Important information: This guide does not constitute financial advice. It's simply a guide to the initial process a typical buy-to-let (BTL) investor might go through when wishing to quickly weigh up a property purchase – to decide if it's worthy of further research and perhaps in order to avoid wasting time viewing unsuitable prospects. It doesn't take into account additional factors which will affect an investment's viability. As with all investments, you should seek advice from a qualified financial advisor and an accountant.
There are numerous reasons for buying a property to let out. Finance methods will vary, as will personal circumstances, all of which will inform the evaluation process. For the purpose of this guide, we will assume the position of a typical buyer using a fairly high LTV (loan to value ratio) of 75% - which means they are using a deposit of 25%.
There are two main ways of creating value from a BTL investment; income and capital growth.
Income
This is where a landlord seeks to maximise the yield of their investment. Rental yield is the return a property investor is likely to achieve on a property through rent. It is a percentage figure, calculated by taking the yearly rental income of a property and dividing it by the total amount that has been invested in that property.
As an example, a property let for £500 per month generates £6,000 per year. If the total invested was £60,000 then the yield would be 10%, as £6000 is 10% of £60,000.
Capital Growth
This is simply the value of your investment appreciating. If you buy a property for £100,000 and sell it five years later for £150,000, your capital has appreciated by £50,000 or 50%.
Yield is important because if the figure is too low, your BTL property won't generate enough cash-flow to cover it's costs; which will need to be introduced each month from somewhere else. Essentially, it will be costing you money. Capital growth is important because nearly all BTL mortgages are interest only and you will need an exit strategy at some point. If the value of your property has not appreciated over time (or even worse depreciated), on pure numbers it will be unlikely your investment was worthwhile.
In reality, most BTL investors will aim for a mixture of both.
Rental income is crucial when it comes to borrowing. It's not enough for the income to cover the repayments; a lender will want a buffer. This means they will want to know that the rent will cover the mortgage payments and a bit more. Typically they will look for cover of 125%. So on repayments of £1000 per month, they will look for rental income of £1250 per month.
The interest rate is also key. Although actual rates may be lower, you'll need to base your calculations on a rate of 5.5% as many lenders are now doing. This is a stress test and it's designed to indicate whether your deal will be cash-flow positive in the event that interest rates rise.
The basic calculation you'll use when determining whether a deal is worth investigating further is-
Monthly rental income multiplied by 12 (months in a year) divided by 5.5 (interest rate) multiplied by 100
This provides a ball park purchase price at which a property might make sense as a buy-to-let. Remember, the lender won't let you cut it this fine in terms of rent covering mortgage; however, you'll be contributing a deposit which will reduce the sum borrowed and bring the numbers into an acceptable range.
Here are some examples:
Purchase price £325,000 Rental income £1,200 per month
1200 multiplied by 12 (months) = 14400 divided by 5.5 (interest rate) = 2618 multiplied by 100 = £261,80
So this deal is probably not worth pursuing as the rental income would not support the purchase price.
Purchase price £275,000 Rental income £1,350 per month
1350 multiplied by 12 (months) = 16200 divided by 5.5 (interest rate) = 2945 multiplied by 100 = £294,500
In this instance the rent would appear to cover the purchase price. Once your deposit was factored in it would reduce the borrowing, bringing the deal to an acceptable level:
Purchase price £275,000 Deposit (25%) £68,750
Loan £206,250 Loan repayments (at 5.5%) £945.31
Rental income £1,350 per month Leaving positive cashflow of £404.69 per month.
This prospect would pass the interest rate stress test and have enough of a buffer to satisfy many lenders. Bear in mind there are additional costs that will need to be deducted from this theoretical profit, and it's not a certainty that this deal stacks up. But quite quickly we've worked out that this property might be worthy of further investigation.
When you're ready to take the next step on your BTL journey, speak to a lettings agent who will be happy to assist you with further due diligence. We'll always be happy to offer advice on some of the other factors that will affect your investment.
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