Understanding Rental Yield and Capital Growth

Get it right and becoming a Landlord can be a very rewarding and even addictive career. Ideally you'll be looking for a property that will give you a good return on the rental yield coupled with a steady rate of capital growth. So it's essential to do your homework.

Consider what type of property you would like to purchase, remember leasehold properties have added annual costs! What type of tenant? Professional or student? Location and age of property are also important factors too. A student property is no good if miles from the heart of the action. And an aging property will undoubtedly bring maintenance headaches and expense with it.

Understanding Rental Yield

Simply put, Rental Yield is the result of the following calculation:

(Annual Rent / Purchase Price) x 100

Throughtout this article we'll use an example property and rent. We'll say the property has a purchase price of £150,000 with an annualised rent of £9,000 (£750 per calendar month). Using the above calculation, the rent divided by the purchase price is 0.06. When multiplied by 100 for easier reading, we've a rental yield figure of 6%. Be mindful of the fact that this represents the gross rental yield; there are other expenses to factor in.

Ground Rent, Maintenance and Services Charges

If you are buying a leasehold property, you will undoubtedly end up paying these charges and they will remain your responsibility during the letting of the property. If you're fortunate to purchase a leasehold property with a part share of the building freehold you may find these costs to be minimal and you'll have a say in how the future costs should be set. Whether you gain a share of the freehold or not, there's unfortunately no hard and fast rule for what these costs should be. So do check carefully, when discussing the property with the Estate Agent or Vendor. Do note that on some developments maintenance and service charges may apply for freehold properties. Such as Avro Court in Hamble. Check with your Estate Agent to be sure.

Maintenance and Wear & Tear

Like our cars, properties need to be maintained too. With a car we're legally required to maintain the vehicle in a roadworthy condition if we wish to drive on a public highway. Similarly Landlords have a legal responsibility to ensure the safety and well-being of their Tenants. So those little odd-jobs around your own home might not be so easily overlooked in a rental property. But safety aside, it shouldn't be forgotten that the property is an investment. Care taken now will reap a greater benefit in the longrun and should help you gain higher rents along that journey.

Depending on the age and build of your property, we'd advise you to allow 10-15% of the rent per annum for essential repairs and preventative maintenance. Depending on wear, you may need to redecorate every three to four years. And at some point those carpets will wear out too.

Contents & Building Insurance

Depending on the level of furnishing, allow 3-6% per annum for your building and contents cover.

Void or Empty Periods

You must allow for void periods during the rental year. There are natural cycles in the rental calendar where market activity greatly reduces, such as just before Christmas. Most Landlords will calculate for a total of one empty month. If personal cash flow is tight, you might consider allowing for up to two months.

Letting Agents Fees

If you're using the services of a letting agent, either to find you a tenant or to find and manage your tenant, fees will become payable. There are as many fee scales as there are agents. For the example we'll use our own fees and assume the property will be managed.

We charge 1/2 month to find a tenant, plus 5% of the annual rent (paid in monthly installments) + VAT. So a £750 managed let will attract charges of £825 + VAT over the year which includes free tenancy agreement, free deposit registration, and free renewal negotiations.

Which brings us to Net Yield

So back then to our example. We've established a gross yield of 6%. Now let's factor in the costs above. We'll assume this is a leasehold property and for the purpose of the example, we've charges of £1,400 for ground rent, maintenance and service charges (GRMSC) over the course of the year, we're making an allowance of 12% for wear and tear/maintenance, 4% for insurance, agents fees of £825 + VAT (£990) and allowing for a void of one month per annum.

This gives us a calculation of:

(Annual Rent / (Property Price + GRMSC + Wear & Tear + Insurance + Rental Void + Agency Fees)) x 100

Using the above calculation and the cost estimates indicated in our example, we've a net yield of 5.82%. Of course there are other costs that you could factor in depending on your circumstance. Such as mortgage payments.

The Importance of Capital Growth

Also referred to sometimes as Capital Appreciation, capital growth is the appreciation in value between present day and the original purchase date of the property. This is really important to take into consideration as you may find that you are financially supporting the rental property at some point. In short, choosing a property in an area more likely to increase than fall in value could make all the difference to your financial survival as a Landlord.

Returning to our example £150,000 property. Let's assume we put down a 15% deposit when purchasing the property. We're left with a loan amount of £127,500. We'll say that we're repaying over 25 years at an interest only mortgage rate of 5.5%.

Our monthly mortgage interest payments would be £584.37. Coupled together with the monthly expense calculations used to establish the net yield above, our monthly spend estimate would be £952.29, leaving a shortfall of £202.29 to find each month. That's where capital growth comes in.

Now let's assume our £150,000 property increases in value at an average compounded growth rate of 2.5% per annum. After 25 years our property would have a value of £271,309.

If our non-mortgage related monthly expenses increased, say by 4% per annum, after 25 years we'd have spent £341,726 when taking into account the mortgage interest payments, non-mortgage expenses, the initial 15% deposit of £22,500 needed to obtain the mortgage, the £1,500 stamp duty and estimated £1,000 legal expenses accrued when buying the property.

However, with a 3% rent increase each year, we would have received £328,133 in rental income over the same period. Add this to the future value of the property, subtract the outgoings and repay the £127,500 mortgage capital, and we'd have a pre-tax profit of £130,216. Possibly more, maybe a little less depending on the number of repairs we had to do along the way.

That's the value of capital growth. Of course, property values, mortgage rates, and rents can move both up and down, so sound financial advice must be obtained before you part with a penny. We're not qualified to give such advice but can put you in touch with a great team if you'd like to explore matters further.

Naturally, if there's a property that you have in mind, we're more than happy to have a look at it for you and assess it's rental potential. Feel free to ask.

More Practical Matters

There are of course many other matters that should be taken into consideration. Being a Landlord is not only about making you money, you've legal responsibilities where the welfare of the tenant and upkeep of the property are concerned.

We've compiled a really useful section on this website, your legal obligations, full of useful pointers and further information.

Click here to view Your Legal Obligations