I might not go as far as to so the ‘ultimate analysis’ but what I do like about this feature from Biggerpockets is the emphasis of measuring our investment returns based on how much actual cash we invested in the first place. Isn’t that what all the press are reporting on when they talk of rental yield you may ask? No, it is not and not even if we buy a property in cash.
Rental yield, of which there are a couple of variations but let’s stick with the commonly reported one for now called Gross Yield, is usually defined as the gross annual rentals divided by the property purchase price. Thus, with a property renting for £700 per month that cost £140,000 would mean a Gross Yield of 6%, which is not bad, is it?
Two slight problems with the definition to clear up first however – the first is that if we calculate based on the purchase price, we lose sight of how the investment is performing under current market conditions – we fix that aspect by looking at the current market valuation and not the purchase price. In a rising market, if we leave the rent the same year-after-year we would actually see our yield fall instead of stay the same.
The second aspect is to recognise the total cost of our investment, of which the purchase price is but one aspect, a big aspect but still not the complete picture. We fix that by adding up all of the costs of acquisition (such as legal, surveys, broker fees etc.) and any works costs we spend before we can let the property out (repairs, upgrades, furniture, decoration, etc.). If we had a rising housing market then perhaps after 4 years at an annual growth rate of 5% the property would be valued at £170,170…again not bad at face value.
However, Gross Yield is not the subject today; instead, we are discussing cash-on-cash (COCR) return and overall return. Put simply, COCR measures the annual income as a percentage of our actual cash invested, with overall return measures both the annual income AND the total capital growth over time, again as a percentage of our total cash invested. The results in either case do then allow us to compare the investment performance of different assets classes – be they property, stocks & shares, bonds and gilts, or peer-to-peer lending for example.
It is perhaps this total cash invested part that makes the most difference with property investing, not so much when an investor buys in cash but more so when they use a mortgage, or leverage their investment. It is true that a mortgage comes with initial costs and a running cost in the form of interest but equally it allows the investor to magnify the value of their initial cash investment and as such to magnify the respective COCR and overall returns too.
This is providing they stick to the ‘golden rule’, which is not paying more in total fees and interest on the loan than the equivalent loan sum returns to the investor in NET rental income. Note that in the outline below; to try to keep some calculations simple I have ignored any non-finance-related running costs from the illustrations.
If I paid cash for the example property I used above, then the COCR and overall return figures after 4 years would be:
COCR: (£700 x 12) / (£140,000 + £8,000) = 5.7%
Overall Return: (£170,170 - £148,000) / £148,000 / 4 = 3.7% plus 5.7% from COCR above totalling 9.4% (I am using a simple annual average and not showing compounding)
If I bought this property with a buy-to-let mortgage, with £2,000 in finance-related fees, on an interest-only mortgage at 75% loan-to-value, charging 4.5% per annum it would change the results as follows:
COCR: (£700 x 12) - (£105,000 * 4.5%) / (£140,000 * 25%) + (£8,000 + £2,000) = 8.2%
Overall Return: (£170,170 - £150,000) / (£35,000 + £10,000) / 4 = 11.2% plus 8.2% from COCR above totalling 19.4% overall
We can see that should this investment scenario have taken place, then both the COCR and Overall Returns would have been higher when using a mortgage. This does assume that we follow the golden rule that I mentioned earlier and also that house prices do not fall – either of which would flip the results around.
Finally, looking at percentages is certainly part of the story but by no means not all of it. In order to get a true picture we also need to look at the absolute cash figures involved.
In this example, we used £148,000 in cash to generate an overall cash return of £55,648 over four years. This compares to a cash investment of £45,000 to generate an overall cash return of £34,920 with our mortgaged property example. But you will note that we could have bought three properties if we used mortgages from that same £148,000 cash sum, which if they were identical would have meant a combined cash return of £104,760 instead.
That is almost double the overall cash return from the same cash investment fund and highlights the benefit if using mortgages quite well I think. However, I must stress that as does using a mortgage multiply profits in a rising market (or with low interest rates relative to rents), it also multiplies losses in a falling market (or with high interest rates relative to rents).
I am conscious that I may have overdone the explanation a little today but I hope the point is clear…that is:
That looking at cash-on-cash returns is a better way of measuring an investment’s true performance…added to which a mortgage can under the right conditions improve the returns yet further. I guess this is why so many ‘ordinary people’ are ultimately attracted to buy-to-let investing, using mortgages.