Calculating the return on investment (ROI) for your investment properties

With any investment it is important to understand what your return on investment (ROI) actually is. As this is the only way to accurately decide on the benefits or value of the vehicle when comparing it to alternatives. For example, a deposit account in the bank that pays an annual rate of 12% once a year is very different to an account that pays an annual rate of 12% on a monthly basis. For investment properties the key to calculating your ROI is understanding what the capital investment is and what the costs are.

Many estate agents advertise investment properties with an ROI based on the annualised amount of rental income divided by the purchase price of the property.

E.g. Purchase price £100,000; Rental income £1,000 per month = £12,000 / £100,000 = 12% ROI

Now this would be true if the following is true:
Your only expense is buying the property
You buy it for cash
You have a rental income for 12 months of the year
The reality is that all three of these is rarely the case when buying an investment property, plus there are some excellent benefits in using mortgages to purchase properties which we will cover a little later.

Capital Investment – Costs to buy

Costs involved with an investment property come in two forms: 1. Costs to buy & 2. Ongoing costs. The costs to buy the property should be included in the capital investment. The capital investment is how much actual cash did you put into the deal in order to be the owner of the property on day one. This figure should include: the deposit, solicitors fees, estate agent fees, loan arrangement fees and any other one off payments incurred such as improvements and furnishing that are purchased.

Ongoing Costs

Owning the property is the first step, renting out the property will now incur additional costs. These figures need to be calculated and estimated in order to work out the ROI. The obvious costs that are ongoing that most people remember to take into account are: mortgage payments, management fees, property taxes. However, marketing the property, utilities, insurance and repairs are often miss-calculated or forgotten when determining the ROI and whether to purchase or not. In addition a non-rental month is an effective cost as the loss of income has a detrimental effect on the ROI. This can and should be allowed for in the estimate of monthly rental per year (see below).

So for ease let’s run through a hypothetical example:

Purchase Price: £100,000
Rental Potential: £1,000 per month (£12,000 pa fully loaded)
Legal Fees: £1,500
Loan arrangement fees: £1,000
Deposit Required: £20,000
Loan Obtained: £80,000 @ 7% pa interest only = £466.67pm (£5,600 pa)
Management Fee & Marketing: 10% of rental (£100pm or £1,200pa)
Property Taxes & Utilities & Insurance: passed to the tenant (£200 per month when empty)

From the above we can calculate the following:

Based on various occupancy rates starting at 9 months.

 

 

Capital Investment: Deposit: £20,000 Fees: £2,500 Total = £22,500	Costs: Interest: £5,600 Management: £1,200 Fees when empty: £200 per empty month Total = £6,800 + empty fees
@9months rental Income: £12,000 x 75% = £9,000	ROI = (£9,000 - £7,400)/£22,500 = 7%
@10months rental Income: £10,000	ROI = (£10,000 - £7,200)/22,500 = 12.45%
@11months rental Income: £11,000	ROI = (£11,000 - £7,000)/22,500 = 17.77%
@12months rental Income: £12,000	ROI = (£12,000 - £6,800)/22,500 = 23%

As you can see from the example above, using all the figures involved and dependent on the number of months rent the ROI is very different from the Estate Agent’s claim of 12% (£12,000 / £100,000).

Financing the purchase

The above example is based on having a loan to purchase the property of 80%. This actually improves the return on investment as the amount of capital needed is much lower and therefore the income has a bigger impact. Of course one also has to note that 8 months of rent is required as a minimum to service the loan, any less than this and the investment is now becoming a debt. So one needs to be confident that the property is easy to let out and the inner pages of this site covers many of the aspects one needs to look into when picking a property for its rentability.

Note: Without a loan the ROI on the above 4 scenarios would be: 7.2%; 8.4%; 9.4%; 10.6%

So you can see that if the expectation is 9 months or less on the rental taking a loan is not a wise choice, but the ROI is significantly higher if you can achieve 11 or 12 months of rental income.

Another aspect of using a loan is that it allows more people into the market to buy a single property as an investment. Although for the serious investor, consider this. If you were holding £100,000 are you better buying 1 property un-encumbered or to buy 5 properties with loans attached. From the above example 5 fully loaded properties would start to produce a serious living income from the investments – but that is for another discussion.