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Forget buy-to-let. I’d rather collect 10%+ from this FTSE 250 dividend stock

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Models of houses on top of pound coins
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According to research published last year, buy-to-let rental yields in London ranged from 4.8% down to just 1.9%, based on current house prices.

Things were better outside the capital, but credit specialists Totally Money could only find 10 postcode areas in the UK with rental yields above 8%.

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For new landlords, I believe that real returns are likely to be very much lower than this. Totally Money’s theoretical yields were calculated ‘gross’, by comparing rents with property prices. They didn’t include the cost of mortgage interest, repairs, insurance, or empty periods between tenants.

In my opinion, anyone buying a house to rent today will be lucky to make more than 5% per year. I think there are much better options elsewhere.

How to earn 10% from housing

FTSE 250 group Galliford Try (LSE: GFRD) is an unusual mix of construction firm and house-builder. Shares in this hybrid firm have dipped by about 45% over the last two years, as the company has fallen dramatically out of favour.

This collapse is partly due to general concerns about the outlook for the construction and housing sectors. But Galliford’s slump has been made worse by some company-specific problems which followed the failure of Carillion.

As a result, Galliford shares now trade on just 5.3 times 2019 forecast earnings and offer a 10% dividend yield.

This must be too risky?

You might think that this extreme valuation is a sign of problems ahead. Normally, I would agree with you. But in this case I think the market sell-off has probably gone too far. The shares appear to be priced for a disaster, but there’s no sign of this at the moment.

The group has recently won two major road-building contracts which form part of an £8bn framework awarded by Highways England. Meanwhile, the performance of its house-building division, Linden Homes, is said to have been in line with expectations in 2018.

Other house-builders are also reporting stable performances with a strong outlook. In my view, Galliford’s 10% dividend yield could make the stock a more profitable investment than buy-to-let at the moment.

Another way to profit from buy-to-let

If you own one or two buy-to-let properties, your risks are highly concentrated. One-off costs like boiler repairs or new kitchen appliances can put a big dent in your rental income.

An alternative way to invest in the rental sector is through Paragon Banking Group (LSE: PAG). This lender specialises in buy-to-let mortgages, which accounted for 72% of new lending during the final three months of 2018.

Paragon’s performance has been consistent and profitable in recent years. The firm’s return on tangible equity — a key measure of banking profitability — rose to 16.1% last year, while underlying pre-tax profit rose by 7.8% to £156.5m.

One attraction is that the group is able to fund an increasing amount of its lending using customer deposits made into its savings bank. Deposits are generally much cheaper than any form of borrowing for a mortgage lender, so by doing this Paragon can remain competitive and enjoy decent profit margins.

This lender has been in business since 1985, so it’s survived several boom and bust cycles already. This gives me confidence in the long-term outlook for the business. With a well-covered dividend yield of 5.2%, this is a stock I’d consider buying.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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