In order to understand the commercial viability of a property investment, it is important to understand not just the numbers but the nuances of what those numbers represent. There are plenty of deals out there that look fantastic on the surface but delving a little deeper exposes frailty.
Your property investments should be treated as a business, so even though you may seek the advice of experts, you need to carry out your due diligence with the same rigour as if you were about to present the deal to the Dragons Den.
There are lots of different figures bandied about, so I am going to concentrate on just four key numbers; namely below market value (BMV), cashflow, yield and return on investment (ROI). For each one, you need to understand how it is calculated, what it represents and why that is important.
To be able to calculate how much below market value a property is being sold for you first need to calculate the market value; that should be self-explanatory, it is the value of the property right? OK, so is that what the vendor or agent is telling you? Is it based on 2-year-old comparables adjusted for market inflation or the figure that bloke Dave gave you when you met in the street whilst assessing the condition of the roof? An economist will tell you that the value of something is what a buyer is willing to pay for it, but that isn’t particularly helpful either.
So, if you are new to an area the best way to value a property is by using all the figures you can gather (except for Dave’s) and applying some emotionally detached and objective common sense. The big but here is that you need to, as far as possible compare like with like so factor in the condition of the property as far as possible. Do not compare the price of a run-down repossession with that of a well-maintained family home two doors down.
The BMV is calculated by simply working out the discount over the market value, so a house sold for £90,000 that could be sold for £100,000 on the open market is 10% BMV. Why would anyone sell BMV? That is for another time but suffice to say the vendor is more motivated by the speed and certainty of the sale than the sale price.
Why is BMV important? Well firstly it gives you instant equity in the property, so you are now a proper investor. Maybe more importantly, it reduces your risk. So, for instance, if there is a change in circumstances with the house, personally, financially, in legislation or any other factor, you have an exit strategy even if prices have dropped slightly. If you are managing risk, you are now properly in business.
BMV concerns the capital and equity of the purchase, the other three indicators all concern the ongoing financial viability of the investment. If you are buying to let, then we would always advise planning to hold the property for at least a few years because otherwise, the transaction costs will eat up a considerable proportion of your profit.
Cashflow is easy in explanation but requires careful attention to the detail for the calculation. It is the estimated monthly income less expenditure. Income will be rent (although not necessarily exclusively); the main items of expenditure are mortgage fees, agency fees, allowances for voids, allowances for maintenance (including accruals for large expense items such as boilers and roofs), service charges, ground rents etc. These expenditure items can be difficult to estimate so be detached and as objective as possible.
Cashflow should always be positive, and you need to set a minimum level that you will accept to act as a buffer; I have heard various figures used from £50 to £250 per property. If it is positive, then you are in business, if not then do not buy a liability.
Yield is the annual return of the property expressed as a percentage of its value. The nuances here depend on what you include or exclude. You can decide what you include when you know what you want to use it for.
Most investor folk use it to compare the headline returns of properties. At WOPT towers we also find it useful as an at a glance review of the risk when using finance. As a rule of thumb, the worst case scenario is that finance will cost about 6% and other costs (maintenance etc.) are around 2%; then the minimum acceptable yield for an investment will be 8%.
Return on investment.
ROI is a similar calculation to yield, but it strips away figures to reveal how hard the investor’s money is working. It is calculated by dividing the net cash flow in a year by the investors capital; that is the equity in the property.
ROI is the actual return on your money similar to the interest rate at the bank and therefore allows the investor to compare investments across not only different properties but also different investment asset classes, e.g. shares gilts and bonds etc. This is important as it allows the investor to check that they are making their money sweat as hard as they can.
Before we finish, it is worth mentioning that the figures are the sum of several estimates. So, to be really thorough you should calculate a best, worst and most likely scenario, only then will you have a true grip on the business case.
Time to deploy the spreadsheet!!