Investment Example

•  Financing
•  Interest Rates 
•  Exchange Rate Risk 
•  Rental Income 
•  Vacant Periods - ‘Voids’ 
•  Buying and Selling Costs 
•  Sample Calculations 
  
  

There are a number of factors that you should consider when calculating the possible yield of a property investment. These are described in the following:

Financing

Because of the possibility of financing most of the purchase with a mortgage, even a modest increase in the value of the property will return a significant yield on the equity invested. If you assume that the rent covers exactly 100% of the total costs of owning the property, a property with 75% financing will thus return a yield on equity of four times the annual increase in the property values. This is because the equity invested only accounts for 25% of the property value while 75% of the value has been covered with a mortgage. If the property value thus increases by 8% in a year, the return on equity would be 32%.

Interest Rates

Another important factor is the level of interest rates. The question is here whether the current interest rates will be maintained. However, it is possible – if you expect interest rates to rise – to choose a fixed interest rate mortgage that will lock the interest rate at the current level for up to five years (followed by variable interest). This is only slightly more expensive that a mortgage with variable interest from the outset. You can thus lock in the interest at a relatively low level for those years where the outstanding mortgage is at its highest level in terms of outstanding repayments.

Exchange Rate Risk

There is no exchange risk in connection with the mortgaging of the property. The mortgage is denominated in Pound Sterling and an increase in the value of the Pound against your local currency will thus not only lead to an increase in the value of the mortgage (to your disadvantage), but also to an increase in the value of the property (to your advantage). Conversely, a decline in the value of the Pound against your local currency will mean a decrease in the value of the mortgage (to your advantage) and a decrease in the value of the property (to your disadvantage).

Only the net equity in the property may thus be influenced by exchange rate fluctuations.

Rental Income

For calculation purposes, we currently expect that the rental income will cover 80% of mortgage payments and operating costs in Year 1 and that it will rise gradually to exceed 100% in Year 10.   

If taking out an interest-only mortgage, the rental income should fully cover both mortgage interest and operating costs already from Year 1.

Vacant Periods - ‘Voids’

An additional factor is the possible waiting time in connection with the search and selection of new tenants and/or the time needed for major repairs or improvements to the property. This can be anything from no months per year (if the tenant extends his tenancy) to, for instance, three months per year (if a new tenant must be found and the rent demanded by the owner is relatively high). It is obviously important to minimise the vacant periods since no rent will be earned when the property stands empty.

In the calculation below a provision for vacant periods has been included in the amount under the heading ‘Other Expenses”.

Buying and Selling Costs

Finally, it is necessary to take Buying and Selling Costs into account. In the calculations below, the Buying Costs have been distributed evenly over the chosen ownership period of 25 years under the heading ‘Other Costs’.

The Selling Costs depend in part upon the value of the property at the time of sale.

Sample Calculations

Below are shown two sample calculations for a typical property where the above factors have been taken into consideration. Currently, it may be possible to achieve lower financing costs than shown below. However, we have used an average mortgage rate of 6% in our calculations as we prefer to estimate conservatively. For comparison, the Association of Residential Letting Agents (ARLA) is currently using 5.50% p.a. as their calculation basis (Source: themovechannel.com, 1st October 2003).

The calculations are based on the following premises:

• Rents rise with inflation

• Other costs rise with inflation

• The parameter percentages are the effective annual rates that are achieved over the full calculation period of 25 years

The first example operates with an annual property appreciation of 4%:

Sample Calculation for Investment in a British Residential Property
(all amounts in £)

This can be illustrated as follows:

In case the annual property appreciation reaches 8%, the calculation will look as follows:

Sample Calculation for Investment in a British Residential Property
(all amounts in £)

The British property market rose by some 25-30% in 2002 (depending upon the index used). At a rise of 27% and with financing of 75% of the property value, the investment would have given a return of 108% on equity in 2002 alone, provided that the financing and operating costs of the property were fully covered by the rent.

It is, of course, unlikely that prices will rise steadily by 27% per year over the next 25 years. However, it is worth noting that British property prices actually increased 26-fold in the period 1969-2002   (See Factors). A high return on equity is thus a very real possibility.

And extended spreadsheet can be downloaded from here so that you may experiment with the consequences of different economic scenarios and price rises. Sheet 2 of the spreadsheet uses the same structure as the above calculations whereas Sheet 1 contains a number of additional calculations.

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