On Capital Appreciation vs. Rental income

Posted by admin in Business, Property Investment, The South of France | October 13th 2006

Capital gain is the reason everyone gets into property investment but it is the rental income that finances the deal while you
wait for the value to rise. In fact it is rental income that consumes a landlord and is a key factor in determining whether new buy-to-let investors stay the course.

Many first time BTL investors will sell up after a year and take the capital gain, and often a significant one at that, simply because they are struggling with the balance sheet.

I can think of at least half a dozen people I have met in the past year who are getting out of property because the rent isn’t covering the mortgage. This is quite natural when you look at it purely in terms of cash flow. It’s no use the property going up ten grand in value because that is just a paper profit. If your current account is in the red then you have a problem, a cash flow problem, despite the actual increase in your overall net worth.

“Cash is king” is the expression.

Poor cash flow leads to bad financial decision making. You should always be operating from a position of strength not a position of weakness.

For neophyte investors it is important to understand the relationship between capital gain and rental yields and to understand how they affect each other.

I am going to start with a perverse, but true example.

I own an apartment that is worth £100,000. This costs me around £4,000 a year just to own. That is not in utility bills and service charges but in pure loss of interest terms. Let me explain further.

I own it outright so there is no mortgage. Sounds good? Not really because if that cash was in a high interest bank account it would be earning me £4,000 a year interest. So just owning the place costs me £4,000 a year in lost income. If I borrowed the money from a bank it would probably cost me around £5,000 a year in interest so either way, having money tied up in property is costing me money before I even get out of bed in the morning.

OK, that’s the downside what is the upside?

Well, there is the rental income and there is the capital gain. Lets look at the rental income first. If I rent it out for say £4,000 to £5,000 a year I have covered my losses and any capital gain knocks through to the bottom line, that’s my profit.

This particular property is in Cyprus where the capital gain is running at around 15%. This means I make £15,000 every year in capital gain. Even if I chose not to rent it out I would make £10,000 every year. The property would remain unsoiled by messy tenants, I wouldn’t have to pay tax and laundry/cleaning bills and I still walk way with £10,000 clear and all I did was locked the door and walked away.

So if you invest in an area where there is a healthy capital gain you could consider the rental income as a bonus. Interesting eh?

I can even use it myself and get free holidays thrown in. It gets better all the time.

Let’s look at the same deal from the other side.

Most people who buy a second property have a mortgage, which they need to finance through rentals. Overseas property offers a choice of three options:

1. Long term rental.

You don’t make much money on long-term rentals but it is guaranteed – you don’t have any voids. It also keeps you out of the bloodbath when the development is first launched and everyone is fighting for tenants. Nothing wrong with this approach at all. No hassle and the tenants are so grateful to get a brand new place that they will normally look after all your first year snagging which will save you an awful lot of hassle.

2. Short term rental.

Far better returns here. You will get as much in one week as the long term rent gets in a month. The downside is you have to work at it. You will pay a letting service and you will be paying for cleaning and laundry. Get it right though and the rewards are handsome.

You don’t have to use a letting service though. Many people rent the property out just to family and friends and this has a lot of benefits. For a start your family and friends are less likely to trash the place (we hope) and I have even heard that some people pay cash in order to avoid tax. Of course I think this is a terrible thing to do and you should never ever try and cheat the taxman out of his well-earned share of your profits.

There are other benefits as well. You will probably find that family and friends are not averse to throwing the sheets in the washing machine and cleaning up at the end of their holiday, all of which dramatically reduces your expenses. With no agents fee as well you may well find that with half the bookings you still make the same profits.

3. No rental.

If your cash flow is healthy you don’t need to rent at all. This is particularly good if you intend to flip the property after say a year because you will always get a better asking price for a brand new place rather than one that has pizza stuck on the roof of the oven (or anywhere else for that matter). Most people do not do this simply because of cash flow issues but it makes the point that even a property with no rental income at all can still be making you £10,000 profit a year.

The other thing worth mentioning is that rental income always lags behind capital gains. If you buy a property for £100,000 and rent it out for £6,000 a year, your gross yield is 6 per cent. If the property goes up by 15 per cent it is now worth £115,000. In my experience the rental value does not alter straight away so in year two the chances are you will still be renting it out at £6,000. Your rental income, when expressed as a percentage of the value of the property means that the yields now falls to 5.2 per cent. This looks bad, particularly if the same thing happens in year three. If the property goes up by another 15 per cent the value is now around £132,000 and the yield falls again, this time to 4.5 per cent even though the rental income hasn’t changed. The only thing that has changed is that you have trousered £32,000 in capital gain.

But although rents do lag behind they do rise over time, they have to, otherwise landlords would sooner put their money in a high interest bank account.

I hope that this makes it clear why those first three years can be such an anxious time for new landlords. Add in a few voids, the cost of furnishing and air conditioning, and you can see why some people are inclined to throw in the towel at the very time when the real profits are about to kick in.

As I said – cash is king.

Make sure that you structure your finances in such a way that you manage the property, not the other way round.

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