This article looks at the reasons you shouldn’t invest in property, in contrast to the previous article (Upsides of Property Investment) which covers why you perhaps should invest in real estate.
In the previous article we covered the reasons why investing in real estate can be a very lucrative investment vehicle to make substantial returns on your investment.
The power of leverage offered by purchasing real estate on mortgage means that any increase in the property value can be greatly magnified into a much higher ROI for your investment.
However, such fantastic yields are not without a plethora of fees, charges, and other deductions, as well as highly leveraged risks.
Charges, Taxes, and Deductions
Taxes
Firstly you need to consider local taxation laws, for example a property in the UK would be liable to council tax.
The average rate of council tax in the UK is currently £120($197) per month, or £1,440($2,361) per year.[source]
If we look at what this does to the rental yield:
From the previous post we worked out that the initial rental yield on a $441k property was $1,240/pcm
Working in a monthly deduction of $197 equates to a reduction of 15.89% of the rental yield.
Insurance
Sinking $441k into something is no small undertaking, especially if that is up to 10 times the amount of money you have to your name.
With that in mind, it makes home insurance a vital purchase. In fact, if you buy a property on a mortgage you will likely find that you are obligated to take out home insurance to cover the property against damage or loss.
Current figures pin the cost of home insurance in the region of £136($223) per year which works out at $19 per month, or another 1.5% of monthly rental yield.[source]
But the fun doesn’t end there.
As a landlord, you are going to also need to take out landlords insurance to cover the property for the purposes of letting it.
On average, robust landlord insurance will run around £150($246) per year, or $20.50 a month, a further 1.65% of rental yield.[source]
Maintenance and Obligations
The obligations of a landlord are many, especially in a developed country such as the UK.
For example an annual Landlord’s gas safety certificate is required to test the safety of all gas appliances in your property at a cost of £90($147) per annum or $12.25 a month, another 0.99% of rental yield.
General maintenance can be a tricky variable to assign a value to, most months there will be no maintenance costs, then other months you could face a boiler replacement at upwards of £1,500($2,459).
If we air on the conservative side and budget £50($82) per month for all maintenance costs, this is $984 a year and a rate of 6.61% of rental yield.
Management Fees
By far one of the biggest costs of a rental property is the property and letting management fees.
Typically around 10% of the rental price (plus tax) in our example that would run at $124 per month, $1,488 per year, another 10% of rental yield.
Service Charges
If your property resides in gated community or residential block then there will also be the obligation to pay service charges or CAM (Common Area Maintenance) fees.
These can range up to 25%, but are more commonly between 10%-15% in the UK.[source]
For our illustration, we will take the number cited in the linked article, another 11% of rental yield $136 a month – $1,637 a year.
Let’s combine these into a table to take a look at the overview of deductions:
| Deduction | Cost | Rental % |
|---|---|---|
| Residential Tax | $2,364 | 15.89% |
| House Insurance | $223 | 1.50% |
| Landlords Ins. | $246 | 1.65% |
| Safety Certificate | $147 | 0.99% |
| Maintenance | $984 | 6.61% |
| Management Fees | $1,488 | 10.00% |
| Service Charges | $1,637 | 11.00% |
| – | $7,089 | 47.64% |
With all costs stacked up, it is clear to see that any rental yield is effectively halved even in the best case scenario.
This scenario assumes a 100% success rate of rental payments being made, in full, and on time, without any exception.
This scenario also assumes a 100% occupancy rate and 0 days of vacant property.
In reality rental arrears and defaults run close to 10% [source] further driving down the rental income by 56.74% to give a net of 43.26% of rental income, before tax.
With a monthly gross rental income of $1,240, a net of 43.26% would give a dollar figure of $536 per month, to give an annual net rental income of $6,437.09
When we look at this as an income from a $441k property, we can work out the net rental yield as follows:
$6,437 / $441,000
=
1.46%
However, that is assuming that the property is owned outright with no mortgage, which in our previous post we decided was a poor choice.
As per the previous post, an interest only, buy-to-let, mortgage at 4.5% would mean monthly payments of $1,488.
In the above scenario this eclipses any rental income and means the cost of owning the property runs as follows:
$536 Rental Income
– $1,488 Mortgage Payments
=
-($952)
As we can see this means running at a cost of $952 per month, or $11,424 per year, to give a rental yield as follows:
-($11,424)/$441,000
=
-(2.59%)
This means that the property would need to increase in value by at least 2.59% per year to break even, not accounting for inflation.
That is to say, when purchasing a buy to let property you are making a prediction that the property will grow in value, and that if the value were to remain stable then you would run a negative return on investment and lose money.
The Double Edged Sword of Leverage
When Interest Rates Rise
The price that one pays for the power afforded by leverage is the interest payments made on the sum borrowed.
As with all things leverage, a small change in the underlying rate can cause an amplified impact to the investor.
As covered in the previous article:
A mortgage at 4.5% would be 0.375% per month:
((104.5/100)^(1/12))-1 = 0.375
Monthly interest payments would be ($441,000-$44,100) * 0.375%
= $1,488
Now let’s see what happens when that interest rate is raised:
| Interest Rate | Monthly Equivalent | Monthly Payment | Increase |
|---|---|---|---|
| 4.5% | 0.37% | $1,488 | $0 |
| 5.0% | 0.42% | $1,654 | $165 |
| 5.5% | 0.46% | $1,819 | $331 |
| 6.0% | 0.50% | $1,985 | $496 |
| 6.5% | 0.54% | $2,150 | $662 |
| 7.0% | 0.58% | $2,315 | $827 |
| 7.5% | 0.63% | $2,481 | $992 |
| 8.0% | 0.67% | $2,646 | $1,158 |
| 8.5% | 0.71% | $2,811 | $1,323 |
| 9.0% | 0.75% | $2,977 | $1,488 |
As we can see, a small rise in interest rates can lead to a substantial increase in monthly repayments.
At time of writing (October 2014) the global economy has been under a sustained period of unprecedented, and unsustainable, low rates of interest.
The rate of interest is expected to rise in the coming months and as such the implications of the table here will be realized in any mortgages that are tied to the base rate of interest.
This would present a problem for anyone that is currently just able to meet their monthly interest payments with little room for error. An increase of 1% would require an additional $331 per month to cover the cost of the interest on the mortgage.
With monthly repayments of $1,488 an increase of $331 represents a 22% increase in monthly mortgage repayments.
That is to say, a 1% increase in the rate of interest paid on your mortgage represents a 22% increase in monthly mortgage repayments.
Such is the power of leverage.
If we apply this to the scenario from our previous article where we used leverage to purchase 7 properties, rather than one property outright.
In this scenario an increase of 1% would add 7 * $331 to the combined monthly mortgage repayments.
This would represent an increase of $2,317 each month.
An increase of 2% in the base rate of interest would represent an increase of $4,634 each month.
Failure to account for potential interest rate increases are one of the most common reasons for homeowners to default on their mortgage obligations.
If we consider an expat in the UAE with an annual net income of $50,000, looking to purchase a single property in the UK as a buy-to-let investment.
Assuming a cost of living of $35,000 per year, this leaves him with an annual surplus of $15,000 to invest, or $1,250 per month.
In the above scenario where rental income is $536/month (as per the calculations above) and the mortgage repayments @4.5% are $1,488/month, this leaves a deficit of -($952) each month to be paid by the investor from his monthly investable surplus.
- Monthly Investable Surplus: $1,250
- Monthly Mortgage Obligation: $1,488
- Monthly Rental Income: $536
- Difference: -($952)
- Remaining Investment Surplus: $298
In a situation in which the base rate of interest rises by a mere 1% ($331), and rental income remains the same, our investor finds himself looking at the following prospect:
- Monthly Investable Surplus: $1,250
- Monthly Mortgage Obligations: $1,819
- Monthly Rental Income: $536
- Difference: -($1,283)
- Remaining Investment Surplus: -($33)
As we can see, the increase in interest rate by a mere 1% puts our investor underwater and no longer able to meet his monthly obligations.
At which point our investor is forced to default on his mortgage and faces the prospect of having his property foreclosed.
When House Prices Fall
As we saw in the previous article, the power of financial leverage means that a small increase in property prices can result in substantial returns on any investment. This is because every dollar you invest is bundled with several other dollars of credit (in the form of a mortgage) and allows us to amplify any change in price.
The same, however, is equally true of any fall in the price of the underlying asset.
Depending on the amount of leverage applied, it could only take a fall of a few percent in order to wipe out any invested capital.
Earlier this year, the Bank of England assessed the countries 8 biggest lenders on how their balance sheets might handle a 35% fall in the real estate market [source]
Let’s see how that would reflect on any property investment made on leverage.
| Month | Property Price | Monthly Rent | Mortgage Payments |
|---|---|---|---|
| 0 | $441,000 | $1,240 | |
| 1 | $425,450 | $1,196 | -($1,488) |
| 2 | $410,447 | $1,154 | -($1,488) |
| 3 | $395,974 | $1,113 | -($1,488) |
| 4 | $382,011 | $1,074 | -($1,488) |
| 5 | $368,541 | $1,036 | -($1,488) |
| 6 | $355,546 | $1,000 | -($1,488) |
| 7 | $343,008 | $964 | -($1,488) |
| 8 | $330,913 | $930 | -($1,488) |
| 9 | $319,245 | $898 | -($1,488) |
| 10 | $307,987 | $866 | -($1,488) |
| 11 | $297,127 | $835 | -($1,488) |
| 12 | $286,650 | $806 | -($1,488) |
| Subtotal | -($154,350) | $11,874 | -($17,860) |
| Combined Return | Percent Return | ||
| TOTAL | -($160,336) | -(258.77%) |
As we can see here, a drop in property price can have a substantial impact on the value of any property investment you may have made with the leverage of a mortgage.
To go over the numbers a little more succinctly:
Total Value at end of Year 1 = (Value of property) + (Amount received in rent)
Total Value = $286,650 + $11,874 = $298,524
Total Invested = (Deposit)+(12 * Monthly interest payments)
Total Invested = $44,100 + $17,860 = $61,960
Mortgage Owed = (Purchase price) – (Deposit)
Mortgage Owed = $441,000 – $44,100 = $396,900
Let’s run those numbers together:
Effective Return = (Total Value) – (Mortgage Owed + Total Invested)
Effective Return = $298,524 – ($396,900 + $61,960) = -($160,336)
In this scenario, our investor has invested a total of $61,960 into his buy-to-let property which is now worth -($160,336) to him.
Worse than simply losing all of his money, our investor has essentially lost 2.6 times his investment amount.
In the case of our investor that chose to invest in 7 properties on mortgage, rather than purchasing a property outright, the losses are substantially higher.
If our investor had chosen to purchase a single property outright, his financials would stack up as follows:
- Total Invested: $441,000
- Total Rental Income: $6,432
- Current Property Value: $286,650
- Effective Return: (Property Value + Rental Income) – (Total Invested)
- Effective Return: ($286,650 + $6,432) – $441,000
- = -(147,918)
However, had he taken the advice of the previous article, and taken out mortgages to invest in 7 properties, his financials would stack up as follows:
- Total Invested: (Deposit + Mortgage Interest) * 7
- Total Invested: $308,700 + $124,992 = $433,692
- Total Rental Income: Rental Income * 7
- Total Rental Income: $83,118
- Property Value: Property Value * 7
- Property Value: $2,006,550
- Mortgage Owed: (Purchase Price – Deposit) * 7
- Mortgage Owed: $2,778,300
- Cash Surplus: ($441,000 – Total Invested)
- Cash Surplus: $7,302
- Effective Return: (Property Value + Total Rental Income + Cash Surplus) – (Mortgage Owed + Total Invested)
- Effective Return: -($1,115,022)
His decision to purchase on leverage has led to a loss of $967,104 higher that would have been realized had he purchased a property outright.
Purchasing real estate is something that most people will likely do at some point in their life, most without taking the time to fully understand the financial risks they are taking by using a large amount of leverage in the form of a mortgage.
Cover photo: Hiroshi Jinza
Investing in property both ‘buy-to-lets’ and ‘commercial’ is not for the faint hearted. Location continues to be a large determinant on stability, hence London continues to shine the beacon of attraction to ‘international’, ‘expat’, and ‘foreign nationals’. Unless you are a cash buyer, borrowing is not easy. Innovative niche lenders have emerged to fill the market, as the market is specialist you may need to approach a specialist and reputable finance advisory firm.