FOOL'S EYE VIEW

How To Become A Landlord

By Neil Faulkner (TMFVertigo)
April 13, 2006

There's more than one way to invest in residential property, but in this article I'm going to focus on buy-to-let investing using an interest-only mortgage. Even with this narrow scope it's a big subject, so I'm going to consider just three questions:

• What sort of money can you expect to make?
• Who should buy to let?
• When should you buy to let?

I thought about answering these questions through the medium of dance. However, on reflection, I suspect the medium of maths may be appropriate -- it's not as succinct and accurate as dance of course, but it's probably less painful to see.

What sort of money can you expect to make?

There's quite a lot to consider here, so I'm going to break down the gains and costs.

Rental income

Let's assume you have a typical first year as a buy-to-let landlord. In this example, you buy your first property valued at £250,000. You decide to get a 25-year interest-only mortgage and you pay a deposit of 25%, i.e. £62,500. You also pay the purchase costs (legal fees, stamp duty etc) which come to, say, £5,000 (2%). The outstanding loan is £187,500.

You charge rent at £1058.33 per month, so a year's rent is £12,700. This is a gross annual rent of 5.08% of the purchase price, which is coincidentally exactly what ARLA, the Association of Residential Letting Agents, reckons is the national average.

However, for 27 days of the year, you had no tenant. (ARLA reckons that's typical too.) So we need to deduct about £940 in 'void' rent, making a total of £11,760.

All this time you've been paying the interest on your mortgage at 6.5%, which is £1,015.66 per month or £12,188 per year. You deduct this from your rental income of £11,760 and find that you've made a staggering property investment fortune of...wait a minute...minus £428! That can't be good.

Capital appreciation and rental income inflation

Buying a property isn't just about rental income. We must also consider the (hopefully) increasing value of the property, or the 'capital appreciation'. The average annual increase in property prices over the twenty years to 2004 was 8.8% (ARLA again). Property prices have had a good run in recent years though, so let's assume we'll see annual gains of 4% for the purposes of this example.

Also, although you're still paying hefty mortgage payments, you're (hopefully) going to charge your tenant more each year. Let's say you're able to get away with increasing their rent by 2% a year. Look at the maths now over a five-year period:

At end of year	Net rental income after voids and interest £	Value of the property £	Cumulative net gain in property value £
0	0	250,000	N/a
1	(428)	260,000	10,000
2	(174)	270,400	20,400
3	85	282,216	32,216
4	349	292,465	42,465
5	619	304,163	54,163

Your rent situation is somewhat better at plus £619 in year five, but the juicy bit is the capital gains. Your capital has gone up 87% to £117,113 (£62,500 deposit plus £54,163 property price increase). That's an average annual gain of just over 13%.

Other costs

Hold your horses though! I haven't yet covered the other costs involved in being a landlord. If I included all the costs in my example above, I would have made so many assumptions that it would be meaningless. These can vary enormously depending on the property, how 'hands on' you are as a landlord and so on.

So, basketfuls of pinches of salt at the ready, here are some other costs to consider:

• Letting fees -- if you pay someone to manage your property, they typically charge 15% of your rental income.
• Household insurance -- a few hundred pounds.
• Repairs and maintenance, including cleaning, wear and tear and replacement furniture -- a few hundred to a few thousand pounds a year.
• And, after interest payments and reasonable expenses, on what's left of your rental income, you have to pay income tax at your highest rate.

The sale

At the end of year five you decide to cash in. There are more legal costs and potentially capital gains tax as well, which could snaffle up to 40% of the profits you make.

I'm lost, what have we learned? Is this good or bad? What are you saying, Fool?

Bear in mind that this is just a simplistic example. But your initial gain of £54,000+ could be tempered by tax of, say, around £18,000 and other costs of, say, £10,000. So your net gain would come down to £26,000 over five years, an increase of around 40% on your original investment of £62,500. Of course, change any of the assumptions, particularly the rate at which house prices increase (they may not and could even fall) and the end result will be radically different.

Who should buy to let?

We know that house prices, like shares, have gone up in value over time and that helps me answer my second question: who should buy to let? The answer is people who are in it for the long haul, obviously. You must also have the spare cash to cover poor rental returns, lengthy void periods and other costs. I don't think this is for people who expect a good rental income, at least not initially.

On a related point, you'll probably want to build up a portfolio of several properties over time -- this will spread your risk.

When should you buy to let?

That's almost like asking, "Which way is the market going to go?" No-one knows the answer to this, not even the governor of the Bank of England. But if you can buy and hold, and wait out poor periods, it looks very promising that prices will head the right way over time. Aim to buy low and sell high.

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