Tim Worstall

Returns to Buy to Let

No, I’ve not done the numbers myself but this looks wrong to me, from the Guardian leader:

As a proportion of house prices, rental yields have hit record lows.
Throw in the cost of managing a property and the "void" periods when it
goes unlet, and the typical yield on a residential property is now
around 3.5%; less than a bank account offers but with far more risk.

OK, not wrong, but misleading. If you’ve got £200,000 in a flat then yes, I can imagine that the income is some £7,000 or so after expenses (from personal experience, about right). However, most such buy to let owners are not in fact putting in anything like 100% of the cost of the property. They’re taking a mortgage (capped at 80% of the value perhaps?) so the return on the actual investment is a multiple of that number.

Which means that while being a landlord might be riskier and less remunerative than sticking the money in the bank (leaving aside any changes in inflation or capital value) being a buy to let investor might still be a highly sensible thing to do.

One further thing:

At the end of 1998 the British had 29,000 tailored buy-to-let
mortgages. By the end of 2006 that total had risen to 850,000, making
nearly a third of the UK’s entire private rented sector buy-to-let.

Using those numbers, that implies some 2.4 million private rental properties. We’ve 24 million or so households, making that 10% of the entire market. I would regard this as actually rather a good thing, wouldn’t you? We know very well that social housing does not allow geographical mobility and the various taxes (stamp duty etc) are certainly reducing the ability to buy and sell houses in order to move…so a growing private rental sector is a good idea if people are to be able to move around the country to where the jobs are, isn’t it?

A decent contribution to the mobility of the population?

In

12 responses

  1. Kay Tie Avatar
    Kay Tie

    “so the return on the actual investment is a multiple of that number.”
    I don’t understand the reasoning. The 3.5% yield on the investment is before costs of capital, meaning that a BTL landlord buying today is paying to take a capital gains risk, which is only rational if capital gains are a certainty.
    When financial nincompoops like my brother have just become BTL landlords, you can be sure we’re into an elevator boys giving Joseph Kennedy stock tips situation.

    Reply
  2. dsquared Avatar
    dsquared

    You do have to pay interest on those mortgages you know, which rather eats into the return.
    I think the comparison to a bank account is misleading though, as the 3.5% rental yield is clearly a real rate of return rather than a nominal one, and the “greater risk” is rather offset by the possibility of a capital gain; house prices do sometimes go up after all.

    Reply
  3. Mark Wadsworth Avatar
    Mark Wadsworth

    What Kay Tie says.
    Further point, the bulls always say “house prices are high because demand is high”, which is arrant nonsense.
    If this were true, then surely rents would have quadrupled as well over the last ten years. I checked with my friend the letting agent and he said that rents where I live (East London) had less than doubled (in nominal terms) over the last twelve years or so, so they have increased roughly in line with earnings.

    Reply
  4. Mark Wadsworth Avatar
    Mark Wadsworth

    More numbers – yes 10% of housing is owned by private landlords, maybe 2.4 million units.
    There are
    – about 800,000 Housing Benefit claimants renting from DSS landlords and
    – 1.5 – 2 million students, at least half of whom must be in shared houses, say another 200,000 units.
    – a million or so foreigners who came to the UK in the last couple of years who must be renting privately, another 500,000 units (assume two sharing on average).
    So how many of the 2.4 million are occupied by people who are actually working and geographically/socially mobile? Less than one million (2 million adults, assuming two sharing on average).
    So far so good, but there are over 10 million people aged 18 – 35 (average age for first time buyer), where do they all live? With their parents? Answers on a postcard.

    Reply
  5. Don Lloyd Avatar
    Don Lloyd

    Tim,
    It seems to me that expecting the rental rate for a property and the market value for the same property to closely track one another is unrealistic, as the causal factors are largely independent of one another.
    The rental rate is almost completely determined by the market demand for rental housing by renters and the market supply of rental housing held by landlords.
    In an economy that could be characterized by sound money, the market value of housing that is dedicated to being rented would be largely the discounted present value of the future stream of expected rent payments, net of expenses.
    In the real world, however, the enormous level of central bank credit expansion and the resulting supression of interest rates below time preference increases both the discounted present value of housing and the present demand for ownership, in part as a hedge against inflation.
    Regards, Don

    Reply
  6. Kay Tie Avatar
    Kay Tie

    “the 3.5% rental yield is clearly a real rate of return rather than a nominal one”
    A yield of 3.5% equates to a P/E ratio of 28. The FTSE 100 is currently trading nearer 12.
    Historically rental yields are about 8%, giving a P/E ratio of 12, which is about right as a long-term risk/reward tradeoff compared to stocks (the long-term P/E ratio for the FTSE All Share is 15, and property is traditionally a less-risky, less-rewarding investment).

    Reply
  7. james C Avatar
    james C

    ‘As a proportion of house prices, rental yields have hit record lows. Throw in the cost of managing a property and the “void” periods when it goes unlet, and the typical yield on a residential property is now around 3.5%; less than a bank account offers but with far more risk.’
    What is there to argue about? This is a corect statement.

    Reply
  8. Kay Tie Avatar
    Kay Tie

    “What is there to argue about? This is a corect statement.”
    It’s true, but only one factor at determining the value of an asset. As Don said, “the market value of housing that is dedicated to being rented would be largely the discounted present value of the future stream of expected rent payments, net of expenses.”. The discounting depends on real interest rates. The current valuations are solely underpinned by the sentiment that the capital price will rise in value.
    Buying an asset purely on the expectation that a “greater fool” will buy it from you in the future at a higher price than you paid is not investment – it is speculation. Smart speculators can make money. Dumb ones usually don’t.

    Reply
  9. Matthew Avatar
    Matthew

    “property is traditionally a less-risky, less-rewarding investment”
    In terms of price they’ve been quite similar – in 1984 the Ft-se 100 was 1000 and the Halifax house price index was 100. Now the ft-se is at 6,632, ie 6.6 times as high, and the halifax index is at 622 as of March, ie 6.2 times as high, so not much different.
    I don’t understand Tim’s point either – surely you have to look at the return on the non-mortgage part of the house purchase as well?

    Reply
  10. Kay Tie Avatar
    Kay Tie

    “In terms of price they’ve been quite similar”
    Similar-ish. Better to look over a longer period.
    Real house prices since 1976 have grown at 2.7% per annum.
    http://www.nationwide.co.uk/hpi/historical/Apr_2007.pdf
    The FTSE All Share index closed at 151.96 at the end of 1976 and now is at 3463.99. Adjusting for inflation gives a real growth of 5.14% per annum (slight above the very long term trend, in fact).
    Bear in mind, though, that none of the index figures (FTSE All Share, Halifax, etc. include re-invested income (rental profits for BTL residential property, or dividends in the case of the All Share).

    Reply
  11. dsquared Avatar
    dsquared

    [A yield of 3.5% equates to a P/E ratio of 28]
    surely no; it equates to a dividend yield of 3.5%. The rent on a property is free cash flow available for distribution, but the earnings of a company aren’t. If you were looking for the equivalent of a PE ratio for a house, you’d certainly have to include some of the annual capital gain as if it were part of earnings.

    Reply
  12. Kay Tie Avatar
    Kay Tie

    “it equates to a dividend yield of 3.5%.”
    No. The dividend yield is the *distributed* profits divided by the capital. The P/E is the total profit (some of which is retained, the rest distributed) divided by the capital.
    The rental yield Tim was talking about is the profits (distributed or otherwise) divided by the capital, i.e. the P/E upside down (or E/P if you like).
    “The rent on a property is free cash flow available for distribution, but the earnings of a company aren’t.”
    It’s perfectly possible to pay out 100% of profits as dividends. Companies choose not to (for a start it signals to the market that the company is going nowhere worth re-investing its profits in). For years Lloyds TSB famously had a very low dividend cover. The market expected the dividend to be cut, but instead profits rose and now the dividend cover is about 200%.

    Reply

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