It used to be the weather – but in recent years its house prices… the subject that seemingly everyone in Britain talks about. The rapid rise in prices since the housing market slump at the start of the 1990s has evoked endless debate. When will prices fall? What will trigger the fall? Will the current credit crunch and the demise of Northern Rock hasten an end to the boom in the housing market? Who will be most at risk if prices fall?
One group that is viewed as being exposed if interest rates continue rising and house prices fall, is the thousands who have bought property to let for rental income. The last decade has seen a burgeoning market in buy-to-let properties with mortgage advances on buy-to-lets growing from £2bn (on 28,700 advances) in 1998 to £108bn (on 938,500 advances) in 2007. Buy-to-let currently accounts for 8% of the mortgage market. These figures do not show the full extent of the buy-to-let market, given that many properties are bought without the use of a mortgage.
So, if you’re thinking of joining the buy-to-let boom, how can you minimise the risks involved? What homework do you need to do before you go hunting for your investment property?
Any investment opportunity should be explored with a financial appraisal, and buy-to-let is no different. You’ve got to look at the income you’re going to draw in, if you’re successful in renting the property out, and set that against the cost of borrowing the funds to acquire the property. Then you need to build in some cautious assumptions about your commitments in terms of things like taxation, repairs, and void periods (when you can’t find a tenant). Also, make some guesses about bad debts, because unless you’re letting through an agency which takes responsibility for chasing the renter, you’ve potentially got that 'financial shortfall' as well.
Now, it’s time to embark upon some stress testing. At the moment, your financial appraisal is based upon your best assessment of the financial facts which relate to the investment opportunity. However, a certain number of cash flows in this model have uncertainties associated with them. So you’re advised to do stress testing, which means applying more conservative or more adverse characteristics to those cash flows, and see if your investment is still viable.
A classic factor to stress test when you’re investigating a buy-to-let is the length of time you can let your property each year. Your best estimate may be that you’re going to let the property for ten months out of every twelve. If you’re in a university town that may be a fair assumption, given the length of the university year. But what happens if something goes wrong and you only actually manage to let it for eight months? Are you in financial trouble, or is the investment still viable?
You may build your case on the assumption that you have to pay £1,000 a year in terms of decoration. But what happens if your tenants cause a lot of problems, or something adverse, like dry rot, affects the property? Instead of it being a £1,000 repair and decoration bill each year, it becomes £10,000. Are you still okay financially? Stress testing now may save you much pain later on.
Lastly, make sure that you build in the cost of funds, even if you’re in the fortunate position of not having to borrow any money, because there’s an opportunity cost. If you put £150,000 into a property you forsake the opportunity to invest the money in, for example, a building society account and earn interest on it. So make sure you factor these foregone interest earnings into your financial appraisal
These financial calculations are the first step in the research which should precede the purchase of a buy-to-let property. There’s more work to be done, but they provide a great foundation to build upon.
Find out more
- Video extras - see the bits that weren't broadcast
- Managing risk - How can managers protect themselves and their projects from risk?
- Buy-to-let no more - the Money Programme examines the fortunes of the buy-to-let market
The opinions expressed are those of the author and are not held by the Open University or BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.