How to invest in residential property

Over the past two years, the 'bears' have become increasingly alarmed by the massive growth of buy-to-let mortgages, as competing providers have relaxed loan-to-value (LTV) conditions. There are now about 849,900 investment mortgages outstanding (£95bn), compared with 73,200 (£5.4bn) in 1999, because lenders have reduced the deposit requirements from an absolute minimum of 25 per cent of value, and no longer demand rental income equivalent to 130 per cent of mortgage repayments. The 'bears' are simply concerned that highly geared buy-to-let investors will be hurt should property prices fall, particularly those who are financially stretched and those involved in co-ownership ventures. Co-ownership is promoted by specialist websites enabling complete strangers to collaborate and raise a loan on a property and, because it's simpler for co-buyers to get a mortgage for a buy-to-let than for a primary residence, many under the age of 35 are tempted to use this route to get a foothold on the property ladder while they continue to live at home.

On the other hand, the 'bulls' claim that the fundamentals of the rented property market are sustainable because the imbalance between the supply and demand for rented accommodation in the UK is unlikely to be resolved in the foreseeable future. This is due to demographic factors such as the size of the student population, a growing working population as a result of uncontrolled immigration, an increase in the number of single-person households and continuing demand from local authorities that are required to provide 'social housing', but cannot fund the construction of new council houses. Certainly, the Association of Residential Letting Agents (Arla) is upbeat about future prospects, as are the mortgage lenders specialising in buy-to-let loans, including Bradford & Bingley, HSBC, Birmingham Midshires, Paragon, NatWest, GMAC, Mortgage Express and The Mortgage Business.

Without doubt, new entrants to the buy-to-let market face a different economic environment to that of five or 10 years ago but, if you select the property wisely, take on a manageable level of debt and invest for the long term (15 years or more), a buy-to-let venture can still be a lucrative proposition. If you're looking for a quick capital gain, then engage in property development rather than a buy-to-let investment.

Inevitably, both the type and location of the property will be determined by what you can afford, and your preference for income or capital gains. But, at the same time, you must also decide what type of landlord you want to be (hands-on or hands off), also the type of tenant you want. As any successful buy-to-let investor will tell you, being a landlord carries major responsibilities. Tenants have rights, and if these are ignored you could end up in a nasty legal wrangle, or with an unacceptable level of 'voids'.

What to buy?

If you are new to the buy-to-let market, don't invest in a large property targeted at either students or other itinerant tenants. Houses of multiple occupation (HMOs) can be financially rewarding, and demand for such accommodation is robust, but the recent introduction of licensing for HMOs means that landlords must ensure that their properties, and the persons managing them, meet particular criteria relating to the standard and safety of the accommodation. The rules are complicated, but essentially they apply to any shared accommodation of three or more storeys that is occupied by five or more people living in two or more households. In fact, Arla has recently reported a decline in the number of HMO landlords because the licensing process is bureaucratic and really only suitable for experienced, hands-on landlords.

Flat or house?

According to Arla there is only a marginal difference in reported returns between flats and houses, although in the south, flats command slightly higher returns than houses. The tables show Arla's estimate of average returns over five years for each region, and assumes house price inflation of 8.66 per cent a year, which is the average annual rate over the past 20 years.

Differences in annual rates of return for houses and flats - Average annual rate of return (%)

The other choice you will have to make is between old and new. In London, much of the Victorian and Edwardian housing stock is in need of refurbishment. This obviously imposes additional costs, delays and hassle for investors, but because demand for rented accommodation in London is insatiable, the effort will probably pay off. Opportunities exist in suburbs such as Haringey, Newham, Lewisham and Dartford, for example, where decently refurbished properties have potential.

Outside London most buy-to-let investors prefer either new-build, or properties that are under 10 years old, and in good condition. Investing in a new-build property allows you to start renting immediately, but with new developments it's important to be alert to the possibility of an oversupply of rented accommodation, creating fierce competition for tenants.

Bear in mind that property developers are heavily dependent on buy-to-let investors for forward sales, so be sceptical of the tempting offers advertised in the property magazines, and focus your attention on both the scale and speed of development in the immediate area.

Differences in annual rates of return for houses and flats (geared)

Where to buy?

Locating 'hotspots' that will generate a robust mix of capital appreciation and rental income isn't easy.

Annual and quarterly variations in house-price inflation are substantial at both the regional and sub-regional levels, and detailed information is easily accessible from various websites. But a close examination of prices and price movements is only useful for compiling a shortlist of possible locations, because however much you eyeball the numbers, they tell you absolutely nothing about the rentability of property in an area.

Rentability is fundamental to any successful buy-to-let venture, and particularly so for highly geared investors dependent on rental income to finance borrowings. Here, unlike property development, which is focused on a quick capital gain, buy-to-let is essentially a long-term income-orientated investment, where all the locations on a shortlist should be evaluated in terms of their economic prospects over a minimum of 10 years.

The most promising areas will be those benefiting from economic growth, rising living standards, an expanding working population and a shortage of decent rented accommodation. It's important that you keep all these factors in mind, particularly the last one. Property in many parts of the country is cheap compared with the south-east, but it would be foolish to assume that a 'bargain' has the makings of a lucrative buy-to-let investment. Buying and selling property is expensive, and buy-to-let ventures that have been aborted after only a few years, for whatever reason, have rarely been profitable, particularly for highly geared investors dependent on rental income to offset mortgage repayments.

To gauge the rentability of an area there is no alternative but to consult as many local letting agents as possible. They will give you an idea of the scale of demand in the area, a profile of the typical tenant and the type of property tenants want.

Always conduct your research with a checklist of questions that will help you identify property that can be rented easily. Access to transport, shopping facilities and schools are usually important, but also find out about crime. Property in rough areas may be cheap but it won't attract decent, reliable tenants.

Local letting agents will invariably quote you property yields, but never take these figures at face value. This is because they typically give a gross rather than a net yield, making the investment look more lucrative than it really is. Even where net yields are given you should again be sceptical, because many relevant costs are likely to have been ignored. In the light of this, it’s important that you do your own property yield calculations on a spread sheet, and test different assumptions about interest rates and capital appreciation.

Net property yield

The net property yield (NPY) calculation is as follows:

Total rental income minus running costs

NPY = ___________________________________________________

Current value of property (including purchase costs)

Rental income

This can only be estimated with advice from local letting agents, but you should build in a reasonable allowance for 'voids'. The average is currently 26 days a year.

Running costs – these are the most important items that should be included:

• interest on the money borrowed

• insurance premiums (building, contents, legal expenses, rental guarantee and emergency guarantee)

• replacement of furniture, fixtures and fittings

• servicing of electrical appliances

• legal expenses

• a letting agent – this will depend on the level of service you require

• ground rent and service charges for leasehold properties

• redecoration

Current value of property (or total sum invested) – this includes:

• purchase price of the property

• survey and valuation fees

• legal costs

• stamp duty

• redecoration and repairs

• purchase of fixtures and fittings

• payment of council tax and utility bills before the first let

• mortgage application and arrangement fees where appropriate

• 'opportunity cost' of whatever interest your deposit would have earned between the date of exchange and completion.

Calculating the current value of the property (or total sum invested) including all the associated costs is relatively straightforward, but estimating the total amount of rental income is more tricky, and you will need to collect as many quotes as possible from the letting agents for the different types of property. There may be greater demand for one-bed flats than for houses, or for two-bed flats rather than one. At the same time, quantifying the running costs of renting is equally problematic, and the list of costs that should be taken into account is extensive so, to avoid the possibility of expected rental income falling short of the running costs, it's important that you pay careful attention to this part of the equation.

So, the current 'hotspot' is Belfast, with an eye-popping annual increase in property prices of 61 per cent, but given the high level of inward investment into the province, there are solid reasons why this should be so.

But, however tempting Belfast may be, a buy-to-let investment that is miles away from your home invariably imposes additional problems and costs, not least all the expenses associated with researching the area and finding a rentable property. If you invest nearer home, you have the option of either employing a letting agent or managing the property yourself, but this is unrealistic for a property at the other end of the country, or in Northern Ireland. Letting agents provide different levels of service depending on how much work you want to do yourself, although it’s recommended that you employ them at some level. This is because letting agents are experts at tenant selection, drawing up tenancy agreements and handling disputes between tenant and landlord over deposits at the termination of agreements. But, if you need to employ an agent to sort out any and every minor problem, such as a broken boiler, or a leaking roof, for example, then you must expect the running costs of the property to mount up. In the light of this, it's important that you find out exactly what services are provided by the local agents, and how much they charge before becoming a distant landlord with little or no contact with either tenant or property except via an agent. Also bear in mind that some agents are more diligent than others, so seek out recommendations before you evaluate agents by the fees they charge.

Useful websites

• Association of Residential Letting Agents: www.arla.co.uk

• Council of Mortgage Lenders: www.cml.org.uk

• Land Registry: www.landregistry.gov.uk

• Nationwide: www.nationwide.co.uk

• Halifax: www.HBOS.co.uk

• House Price Crash: www.housepricecrash.co.uk