To measure how successful your business is, it’s important to be able to calculate the profit of your buy-to-let portfolio.
This guide will help you calculate four different figures. Each will help you make different comparisons across your portfolio and determine your return on investment.
A simple figure investors use to make snap comparisons between properties is the gross yield. Gross yield is the annual return on investment before expenses. You calculate it by dividing the annual rent by the value of the property.
Example: A property worth £200,000 fetches £750 rent per month. This equates to £9,000 per year.
9,000 ÷ 200,000 = 0.045
Thus, this property’s gross yield is 4.5%.
Research that compares rental yields between two or more areas often uses gross yield figures. Property investment companies also tend to use gross yields in their advertising, as these figures are the most attractive.
Gross yields are useful for making quick assessments, but not for determining how profitable an investment is. A more suitable figure for this is the net yield, which takes into account expenses, finance costs and tax.
Example: The above property is subject to a buy-to-let mortgage of £100,000. The mortgage costs £3,000 per year to service.
Ongoing expenses include repairs, rental arrears, service fees, running costs and voids. Total expenses will depend upon the age and size of the property, the local market, and the services you use. Experts recommend setting aside up to 35% of gross annual income for such expenses.
Finally, rental income gives rise to an income tax liability. Let’s assume that the tax rate is 20% in this case. After deducting allowable expenses, the total tax due is £450.
£3,000 plus £3,150 in expenses plus £450 tax comes to £6,600. Net cash flow is therefore £2,400.
2,400 ÷ 200,000 = 0.012
The property’s net yield is 1.2%.
A net yield of 1.2% may seem small, but income is not the only reason to invest in property. Long-term capital growth is what makes buy to let such a strong investment.
The real yield accounts for capital appreciation or depreciation in the time that you have owned your property. You calculate it by adding the annual change in value, as a percentage of the original value, to your net yield figure.
Example: The property above was bought five years ago for £160,000. This equates to a £40,000 gain, £8,000 per year.
8,000 ÷ 160,000 = 0.05
Added to the net yield, this figure gives a total ‘real yield’ of 5.9%.
It is important to take everything into account when calculating profit. Doing this will help you determine which of your properties are performing better than others.
Capital growth is not the same as cash flow. Because it is tied up in equity, it won’t be realised until you sell your property.
For this reason, you may wish to account for inflation in your calculations. This will help you determine the value of your property in real terms at the time of purchase.
First, you need to determine the retail price index (RPI) for the two years you wish to compare. (RPI is a better metric because it includes the cost of housing.) RPI data is available at the Office for National Statistics (ONS) website.
You then use the following formula to determine the percentage by which prices have changed in that time:
x ÷ y − 1
(Where ‘x’ is the most recent index and ‘y’ is the older index.)
Example: The RPI index for this year is 260, and the index five years ago was 235.
260 ÷ 235 − 1 ≈ 0.106
This means that retail prices have inflated by approximately 10.6% in the past five years. To determine the real value of something bought five years ago, you multiply it by the sum of this figure (0.106) and one.
160,000 × 1.106 = 176,960
This means the value of the property in today’s money is £176,960. Thus, the real gain is £23,040. This equates to an annual return on the original purchase price (£160,000) of approximately 2.9%, making the inflation-adjusted real yield 3.8%.
You might wish to determine the return you have achieved on the total capital you have invested so far. This will give you a snapshot of how a property is performing at a given moment in time.
As with net yield, you must first work out your annual cash flow. You then calculate your total capital expenditure so far. Using the above example, making the simple assumption that costs have remained level over fifteen years, this would be:
- £54,000 in mortgage payments
- £47,250 in running costs
- £6,750 in tax
- the £40,000 mortgage deposit and any other transaction costs, such as mortgage fees and stamp duty
Example: An property generates £2,400 cash flow per year. Its owner has invested £115,000 capital in it in total.
2,400 ÷ 115,000 ≈ 0.021
The yield to date from cash flow alone is 2.1%. Adding the inflation-adjusted annual capital growth from the example above, we arrive at the true rate of return: 4.0%. This is a healthy annual profit, and shows that the investment is on track.