One
of the main benefits of investing in property is the
significant capital gain you can make as your property
rises in value over the long term. However, to benefit
from the gain you need to make sure you can afford
to hold the property in the meantime. Ideally you
don’t want to have to support your property
portfolio. Quite the opposite in fact! Your portfolio
should support you financially. The rent you receive
from your tenants should more than cover all the costs
of ownership such that each month there is surplus
cash profit left over for you to enjoy.
Investors
who lose money are often the ones who get it wrong
because of cash flow. They can’t afford to hold
their property and so have to sell which depending
on the market conditions means they themselves may
become motivated sellers. The purpose of this chapter
is to help you ensure you maximize the cash flow from
your investment properties.
So
let’s go back to fundamentals for a moment.
As a property investor, one of the critical skills
you need to develop is the ability to quickly assess
a particular opportunity to decide if it is a good
investment and suitable for you or not.
What makes a good investment?
Now
let's just remind ourselves of the first 3 of my 5
Golden rules of Investing.
1.
Always buy below market value from motivated sellers.
2. Buy in an area with strong rental demand
3. Buy for cash flow
Of
course you want to ethically pay as little as possible
for the property but the discount alone is not the
only factor to consider. There is no point buying
a property even with a great discount if you cannot
easily rent it out and make a positive cash flow.
To
help you focus on only buying good cash flow properties
you could buy “as if prices will never go up
again” and so the only reason to buy would be
for the great cash flow and return on investment.
When
researching any potential investment there are two
main factors we are concerned with. We want to determine:
A) The true market value of the property
B) The realistic market rent that could be achieved
This
is the information that a mortgage company would want
a chartered surveyor to collect on their behalf in
order to assess whether to grant you a buy to let
mortgage on a particular property. You need this information
a long time before you even apply for the mortgage,
to decide if it is the right kind of investment for
you.
With
these two pieces of information you can ascertain
whether you are going to make a profit each month
after covering all of the expenses.
The
main expense you will incur on a monthly basis is
the interest on your buy to let mortgage. I have a
very simple rule of thumb which you can use to asses
this monthly expense.
For
every £20,000 you borrow, at an interest rate
of 6%, you will pay £100 per calendar month
(pcm) in interest. For example, if you were to borrow
£80,000 it would cost you £400 pcm.
This
is based on a 6% annual interest rate for two reasons:
First of all it’s the average rate I've had
over the last 15 years. Secondly, it keeps the numbers
easy to calculate because every £20,000 you
borrow cost just £100 pcm. I like to keep thing
as simple as possible.
If
the average cost of a mortgage is only 5% per annum
then this rule of thumb is very conservative. This
means that in reality £20k will not cost you
as much as £100 pcm but by using this in your
calculations you are being very cautions which is
good because you don't want to be too optimistic.
When
working out the cash flow many investors are too optimistic
on what the costs will be and they don't get it right.
It’s better to be pessimistic and have a nice
surprise to make more money than expected.
Does
the investment stack up?
The
mortgage lender will then use a rent multiplier
to make sure that the rent is going to be enough
to cover the monthly interest and the other
cost associated with the property.
This
rent multiplier can vary from lender to lender
but most will uses something like 125%. This
means that the lender wants to check that the
monthly rent is 125% of the monthly interest
payment. (Rent > Monthly interest x 125%).
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With
a mortgage of £80,000 and a monthly interest
charge of £400 your lender would generally want
to see a monthly rental income of at least £500
pcm (£400 x 125%). The extra 25% over and above
the interest payments is an approximation of the other
monthly costs.
Using
this rent multiplier will help you to very quickly
asses if a property is going to make monthly cash
flow for you. With a monthly interest cost of £400,
if the monthly rent was just £500, it may only
just about covers the costs. However, if the monthly
rent was £550, then it means you would probably
make some cash flow from this property each month.
If the rent was just £450, you wouldn't be making
positive cash flow, in fact we know it's going to
cost you month each month. In reality the lender may
not lend the full amount.
To
summarise, you can quickly work out if a property
stacks up as follows:
1. Work out how much is the mortgage going to cost
you
2. Multiply the monthly interest by 125% to give the
required rent
3. Check that the actual rent is more than the required
rent
Having
used this quick approximation, if the property does
not stack up you can move on to the next one without
wasting too much time. If however it looks like it
does stack up well, it may be worth spending a little
more time to properly work out the true cash flow
to help decide if you want to purchase it.
This
article is taken from the new 2010 edition
of “Property Magic: How to buy property
using other people’s time, money and
experience.” Property Magic is an Amazon
No 1 best seller and we highly recommend it.
You can buy
it here
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