Does Buy-To-Let Make Sense Financially?

Most buy-to-let landlords invest for capital growth rather than the prospect of increasing their income.

This is reflected in the way they weigh up the decision whether or not to purchase a property.

A common approach is to compare rental income with the mortgage costs to see if there is sufficient margin to cover the expected running costs.
Their overriding concern is how much they expect to make in profit on sale of the property perhaps ten or twenty years later, when they are ready to retire.

Lenders use similarly simple criteria in judging whether it is safe to lend, having first checked the investor’s credit rating, and whether they are reliable, and financially strong enough to cope with the risks involved.

Banks and building societies want to know the ‘loan to value’ ratio, and ‘rental cover’.

Typically they will only lend up to 75% of the open market value, which does not include all the additional fees and other costs in procuring the property.

They usually require the rents to be at least 25% above the mortgage repayments. It may still be possible to borrow a little below these criteria, but on less favourable terms.

The housing market over the last twenty years has made almost any investment in housing profitable, with prices across the UK since the end of 1993 rising by 235%, and in London by 389%, compared with inflation of 54%.

As the market tightens it becomes increasingly important to make the right choices, and that requires a more professional approach to the purchase and management of rental property.

The professional way to appraise the viability of an investment is to use financial modelling. At first sight a financial appraisal may appear daunting.

It requires a lot of information that you cannot be sure about, and gives some very precise answers which will almost certainly be wrong, because nobody knows what the future holds.

Like any business plan the point of it is to explore the potential gains and losses, and whether the set of assumptions on which an investment would be viable are reasonable. What are the risks and can they be managed? Could it withstand a period of stagnation in house prices, or a recession? By how much would house prices have to rise to offset any initial losses on rental income?

This article begins by describing a number of different measures of viability, and what they mean. It then examines each of the assumptions, and what information is available on them.

Mastering the techniques of financial appraisal can lead to a much deeper understanding of the risks and potential benefits of any investment, not just an investment in rental housing.

Letcheck is a simpler version of the financial appraisals used by social housing provides, designed to suit the needs of a buy-to-let landlord. It can be downloaded free and used to appraise your own investments, and to explore the examples used in this paper in more depth. Click on the Letcheck logo to download it.

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