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Aha! We have the answer to the question, which is the better property investment – the classic ‘doer-upper’ or the perfect ‘ready-to-rent’ property? It is the one with the best gross yield right? Well, no not necessarily…
Gross yield is the total annual rent divided by the total purchase price, or in fact, as I prefer the current market value, of a property…expressed as a percentage. In the article, we can see that the figures used for the national averages are:
Ready-to-let property - average purchase price (before costs) £194,599 & 5.4% average gross yield
Doer-upper property, average purchase price (before costs and refurbishment) £136,042 & 4.4% average gross yield
Who would take the 4.4% yielding property when they could take the 5.4% yielding one instead? I mean that’s nearly a 23% higher rate of return…you would be crazy not to wouldn’t you? Maybe not actually….
The reason why not is that gross yield is only one measure of a property investment’s performance and in truth not a very effective one anyway. Let me explain.
First, gross yield ignores the costs and deductions associated with the investment – so I prefer net yield to gross yield for this fact alone. Net yield is the gross annual rent less all annual costs expressed as a percentage of the purchase price or current value. This washes out maintenance costs, service charges, voids and the like and so is a superior comparative measure in any event…although it is more difficult to calculate, especially when we don’t actually know what all the costs will be anyway. But we can at least make an educated guess.
Second, both of the yield measures ignore how hard our cash is working for us as they fail to distinguish between our own funds and those of a third party, such as a buy-to-let lender. Whilst net yield can address part of this point by taking the cost of the mortgage repayments into account as a cost (and so another reason why net yield beats gross yield for me), an even better measure as far as I am concerned is return on investment (ROI). Many people actually confuse either of the yield calculations with ROI but the correct calculation takes the net yield figure and divides this by the actual cash funds invested by the investor only (i.e. ignores borrowed funding). This is a much better measure of an investment’s effectiveness and allows comparisons between different asset classes to be made, such as stocks and shares vs property. What do the ROI figures look like then?
In my experience, the net yield and ROI would respectively look as follows, after allowing for all costs on an average basis.
Paying cash
Net yield of 4.6% if self-managing or around 3.9% if using an agent
Using the 75% mortgage
Net yield of 1.1% if self-managing or around 0.4% if using an agent
Oh dear, I here you cry…that’s blown the argument a little hasn’t it? Well note quite yet, let’s look at the ROI now:
Paying cash
This by definition is the same as the net yield figures, so:
ROI of 4.6% if self-managing or around 3.9% if using an agent
But using a 75% mortgage…
ROI of 4.4% if self-managing or around 1.6% if using an agent
OK, so now I am getting close with my leveraged model if self-managing but it looks at first glance that I may still come unstuck if I decide to use an agent right? Well, not quite yet...
I need to highlight that the actual cash used in the leveraged model is around 5.7 times less at something like £34,010 for my ‘doer-upper’ (£136,042 x 25% deposit) versus £194,599 with my ‘ready-to-let’ property if paid in cash. Stay with me now…and assuming we will in fact use a mortgage and an agent (to simplify a little!).
Using the same cash funds of £194,599 but with a mortgage, I can multiply the total number of investments and so the total returns, a term known as leverage, to convert my total ROI from the same total cash investment fund to 9.1%. OK, so I also ignored the cost of the refurbishment for now, as that would just get too complicated. However, even if I did include them but it increased the value of the property (as I would expect), I should be able to refinance at some point and pull out some of the additional cash invested in the property to compensate. After a perhaps long-winded explanation (sorry!), would you prefer a return on your cash investment of 5.4% or 9.1% instead? I think the pendulum may be swinging back again now when we look at ROI…
I do love net yield and in particular ROI and in truth the net annual cashflow figure as well, although the latter measure will have to wait for another day for a full explanation.
In summary, at face value judging an investment based on gross yield alone could support the proposition presented in this article that buying a ready-to-let property could be best. However, when we take into account the lower cash input and assuming we refinance to release increased equity post-works with the ‘doer-upper’, we can see that net yield and in particular, ROI can give rise to a potentially different conclusion. This would be even more the case when we introduce powerful leverage into our analysis and I haven’t even mentioned the impact of capital growth yet either!
I guess, as the motto don’t judge a book by it’s cover is true in publishing; so too is, don’t judge a property investment by it’s gross yield in property. Net yield and ROI are more reliable and more useful in my opinion, even if the conclusion remains that the ‘ready-to-let’ beats the ‘doer-upper…although I have not usually found that to be the case myself 😉
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