One of my golden rules of property investing is that you must only buy properties which generate a positive cash flow for you.
As a property investor, one of the critical skills you need to develop is the ability to quickly assess a particular opportunity to decide if it is a good investment and suitable for you or not. Many investor just don’t know how to do this, so I thought I would make it as simple as possible for you in this blog.
When researching any potential investment there are two main factors we are concerned with.
We want to determine:
A) The true market value of the property
B) The realistic market rent that could be achieved.
This is the information that a mortgage company would want a chartered surveyor to collect on their behalf, in order to assess whether to grant you a buy to let mortgage on a particular property. You need this information a long time before you even apply for the mortgage, to decide if it is the right kind of investment for you.
With these two pieces of information you can ascertain whether you are going to make a profit each month after covering all of the expenses. The main expense you will incur on a monthly basis is the interest on your buy to let mortgage.
I have a very simple rule of thumb which you can use to asses this monthly expense. For every £20,000 you borrow, at an interest rate of 6%, you will pay £100 per calendar month (pcm) in interest. For example, if you were to borrow £80,000 it would cost you £400 pcm.
This is based on a 6% annual interest rate for two reasons: First of all it’s the average rate I’ve had over the last 15 years. Secondly, it keeps the numbers easy to calculate because every £20,000 you borrow cost just £100 pcm. I like to keep thing as simple as possible.
If the average cost of a mortgage is only 5% per annum then this rule of thumb is very conservative. This means that in reality £20k will not cost you as much as £100 pcm but by using this in your calculations you are being very cautions which is good because you don’t want to be too optimistic.
When working out the cash flow many investors are too optimistic on what the costs will be and they don’t get it right. It’s better to be pessimistic and have a nice surprise to make more money than expected.
The mortgage lender will then use a rent multiplier to make sure that the rent is going to be enough to cover the monthly interest and the other cost associated with the property. This rent multiplier can vary from lender to lender but most will uses something like 125%. This means that the lender wants to check that the monthly rent is 125% of the monthly interest payment. (Rent > Monthly interest x 125%).
With a mortgage of £80,000 and a monthly interest charge of £400 your lender would generally want to see a monthly rental income of at least £500 pcm (£400 x 125%). The extra 25% over and above the interest payments is an approximation of the other monthly costs. Using this rent multiplier will help you to very quickly asses if a property is going to make monthly cash flow for you.
With a monthly interest cost of £400, if the monthly rent was just £500, it may only just about covers the costs. However, if the monthly rent was £550, then it means you would probably make some cash flow from this property each month. If the rent was just £450, you wouldn’t be making positive cash flow, in fact we know it’s going to cost you month each month. In reality the lender may not lend the full amount.
To summarise, you can quickly work out if a property stacks up as follows:
1. Work out how much is the mortgage going to cost you
2. Multiply the monthly interest by 125% to give the required rent
3. Check that the actual rent is more than the required rent.
Having used this quick approximation, if the property does not stack up you can move on to the next one without wasting too much time. If however it looks like it does stack up well, it may be worth spending a little more time to properly work out the true cash flow to help decide if you want to purchase it.
This article has been taken from the new “2010 and Beyond” edition of Property Magic which is an Amazon No 1 Best seller. This new edition is available on Amazon now. Click here to Buy Property Magic 2010 now!
Founder property investors network