Rental yield or capital growth?

When investors first look at getting into the buy-to-let game, they look for properties producing as high a rental yield as possible. Whether it’s a house, flat or apartment, every property’s rental yield depends on a variety of different factors; its type, where it’s located and how appealing it is to prospective tenants, to name just some. Knowing your market is extremely important.

Put simply, the rental yield is the return on the capital invested – shown as a percentage. In Cardiff, a good return is considered to be around 6% - which can be compared to alternative investment avenues that are available, such as interest from savings in a bank account. However, you don’t benefit from capital growth with a savings account, nor the effects of inflation of any monies borrowed to help purchase the property, which are two of many reasons why people regard property as a far better investment option.

To help you decide which type of property to invest in, it’s a good idea to calculate the potential rental yield on a selection of properties across a few different markets – or visit our helpful guide on the different types of Cardiff lets.

Calculating gross rental yield

The gross rental yield is a simple calculation, but it’s important to bear in mind that it doesn’t take into account expenses such as mortgage interest, maintenance costs, insurance and agent fees.

The calculation is as follows:

Gross yearly rental income ÷ purchase price × 100 = gross rental yield as a percentage.

Calculating net rental yield

Working out the net rental yield is a far more accurate calculation of what you stand to earn as it accounts for the net annual rental income – which has already had mortgage interest payments, maintenance costs, insurance and agent fees subtracted from it – rather than the gross annual rent income.

As well as the aforementioned costs, calculating the potential net income of a property depends on a variety of different assumptions concerning rent, vacant/void periods, interest rates etc, so it’s always worth looking at a property’s rental yield within several different scenarios. You may find that the net rental yield works out as less than the cost of your mortgage, resulting in a shortfall. However, if you’ve bought well, such is the strength of the lettings market and the demand for properties in the private rented sector, you can expect to see the rental income increase over time.

When a property’s value increases over time, it’s known as ‘capital growth’. Capital growth occurs when the property’s current value exceeds the original purchase price, but a capital loss occurs when the current value is lower than the purchase price.

Property values are, of course, affected by both current market conditions (usually influenced by the current economic state in general) and anything significant to have happened locally.

Investors who purchase properties for their capital growth typically aim for an annual increase in value of 7-10%, combined with a rental yield of 2-5%. They’re bought with the confidence that there will be big increases in market value, meaning they can be sold for a significant profit or used as equity to buy additional buy-to-let properties. Flats and houses geared towards capital growth are generally more expensive to buy in comparison to properties that are cash-flow positive, and they’re usually found in cities or areas where there is strong demand from buyers.

A capital growth buyer’s worst nightmare is that a substantial rise in interest rates means they suddenly can’t afford to keep it due to the significant contributions they have to make towards the ongoing cost of the property. This is where financial forecasting takes on utmost importance, and it’s advisable for investors to include a buffer in their calculations in order to safeguard against increased costs.

Finally, it’s important to be aware of Capital Gains Tax (CGT), which is payable at the appropriate rate when selling a property that has increased in value. It’s based on the gain made, rather than the amount of money received.

If you’ve ever wondered how some landlords acquire such large property portfolios, they’re probably doing it through a process called gearing.

Even if you have enough capital to purchase a buy-to-let property outright, you should consider borrowing to fund part of the purchase. Using a buy-to-let mortgage to support an investment can make a substantial difference to your return. The mortgage interest is an allowable expense to set against your tax bill, so it’s often financially better to have a loan on the property, especially for higher taxpayers.

In a rising property market, investors regularly re-mortgage their properties to raise enough capital to put down a deposit on another one, so on and so forth. With property market typically rising year-on-year, it’s not hard to see how quickly a landlord may acquire a portfolio of 20+ properties.

Now consider the effect of borrowing money to support the deal;

In summary, gearing allows investors to stretch their available capital and purchase further investment properties. These options very much depend on a person’s views and attitudes, and whether their objective is for maximum income or maximum capital growth over a set period of time.

There are many different types of mortgages available – and even more mortgage providers. Our helpful Mortgages Guide is a useful read, or alternatively call us on 02920 668585 for free, personalised advice on what will suit you and your circumstances best.