

  • rent = £1000 pcm
  • mortgage interest = £600 (annualized)
  • it’s unrented 20% of the time
  • sundry costs = 300/year (insurance/agency/etc, I suspect this is too low)

Starting with £50,000, spending half on a deposit and keeping half to cover costs.

  • Initial assets
    – £250,000 (house)
    – £25,000 (cash)
  • Initial debts
    – £230,000 (mortgage)

Expected end position

  • Assets
    – £500,000 (house)
    – -£50,000 (depreciation - say 2 kitchens and 2 bathrooms, etc)
    – £27,500 (cash)
  • Debts
    – None

Profit over 25 years = £202,500(change in assets) + £230,000 (change in debts) = £432,500
Profit adjusted for inflation = £233,286

  • £9,331 per year profit
  • £9,331/£50,000 = 19.7% (RoI)

Notice though, that whilst the RoI is good, my assumptions would lead to a cash-negative position. You would need to put more money in over the years, just to keep afloat.
To make this work in reality, you would need more than £25,000 starting cash, maybe £50,000, which drops the RoI to around 12%.
Compare this to a RoI of around 10% on the FTSE.

The learning lesson maybe that you need deep pockets to be a landlord, but you can expect good rewards. This example shows that you probably will make a cash loss for the early years.

Buy to let mortgages generally require 145% rental cover at a 5% interest. This often requires a 40% deposit, in areas where propert is cheaper relative to rents a minimum deposit of 25% is required so you wouldn’t get close to your level of mortgage. 20% empty is unrealistic over long term given housing crisis. I have had 3 rentals for 6 years and my total empty period across all of them is 4 days in 6 years. 5% is more realistic.

You do need deep pockets to start for deposit, stamp duty, getting property ready to be rented etc, but should be profitable from the start, although can be years you would make a loss if doing lots of maintenance and have a big mortgage.

Sorry to rant, but be aware of the most common mistake when talking about house prices.

It’s common to include inflation when quoting house prices. This gives an unrealistic expectation of how fast house prices rise. For example,

  • If you borrow £200,000 to buy a £250,000 house
  • The house only rises by inflation £275,000 (10% inflation)

It looks on paper like you have made a £25,000 (50%) profit… but you cannot make profit on inflation, so you might ask where the money has come from?
It’s in your interest payments. If inflation is 10%, then the bank will want at least 10% in interest. For example, if you look at the 80’s then houses look like a fantastic investment. What you don’t see is inflation (and interest rates) meant that house owners felt like they were being “gauged” by inflation, and never realized they would get the money back when they sold the house. This is a major reason why many older people hate inflation, but expect house prices to always rise (they never put 2+2 together).

@Richard19
I thank you for your comment, and your support in other discussions.

I’m not a landlord, so I don’t doubt my figures are out. I just wanted to show an example calculation. It’s relatively easy if you use the lifetime of the mortgage, just remember to adjust for inflation,

Okay, I’m a nerd, I couldn’t resist plugging in the figures Richard gave me,

It gives me a figure of around 7% consisting of

  • 3.5% asset inflation (the amount the house goes up in value - after depreciation is paid by the rent)
  • 2.5% debt repayment (you do end up owing the house)
  • 1% cash profit (after depreciation costs)

Which, if you don’t account for depreciation would look like…

  • 3% cash profit (no repair costs)
  • 2.5% debt repayment
  • 1.5% asset inflation

But then if you don’t repair anything, I suspect your rent will suffer, so it’s probably a false economy.

Most BTL mortgages are interest only and tax makes a big difference to returns. Assumptions will depend on circumstances but I think below is reasonably common.

Assuming a £200k property rents for £10k pa with a mortgage of £120k for a higher rate tax payer figures look like this

10k rent less 2k to cover maintenance, insurance, void periods etc leaves 8k income. After 40% tax this is £4,800, prefinancing
Mortgage interest is £3,600 (assuming 3% interest), LL then gets a £720 tax credit.
Net income for landlord is £2,320 pa. Based on an investment of £90k (10k allowance for stamp duty and initial costs, assuming nothing major needs doing). This is an income yield of 2.5%. It would take 4 years just to cover the initial costs.

There may be capital growth on top but also there could be also be losses. There will be at some point. It’s a huge amount of risk for minimal returns. I certainly wouldn’t buy more in current market.

Once again thanks for the information. It’s interesting and has expanded my knowledge.
Your calculation is a different quantity (yield), but I had no idea that the tax situation is so complex.
According to google, the yield on FTSE 100 is currently 4.1%, and 1.1% on 20-year UK bonds. However you can buy shares/bonds completely free of stamp duty/tax (in an ISA). This is one reason why including tax is normally not done in yield calculations.
Given a £20,000 investment Imperial Brands* would give an estimated dividend of £1,756 PA (tax free), I can see why you think the risk/reward is not great enough to dive deeper in.

*Imperial Brands is an evil cigarette company, which is why the yield is so high.

all of this goes right over my head . i buy stuff if it is a BARGAIN. It might be a property a car , insulation , Machinery.

I’m probably the only one who cares at this stage :slight_smile:

Once more I see the different points of view, as simply different ways of looking at the same problem.
Yield is a measure of cash-flow, and if your primary concern is cash it’s the most important view.
However, for most people, it’s the total-return (TR) that is most important. RoI is measure of TR/year as a percentage.

So using my example above, tobacco companies are cash cows. Typically they give 8%+ yields… But how many smokers will there be in 20 years? So tobacco companies have low Total Returns, because they are a (literally) dying industry.

Now… why does this drive multiple views of the renting sector. If you are a cash-based landlord, you concentrate on yield, as that is the measure of how much money you are getting, and how “liquid” you are. Using this measure renting looks like a bad investment.
But… As I pointed out above, there is something hidden going on. Inflation makes banks charge higher interest (who would lend at less than inflation), but it also makes the value of the assets increase. In other words part of your profit is being paid to bank, but returned to you when you sell the house. It’s almost like a savings account, that the bank makes you pay into, but pays you back at the end.
So… If you pay a mortgage rate of 3% and inflation is 2.5% (who knows what the rate really is at the moment) then the effective rate is .5% after inflation. This transfers (60% of 2.5%=) 1.5% of the house value from cash, to the asset value of the property.
So a 2.5% yield is really a 4% profit (RoI).

My assumption was that house prices move in line with pay rises, which is currently around 3%. This historically has been true for around 200 years, but it has been broken for ten years, as house prices increase and pay does not. This assumption added .5% to the asset price rise, which because of the gearing (leverage) added more than 1% to the profit.

So my estimate of RoI and Richard’s estimate of yield are not that much different (mostly I did not account for taxes).

That said, if you believe in “reversion to norm”, that house prices will eventually fall with respect to salaries, then Richards assertion that house prices may not deliver the expected profit margin, is a reasonable point of view.

It’s hard to see how prices would not rise with inflation though, so expect the profit to be higher than the yield (due to the effect of inflation moving cash(interest)->asset).

None of which changes the fact that radically higher profits can be made if you can find a lender who will lend a higher loan/value; Even if you make a cash loss and put aside 2*deposit as a cash buffer. Expect Lloyds to take this angle when it enters the market.

EDIT:
Whoops, My calculation is off… If you borrow 60% of the value, and the inflation makes the value rise by 2.5% then your asset increases by 2.5*2.5% = 6.25% (relative to your deposit)

  • (3/5th of which) 3.75% is money that you have already paid for in the form of interest and is “hidden profit”
  • (2/5th of which) is the inflation on your deposit.

So… @2.5% inflation a 2.5% yield is 6.25% profit
And… If you add the extra for pay-inflation then…
.5%*2.5 = 1.25%, then RoI is more than my figure, around 7.5%

Nigel1 You are probably right . I for one do not care.!! All I know is that everything I have bought has gone up in value , except my cars.

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