Your Life in Property - Chapter 4

Annual Rental Income Generated Value of Property

The idea of yield is important when evaluating new investments and also the investments already held in your portfolio. Come to think of it, if this is the cornerstone of the property investment world, this is really simple! I will make it even simpler in a moment.

For the time being, let's look at the equation and examine what it says (and what it doesn't). First off, looking at annual rental income, there are a number of ways of expressing this. Do you quote the gross or net figure here and what is the difference? For me, I like to capture the expected annual rental income with any deductions which must be made to make the investment work. So, for example, I would deduct the cost of any routine maintenance (boiler, lift for example) and also the cost of employing a factor or managing agent if this is applicable. I would also deduct the cost of insurance as this is unavoidable. I would not include unplanned maintenance at this stage or indeed the cost of a letting agent. The work of a letting could be conducted by yourself for certain properties so at this stage is not included.

Secondly, the value of the property should be the current market value of a property you intend to buy or hold in your portfolio. It is not a fantasy figure you have about what a property could achieve, but what other similar properties are achieving in the prevailing market.

Anyone who has met me knows that, within a few minutes and regardless of the situation, I would have mentioned the word yield probably 5 times or more. This makes me extremely dull company, I know. However, it is refreshing (for someone as dull as me anyway) to hear more and more investors discussing yield and the resultant cash flow more frequently now when discussing property. For some reason we forgot this in the years of booming capital values⁵.

Every investment made has an associated risk (more in Chapter 6) and will also require some work for which you should be rewarded as an investor. Property investment is no different. Indeed, investing in property is very "hands-on" in terms of tenant and property management and the investment is very illiquid. That is to say you cannot cash your chips in on a profit as easily as you can, say on the stock market. So what should this reward be? Well clearly, depending on the type of investor you are, the rewards you seek will be higher the more that you require a monthly cash flow to support your lifestyle. It is therefore logical that the higher rewards are made for the investor taking higher risk.

At the very lowest level of risk, large investors and funds purchase commercial property to provide a level of return on their cash holdings. A widely-held approach is that the level of reward here is around 2% above the prevailing 10-year bond rate issued by their government. That is to say, as opposed to buying safe government bonds, commercial property of a good standard is attractive once a 2% reward is in place to cover the more intensive and riskier ownership of property. So, as I write this page, government bonds issued by the US, UK and EU governments stand at around 3%. Therefore, an investor in commercial property could take a position in a project when yields reach or exceed 5%. Commercial property of less than premium quality would perhaps require a corresponding increased yield.

Due diligence into the project would reveal the risk level and the "fair value" reward required.

5 Actually, the reason is extremely well-laid out in 'The Property Clock by Ajay Ahuja ' – a must read.

So, in figures, a £1 Million AAA-quality commercial investment might stack up if:

Annual Rental Income Generated

Value of Property

£50,000 £ 1,000,000 Yield = 5%

What about residential investment? The cold view of the commercial investor is widely used in some residential markets around the world where owner-occupation level is historically low. However, it is has not been used so widely where competition exists from owner-occupiers where the hunt for a home rather than a return on investment is the objective.

I would make an estimate as a Yield to Break-Even Point (YBEP) for residential investment, funded by finance as follows:

Unfurnished Property = Finance pay rate +2% Furnished Property = Finance pay rate +3% Houses for sharers / students = Finance pay rate +4%

This loading makes account for void periods and costs associated with ownership (including property tax and letting agent fees but not income tax).

The figures are based on the actual holding of my own in UK and Europe since 1993 and the holding of fellow investors, to provide a guide. Current investors may work off slightly different figures, as may holders of varying types of commercial property.

With finance pay rates for investment finance averaging around 5% over the last 5 years this would mean a YBEP for the respective properties:

Unfurnished Property = 7% Furnished Property = 8% Houses for sharers / students = 9%

Now, the above is only a guide but it has served me well as a basis for my investment decisions in the last 5 or so years and will continue to do so. So, what does it mean to you as an investor?

EVERYTHING

Going back to chapter 2, we examined what kind of investor you were and what returns you seek as a consequence. So, let's look at that list with this in mind. For those that require some level of income from the investment from rentals, the yields achieved will need a margin above the YBEPs before. For those holding property for reasons other that creating an income, the levels above may be sufficient and would generally result in the purchase of less "risky" properties, other factors being equal. Lets look at couple of investor types:

Finding the Deals

If you have spent any time looking for deals with yield to the higher levels discussed, you will know that it is hard work. This is the work that determines the success you will make as an investor. A quick search of your local market will probably provide an abundance of potential investments, most of them around plus or minus 2% the prevailing finance rate. For example, I have just been on the net this week and found an offer near to a property I own in Grantham so I know the area well. It is a brand new 3-bed house with garage offered at £109,000. It will rent for £500 pcm. I have been offered the property for £95,000 for a swift completion, based on one phone call, such is the market. The same houses were £150,000 24 months ago so sounds like a good deal. Perhaps it is for long-term capital growth as you could take a view that it must return, at some point to its 2007 price level. However, let's analyse it quickly in terms of rental income. Will it bring money into my pocket or remove it?

Annual Rental Income Generated

Value of Property

£6000 £109,000 Yield = 5.5%

Current finance rates, if you can get it, are around 5.5% on an investment product so the YBEP for an unfurnished let would be 7.5%. This is typical of deals available in the market when supply and demand is in equilibrium or supply exceeds demand. The YBEP is reached, if that. This house will need to be £60,000, and ready finance in place, before it becomes viable. This is unlikely to occur.

And this is the point. In a market that is in equilibrium or that has excess demand over supply, it is unlikely we will find property that provides the "yield reward" we seek over the YBEP. So when is the best time to buy? When supply exceeds demand, as in the Grantham case above, we may get closer to YBEP and may even beat it but it is likely due to market principles that capital values are falling. The capital losses, in the short term, will dwarf rental income.

The time to arrive in the market therefore, with your superman cape on, is when a flat period occurs over capital values have dropped and the rental incomes (due to wage increases) have recovered to a point where the yield reward is in place. This condition does occur but it lasts a relatively short period of time, particularly when banks recover their confidence to lend again to a good level.

On the next page is a graph showing the yield reward first for a typical 2-bed unfurnished rental property property in the south east of England and second for a 1-bed furnished property in north east Scotland between 1990 – 2011 Q1. I have chosen these areas because my investment history was in these areas and data is readily available from governmental websites.

For me, this graph tells the whole story. Let me repeat that! This graph captures perhaps all my thinking on property investment in terms of when and what to buy. There is nothing else, that's why I keep looking at this graph, or graphs based on other locations, nearly every day. So what do we see? First for south east England, the results show that the purchaser buying using the Yield Reward criteria would have been very busy around 1995-96 and could have been tempted back into the market around 2002-2003, seeing rewards above 2% at these times. I remember back in 1996 that yields of 12% were quite common, even in London which seems remarkable when considered today.

The market was quite different for Scotland with yield rewards above 3% (for a furnished property) from 1996 – 2004, with spectacular rewards of around 7% between 2000 – 2004. Buying at these times would have ensured a steady cash flow was achieved and is still being achieved from the properties.

From a capital gain perspective, it is interesting to note that times good for the Yield Reward investor these were also times when capital values saw steady increases or were just about to experience strong growth. This is unsurprising when we consider the interest that investors would have, regardless of owner-occupier sentiment, at the times of high Yield Reward. This interest from investors when Yield Rewards are high (often at a time of low owner occupier confidence in the market) provides a floor to values and provides an additional demand element.

From my own perspective, I look at these 2 graphs with interest at my own investment history. My first property I purchased (my own home) was in 1990 in SE England. These were woeful times and I fell into negative equity, coinciding with the point on the graph when yield reward was below zero. I became an accidental landlord in 1993 and after a year or so found myself making money from the rental of that property all the way to when it was sold in 2000. I enjoyed capital growth of around 100% during this period of high Yield Reward. In Scotland, I was perhaps late to the "Yield Reward" party, entering in 2002. I purchased using the idea of Yield Reward right up to 2006 when deals became harder to find. Again, this was a time of high capital growth and the properties have all been cash flow positive every month that they have been owned.

Looking at the graphs, it is also interesting to see what happened to investors buying at times below the Yield Reward criteria. For example, 2006-2007 were years when the Yield Rewards were near or below zero in both markets. The Yield Reward investor would have missed out on some spectacular capital growth during these periods, as values soared by owner-occupiers with ready finance taking the market to unbelievable levels. However, we are now seeing a correction in this market with all these gains being lost. For the speculator, timing is everything and money can be made when lady luck is on your side. For the Yield Reward investor, a steady cashflow is ensured every month and the points when property is purchased is rarely when values are about to collapse. These ideas can be applied to any property market around the world when carrying out your analysis.

And now a very painful confession. I have strayed from the "Yield Reward" path only twice in my investment history, both times when greed and expectation of capital growth took over. The first time was in 2006 when a property in Berlin caught my eye. A 1 bedroom property in the centre of a capital city for 30.000 Euro seemed too good to be true – surely it must go up in value! Buying with a yield reward of only 1% was not so clever and the property has not gone up in value significantly and taken money out of my pocket every month since I owned it. The really embarrassing one was a purchase of a new build flat in August 2007, just before Northern Rock collapsed and speculation was rife. Again, the Yield Reward was a whole 0% and the property has gone down in value from the day I bought it, around £25,000 as we sit here today in October 2010, if I could find a buyer at all. I will learn from these mistakes, I hope. Why don't you pick up the lesson for free?

We spoke in Chapter 3 about locating property. In the appendicies to this book, I will examine particular markets to discover where in the world the yield rewards can be found for a range of investors today.

One further method to analyse the market you are researching is to look at affordability, either from a buyer or tenant perspective. Should the rent levels be cheap compared to wages then this is a possible indicator that rents have some upward pressure, other factors being equal. Different marketplaces and tenants will bear a higher proportion of their take home pay going towards their housing costs than others. For example, tenants in London can pay up to 50% of their take-home-pay towards their rent and associated costs. In Berlin, 25% is more typical. But it is the comparison of this figure over time that will reveal any latent upward [or indeed downward] pressure in rents. A similar affordability index can be researched for owner occupiers, ie how much does their housing costs soak up of their net income. An interesting feature will be if you discover that owning a property is far cheaper than renting, as this reveals latent demand for owner occupation [just another way of stating yield reward].

Finally, a measure to reveal any potential pressure in capital values is to look at the House price to Earnings ratio. Below is a graph showing this index over the past 30 years.

It is clear, from the graph above showing average house values, that purchasing at any point when the index was far below trend was not such a bad idea.

Closing the Deals

Just a short note here, on the topic of negotiation. There are lots of good books that cover this topic to a far greater level than I could dare. However, I am going to look at a particular aspect of negotiating in a "hotspot" for a yield investor.

Let's say we have found an area abundant in property that meets our objectives. It is likely that, particularly for the higher yield deals, you are early in the market and fully welcomed by estate agents and sellers alike. As the market develops, other investors (and owner-occupiers) will join you and demand increase. So, what should your approach to negotiation be?

My experience with many investors is that "a deal must must done" i.e. some mark off the asking price must be achieved, regardless of conditions. The approach in a Moroccan Bazaar if you like. This could be a valuable approach, particularly if you are truly alone in a market or seeking only a limited amount of property. But as demand increases, this approach may have a disastrous effect.

So a story:

When I was purchasing in Aberdeen, Scotland I was fairly lonely in the market with the only real competition from owner-occupiers in the better residential areas. Prices for the 1-bed flats we sought ranged £20,000-£30,000. Our early deals were closed very successfully and we achieved a few thousand off the asking price in each case, applying 'Moroccan Principles'. It felt good, even though purchasing at the asking price we still generated in excess of the 12% yield we sought. But after 6 months we started losing deals and this lost us time in the developing market. Quickly, we changed tack to paying what the owner wanted or even slightly more to secure the deal. To the owner, it was great as they still remembered the bad times of the last 5 years of falling or stagnant prices. To us we still achieved 12% yield and were growing. To the estate agents, well they loved us as they knew we were good for the money and paid 'top dollar'.

Now the point is, I knew a band of investors that came in and were doing just the same as I was and who can blame them. However, they seemed to be fixated on "doing a deal" and shaving a few pounds off where they could. The result is that I beat them nearly every time in securing property in the developing market and grew very quickly at a rate of one purchase every 3-4 weeks, my maximum really as I had a full-time job at the time. They, on the over hand had a very frustrating time losing deal after deal to me or owner-occupiers and picked up only the poorest quality property that no-one wanted.

I sometimes pull the sales expose which I keep out of my filing cabinet to look back at what happened. At the peak of activity, a typical deal for £30,000 I may have paid £32,000 (rent for £325 so don't cry). Fellow investors found this to be foolhardy at the time. However, with the benefit of perspective, these properties peaked in value in 2007/08 at around £105,000. The deciding success factor was not if you could save a few pounds at the point of purchase but how many properties you could secure while the market fitted the yield objective. The investors I consider to have lost ended up with poor-quality properties which are hard to fill and they continued to purchase as the market moved up and away from them and overpaid. A useful lesson if you are looking to purchase multiple properties over a time frame that includes an increase in market activity.

Activity 4

Determining Yield Reward is an interesting exercise to carry out for a market you know well (perhaps in your area) or a market you are researching. You need to know finance rates, rent levels and property prices for a given year, that's all. If this data is not to hand, the data for property in today's market is easy to find and should help you make investment decisions. So, find out some typical Yield Rewards in your area over a given time and some Yield Rewards (today) for an area you are researching. The results could be surprising.

Next Chapter - What to buy and from whom