Buying an investment property: buy-to-let guide

House-buying expert Naomi Heaton highlights the figures that count when you want a sound rental investment
Searching for a rental investment
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Property investment can yield more than cash in the bank
Bank of England Governor Mark Carney has predicted stable interest rates for the next few years but while he paints the prospect of negligible returns on cash investments, this need not apply to the investor who favours property.

Low and stable interest rates mean cheap mortgages. This comes at a time when rising property prices are an even hotter dinner party topic, thanks to the early introduction of the second phase of Help to Buy. While schemes like this do not help anyone looking to buy a second property — perhaps to supplement their pension — they give the slowed-down housing market a shot in the arm.

The new phase of Help to Buy helps buyers boost their deposit for homes under £600,000. This will allow second-steppers to move up. And it means that if you are looking for an investment property, you should get going.

The Land Registry's latest stats show average prime central London prices reaching £1.47 million, up 7.2 per cent over the last quarter. There has been consistent growth, averaging nine per cent a year since the first stats were published in 1996. The average house price in Greater London is £475,940 — up nearly four per cent in the last recorded quarter. Rental income can provide a return of about four per cent a year compared with, say, one per cent for cash in the bank.

No wonder 40,000 buy-to-let mortgages were approved between April and June 2013, 19 per cent up on the previous quarter.

What you need to know:
Suss out your market

The consistent growth is not a London-wide phenomenon. Take for example, Tower Hamlets, home to the iconic Canary Wharf: prices have fallen there by three per cent since 2008. Or Newham, with its Olympics legacy, where prices have fallen by 10 per cent. So the first step is to identify areas with capital growth potential. This often means avoiding large new-build developments where all the units are the same and can only compete on price.

Check all house prices paid across the UK

Check the going price per square foot
This knowledge is essential, and the price varies dramatically by postcode. In Bayswater W2, you might get an unmodernised flat for £1,000 a square foot. In near neighbour Kensington W8, this might be more than £1,500. While not an exact science, exceeding the yardstick and failing to get a rent to match, will lower returns.

Check home values for any UK home

Know your tenant
The next step is to understand what a tenant actually wants. My company specialises in singles or couples who are looking for a one- or two-bedroom flat. Going for three bedrooms or buying a super-spacious flat, surplus to requirements, is unlikely to see an increase in rent, again reducing returns. Tenants mostly know what the going rental rate is — and so should you. Over-optimistic rents will throw out every calculation, with potentially dire consequences. Rents are also a good rule of thumb for calculating the right price for a property. For example, if a flat commands a rent of £400 per week, the price should be no more than £520,000 on the basis of a four per cent gross yield.

Current properties to rent in London

Searching for a rental investment
© Rui Vieira
Prime Minister David Cameron with first-time buyers in Northants at the launch of Help to Buy's second phase last week
Consider your costs
As well as the purchase price, there are other costs. There will be stamp duty, at three per cent for properties over £250,000 and four per cent over £500,000. There will be the lawyer's and valuer's fees, and mortgage arrangement costs.

Tenants of one- and two-bedroom flats often prefer furnished properties — another cost to factor in. So it may be necessary to put aside a further seven per cent on top of the purchase price for all this. And if an investor is looking in the older, iconic areas of central London, think renovation, too.

Understand your yields
If you are taking out a mortgage, understanding your rental returns is a must. Running costs, such as service charges, letting fees and maintenance will reduce the rent in your hand by 25 to 30 per cent, leaving a net return of no more than three per cent in prime central London.

One of the most competitive mortgages on the market is quoting an interest rate of 3.35 per cent. A 70 per cent mortgage means annual interest payments equal to 2.35 per cent of the property value. On this basis, the rent covers the mortgage by a healthy 1.27 times (per cent return vs. interest payment) but if the mortgage rate or amount borrowed is higher, the margin gets tighter, leaving less wriggle room.

Know your bank - well
Many investors take out a mortgage to assist with the purchase but it has other financial benefits. As buy to let is a commercial enterprise, loan interest and other costs can be offset against rental income for tax purposes, like any other business. Even if there is a small surplus income after these deductions, it is unlikely to be taxable due to other allowances. So the smart investor will be liable to capital gains tax of up to 28 per cent on the sale of the property, rather than income tax which can rise to 45 per cent.

The bank's money can also make the investor money in a rising market. For example, buy a flat for £500,000, see it double to £1 million and you clear £500,000, doubling your equity. On the other hand, you could use your £500,000 and borrow £500,000 from the bank to buy something for £1 million. See it double to £2 million and after paying back the bank, you have £1.5 million — trebling your original investment.

Naomi Heaton is chief executive of London Central Portfolio (LCP), an investment adviser and asset manager specialising in the private rented sector in prime central London. It has launched three property funds targeting this market. For more information go to londoncentralportfolio.com or follow @LCP_Ltd.

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