Chapter 1: Rental Yield Calculations

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. –Benjamin Graham, The Intelligent Investor

Gross yield is simply the annual rental income from a property divided by the purchase price of the property. So, for those of you who like a formula:

Firstly, gross yield is a simple way to compare different investments. For example, all other things being equal, an investor would prefer a property that offered an 8% p.a. gross yield to one that offered 6% p.a. Secondly, you only need a small amount of information to calculate it. So, it’s a quick and easy place to start when assessing potential property deals. However, the limitation of gross yield is that it doesn’t consider your upkeep costs.

It’s really only useful for headline comparisons and perhaps an initial screening of potential investments.

Net yield is the annual rental profit from the property divided by the purchase price of the property. Net yield is calculated as follows: or when calculating the net yield for a potential property investment, we need to include all the costs associated with running the property over the course of the year. For example, we would include all the following costs: mortgage payments marketing costs letting agent fees repair and maintenance costs service charges and ground rent insurance costs (e.g. buildings insurance) an allowance for voids (e.g. lost rent, utilities) other administration costs.

Net yield is a much better metric to use when comparing potential investments. It considers all the costs of running your rental property, so it’s based on the money you’ll have left over after all costs have been paid. Also, it shows up any fundamental differences in the running costs of

different properties, e.g. between flats and houses, old and new properties, etc. That means it provides a much better comparison of the potential investment returns across different types of property. 

However, the key factor that net yield ignores is the amount of cash you have tied up in the investment. Net yield compares our annual rental profit with the purchase price of the property. But we’re unlikely to have purchased the property in full, in cash – we’re more likely to have used a mortgage, so we won’t have put in 100% of the purchase price ourselves. 

Cap rate is calculated as the annual net operating profit from the property divided by the purchase price of the property, assuming the investor buys the property in full without using a mortgage. As such, the calculation excludes mortgage costs. Capitalization rate is calculated as follows: or So, the only difference between net yield and cap rate is that cap rate excludes mortgage costs. We still need to include all the other costs that we listed above, i.e. marketing costs, letting agent fees, repair costs, service charges, ground rent, insurance costs, etc.

Cap rate is useful precisely because it excludes mortgage costs. The formula for cap rate is based solely on the profitability of the rental property itself, not on the mortgage financing used by the buyer to purchase the property. 

This calculation shows us how our rental profits compare with the actual cash we have invested in the deal.

ROI is the annual rental profit from the property divided by the cash you’ve invested in the deal. If you bought a property in cash without a mortgage, this would be the same as the cap rate. But if you used a mortgage, you’ll have put in much less of your own cash. 

In practice, we also need to consider additional costs like stamp duty, legal expenses, surveys, broker fees, etc. These are all real cash costs that need to be paid upfront, and so we should add all of these to the “cash invested” in our ROI formulae above. 

ROI is our best guess at the return we’re actually going to achieve on our cash. Because of this, you can even compare it with the returns you’d get on non-property investments, e.g. the interest that we’d receive on a bank account or the dividend yield on a share. It shows you how hard your money is working for you and how this compares with other available investments. 

Gross yield is quick and simple and it’s okay for comparing investments when they have similar running costs Cap rate estimates the return you’d achieve if you owned the property outright and separates out the financing decision, so it gives a more objective measure of the potential returns Return on investment shows you how hard your money is working for you For most investors, ROI is the most useful of these calculations. It factors in all the running costs of the investment and it takes into account the method you’re using to finance the deal. It also tells us something about the likely payback period for the investment.

Payback period is a useful concept in investing. It tells us the length of time we’d need to hold the investment for it to pay us back the money we’ve invested. It follows that if we don’t think the investment is going to be profitable for at least that length of time, we should give this investment a miss. In summary, gross yield is useful for screening potential investments in the early stages of due diligence. Cap rate is useful for comparisons between properties and for property valuation work. 

But ROI is the ultimate metric, and it’s the one you’ll likely base most of your investment decisions on. In all honesty, most investors don’t use net yield at all.

In short, you can flex the criteria you apply to these rental yield calculations, depending on your views around the future growth prospects for a property and for an area. 

Yields are often highest after a property crash and lowest in the boom period.  

Chapter 2: Stress Testing Deal Cash Flow

You can and should have different criteria for accepting and rejecting deals, based on your convictions about future capital growth potential. Where the capital growth prospects appear less strong, you absolutely should demand a higher ROI or cap rate from your property investment. Finally, it’s worthwhile saying that the number one criteria for accepting or rejecting a deal is that it should be cash flow positive.

Cash flow is simply the cash profit the property makes each month or year after all expenses are taken into account. It’s closely related to ROI, or on a monthly basis.

Real life cash flows are unlikely to be as smooth and consistent as $200 per month. There could be months when cash flow is zero or potentially even negative. But if real life cash flows aren’t smooth, then what shape are they? Well, they’re shaped a bit like a frown. Rental expenses are often higher at the start of a tenancy. You’ll be paying for things like advertising the property to potential tenants, final repairs, inventory checks, and so on. Likewise, at the end of a tenancy, there will be higher costs related to cleaning, refurbishment, and tenant check-outs. Rental costs in the middle of a tenancy will likely be lower, but with some lumps and bumps along the way due to one-off repairs, service charges, ground rents, etc. But our rental income, the other side of the cash flow equation, will likely be spread evenly throughout the tenancy. In general, you won’t go far wrong if you expect your cash flows to be frown-shaped – lower at the start and end of a tenancy and higher in the middle. This means you’ll likely need some cash in your account at the start of a tenancy to meet any initial upfront costs. You’ll also need some funds spare at the end of the tenancy, so don’t take out all the cash you make in the middle.

The best thing we can do to avoid bad property deals is to improve the accuracy of our cash flow modelling. When estimating the future cash flows, we need good estimates of all the costs involved in running the property. We also need a good estimate of the potential future rental income from the property.

Rental income

The figure you use in the modelling should be a conservative estimate of the likely rental income from the property. Err on the side of caution.

Mortgage Interest

To get to grips with your likely mortgage costs, get in touch with your broker, and always work off actual mortgage rates available at that time.

Marketing and tenancy set-up costs

My main message here is not to underestimate these costs. Make sure you base your modelling on research of the actual costs of using local letting agents in the area.

Management fees

Management fees for a typical rental will be in the region of 10% to 12% of the monthly rent.

Repairs and maintenance 

As a general rule of thumb, I tend to make an allowance of 0% to 5% of the monthly rent for apartments. I’d use something at the lower end of this range for a new build apartment. For houses, I typically make an allowance of 5% to 10% of the monthly rent, possibly higher for older houses with extensive maintenance issues. Again, it’s important to be consistent in your modelling and to err on the side of caution. Try not to underestimate these costs.

Insurance

Try phoning an insurance broker to ask for a quote or ask the seller for details about the cost of their building’s insurance. Factor in something small for public liability insurance and accidental damage cover.

Vacancy 

Allowance for voids In between tenancies, your property will likely be sitting idle for a couple of weeks. You should factor the cost of this into your cash flow estimates. Also, you’ll need to cover the cost of any utilities used in the void period, e.g. electricity costs.

If a deal doesn’t work on fairly cautious assumptions, it’s probably not worth doing anyway. 

Margin for safety is a concept taken from the accounting world. In accounting, it’s the amount that the sales or revenues of a business can drop before it starts to make a loss. It’s a buffer, if you like, against future uncertainty.

To stress test my cash flows, I look at the impact on monthly cash flows of an adverse change in one of my key assumptions. I first examine the impact on an “all other things being equal” basis – that is, I change just one assumption at a time. Then finally, I think about the potential combined impact of these changes. You should aim to invest in deals where the cash flow is strong and where you expect it to remain positive under the combined impact of two or more stresses. That way, you’re almost guaranteed to be doing a deal which is cash flow positive and which puts money in your pocket every month. So what changes in the assumptions should we consider in our stress testing? (1) A fall in the market rent You should consider the impact of a fall in market rent. A sensible stress test might be a 5% fall in the monthly rental income from the property. (2) An increase in mortgage interest costs. To stress test a deal, consider using a higher interest rate in your modelling. (3) An increase in repair costs We’ve already looked at a typical allowance for repairs above – that is, 0% to 5% of the monthly rent for apartments and 5% to 10% of the rent for houses. In your stress test, you could consider increasing this allowance by say 5% from the figure you’ve used in your base case. (4) A general increase in other costs Finally, there will be a whole load of other costs which individually aren’t that significant, but which can add up. It’s not worth stress testing these costs individually, but you can group them together and consider say a 10% increase in the total.

As a parting thought, it’s worth calling out the two main reasons that property investments turn out to be cash flow negative for some property investors. (1) The capital growth trap – Investors chasing price growth will sometimes convince themselves it’s okay to have thin margins for safety. They’ll trade off yield and cash flow for the hope of capital growth – that’s what I call the capital growth trap. The value investor, however, looks for a strong margin for safety and some growth potential, seeing growth potential and cash flow as two sides of the same deal. (2) Using too much leverage – The larger the amount of money you borrow, the thinner your margin for safety. If you’re uncomfortable with the cash flow position, you could consider putting more money into the deal and borrowing less. It will lower your ROI but improve your cash flow position. Remember that debt is always destabilizing, so use it with caution. 

Chapter 3: How to Value Residential Property

The comparison method of valuation

Of our three methods, this is by far the most straightforward. As its name suggests, it relies on an analysis of previous transactions to give us an estimate of a property’s market value. The idea is that if a similar property sold for a certain price, this tells us something about the market value.

Adjustments to raw data

Here’s a list of some of the things we could consider adjusting for: Usable space – Any differences in the usable floor space. Location factors – If the house you’re looking at is right next to a pub or a busy junction, the value will likely be lower than for an otherwise identical house in the same street. Amenity – The overall quality, desirability, or convenience of an area. Aspect – The specific positioning of a property, e.g. within a block, can have a significant effect on value. Ground floor flats tend to sell for less. Apartments with riverside views, double or triple aspects, and balconies, tend to sell for a higher price. Rooms – The number of bedrooms and bathrooms will affect the price, but we need to make sure we don’t double count this versus the usable space. Parking – The presence or absence of onsite parking will also affect value. Condition – The condition of a property will affect its value too. Poorly maintained properties will be harder to sell, and buyers will discount properties by the sum needed to bring the condition in line with more marketable property. Other factors could include the size of the garden, the standard of decor, the condition of the central heating system, the presence of double glazing, the condition of internal fixtures and fittings, and many other things that we haven’t listed here.

The investment method of valuation is most useful for property investors. The method is a way to value a property from its actual or anticipated net rental income. It assumes an investor will look at the net rental yield and will be prepared to pay a multiple of that income to purchase the property. The investor’s main reason for owning the property is not for occupation then, but for its financial reward from the flow of rental income and future potential for capital growth. 

How does the method work? The method begins with the relationship between the income from an investment and its purchase price or capital value. Where an investor has a minimum rate of return for a certain type of property, this can be factored into the mathematics. 

Here, i is the investor’s required capitalization rate from the property. Also, to recap, the net operating profit is the annual rental income less the annual rental costs, excluding mortgage costs. That’s because cap rate assumes you purchase the property in full with no mortgage. 

When setting the cap rate, an investor should take into account the trade-off between the risks posed by the investment and the potential for rental and capital growth. The 5% p.a. cap rate used in the example above suggests the investor is confident there will be some combination of rental and capital growth in the future. The investor may seek a higher cap rate on a property they consider riskier than this or a lower cap rate where the growth potential is even higher.

The residual method of valuation Our final method is the residual method of valuation. Property developers use this method to estimate the price they’re prepared to pay for a piece of land that they intend to develop. To do this, they estimate the final value of a completed development and subtract off the cost of the development and their profit margin to arrive at a residual land value. That is, they use the method to work out what they’re prepared to pay for the land itself.

Which of these techniques is most useful to you will really depend on your property strategy. If you’re interested in plain, simple buy-to-lets, the investment method will likely be of most interest to you. If you trade properties for a living, then you’ll likely be most interested in the comparison method and buying below market value property. If you’re flipping, then you’ll be making use of the residual method of valuation combined with the comparison method to estimate the final sale price for the property.

Chapter 4: Calculations for Deal Financing

So, leverage can be used to power up our ROI. But it’s worth pointing out that as our deposit amount decreases, our monthly cash flow from the investment will decrease because of the higher borrowing costs. In practice, therefore, the amount of leverage you’re comfortable with will depend on how much of a cash flow buffer you want from your investment. Ultimately, it’s a trade-off you need to make – a lower deposit amount gives a better ROI, but a higher one will give a better margin for safety on your cash flow. You’ll need to find the sweet spot in the middle that you’re happy with. As a final word of caution, leverage will only increase your ROI if your cap rate is bigger than your cost of borrowing.

Chapter 5: Ten Negotiation Tips and Tricks

Negotiation Tip #1 – Proof of Life

The idea is that the negotiator (our hero) will refuse to enter the negotiation unless the hostage taker provides proof of life. This could be putting the hostage on the telephone or sending one of those classic photos of the hostage holding up a copy of today’s newspaper. It’s the way the kidnapper proves he’s got the thing we’re after. But how can you use this technique in property negotiations I hear you ask? Well, in business deals, we can use the technique as a kind of “proof of life of the deal”. That is, we can ask a question or create a hoop that someone needs to jump through to earn the right to do business with us. The test we use is designed to open the dialogue in a professional way and their answer will indicate whether they plan on doing business with us and whether they can be trusted to honour their subsequent agreements.

For example, you could ask for things like: details of the current service charge and ground rent a copy of the tenancy agreement (if the property is tenanted) a copy of the lease agreement to check things like ground rent increases and/or your ability to sublet any fees that will be applied by the freeholder on subletting the property your rights around changes or repairs to the property. 

Negotiation Tip #2 – Establish Your Credibility

When you’re dealing with a new agent or seller, you can tell them a little bit about yourself and your background to establish your credibility. This could include telling them about things like: your experience as a property investor what you do for a day-job / your occupation where you are in your property journey any past experiences investing in their local area details of any relevant deals you’ve done. 

Negotiation Tip #3 – No Kicks Off the Negotiation

Getting a “Yes” is the final goal of every negotiation. But you shouldn’t aim for it right away. Saying “No” makes people feel safe, secure, and in control. So, you should aim to trigger a “No” early in the process. By rejecting your offer, your counterpart will start to define the space for negotiation in their own minds. They will also gain the confidence and comfort to listen to your next offer properly. 

Great negotiators seek a “No” early on because that’s when the real negotiation begins. Before you get to a deal, the other party will need to convince themselves that the solution you wanted works for them or even better that it was their own idea. They’ll only get to this place by going through “No” first. You won’t beat them with logic or brute force. Remember that to get to a deal – it’s not about you, it’s about them.

Negotiation Tip #4 – Use an Extreme Anchor

Researchers have discovered that we tend to make adjustments from our first reference point. That’s because we focus on the initial number and then extrapolate. And we end up depending too heavily on the initial piece of information offered (the “anchor”) when making later decisions.

Research shows that people who are presented with extreme anchors unconsciously adjust their expectations in the direction of the opening number. Many people even jump straight to their price limit in this scenario. Unlock the potential for a deal by using an extreme anchor to bend their reality.

Negotiation Tip #5 – Explain Your Offer

The best strategy for getting the agent onboard is to explain any offer you put forward. You can do this in a number of different ways. For example, you could use a sales schedule to present your research on what similar properties have sold for in the same block. This can help to support your assessment of the property’s current market value. You can also combine this with a range, as discussed above. 

Negotiation Tip #6 – Try Ackerman Bargaining

It’s easy-to-remember and it has five steps. Let’s look at how it works.

– Set your target price (your goal)

– Set your first offer at 86% of your target price

– Calculate three raises (94%, 98% and 100% of your target)

– The final offer should use a non-rounded number On your final offer, throw in a non-monetary item

For this strategy, use increments of 1%, 2%, and 4% (that is, offer percentages of 100%, 99%, 97% and 93% in reverse order) can also work well if the range for price negotiation is a little bit narrower and the buyer and seller are closer in their views.

Negotiation Tip #7 – Pivot to Non-Monetary Items

There’s more to a negotiation than price. And when we forget this, we leave money on the table. People get fixated on the “How much?” and this can lead them to take a series of arbitrary positions wrapped up with their emotional views of fairness and pride. You can take the focus off price by pivoting to non-monetary terms. In any property deal, there are a truck load of other things that can be used as bargaining chips. For example, there is the timeline for the move, the fixtures and fittings that are included, whether the property gets a clean beforehand, etc. 

Negotiation Tip #8 – Understand Leverage 

Positive leverage

This is your ability to provide things your counterpart wants. In a property negotiation, positive leverage could be a movement on price or on one of the non-monetary terms discussed above. Here, you’re trying to work out what your counterpart values. You should try to help your counterpart get what they want. Negative leverage This is your ability to make your counterpart suffer. In a property deal, there are probably limited opportunities to use this type of leverage. Mild examples could include stalling for time when your counterpart is burning cash, e.g. with a vacant property, or being pedantic on legal points, e.g. if you require your counterpart to register a title with the land registry when it’s not a formal requirement. Use this type of leverage carefully, as threats, even mild ones, can be toxic and they can kill a deal.

Normative leverage

This is using the other party’s “norms” to advance your position. Every party has a set of rules and a moral framework. You can use these to present your offer in the best possible light or to highlight inconsistencies between their beliefs and actions. No one likes to look like a hypocrite. For example, if your counterpart says they won’t sell the property for less than the market value, you can frame your desired price within the context of a market valuation. Think of this as negotiation Tai Chi, using your counterpart’s energy against them. 

Negotiation Tip # 9 – The Waiting Game

Making your counterpart wait before you make your next move can work wonders. Waiting can help your extreme anchor work its magic on their subconscious. It can give your counterpart the time they need to come to terms with the idea that they won’t get top dollar. It can also make you look like you’re working hard in the background on a revised offer. How long you wait will depend on the situation. Oftentimes, I’ll leave it a couple of days after my extreme anchor offer is rejected before I put in a higher offer.  You can experiment with different timings here. I tend to find that waiting a week or so between offers works quite well in the middle phase of a negotiation. Any longer and the deal kind of loses focus and energy. Towards the end of a negotiation, picking up the pace works well to try to seal the deal. 

Negotiation Tip #10 – The Silent Partner

The silent partner Our final negotiation tip is called the silent partner. When I’m talking with agents, I’ll often use my ‘investment partner’ as the excuse for needing additional time to consider the seller’s counter-offer or the attractiveness of a revised deal. 

Use the silent partner technique to avoid making a decision there and then and to buy you time to properly consider your next move.

Chapter 7: How to Measure Your Returns

Return on Capital Employed (ROCE)

ROCE is a measure of how well the business is generating profits from its full capital base or capital employed. It’s worth pointing out that “capital” here means something slightly different in this context than it did in our previous chapter. This can cause some confusion to new property investors. 

Capital employed is defined here as the net assets (or owner’s equity) plus non-current (or long-term) liabilities like bank loans. As such, capital employed is a measure of the total funding that the business has received from both the owners of the business and the lenders. ROCE is frequently regarded as the best measure of a business’s profitability. It indicates how successful a business has been in utilizing the funding it has received to generate profits. In effect, it tells us how much profit has been made for each pound of funding the business has received from the owners and lenders combined. 

Return on Equity

Return on equity (ROE) looks at the return earned by the owners of the business. For a business set up as a limited company, this is the return earned by the ordinary shareholders. For a sole trader, this will simply be the return earned by the owner.

Note: In other words, it’s profit / (assets – liabilities) or shareholder equity. 

ROE tells us about the profitability of the business after paying all its expenses, including interest on its borrowings. In this way, ROE is a sort of ROI measure for your property portfolio as a whole.

However, it’s worth noting that these yield metrics will also move around with changes in property prices. For example, if one of your properties experiences strong capital growth, this will decrease the capitalization rate by increasing the “purchase price” input into the formula above. As such, gross yields and capitalization rates will sometimes fall in areas which have achieved strong capital growth. In this type of situation, you’ll naturally be asking yourself whether now is a good time to sell the property and lock in the gain or whether you should continue to hold the property for the rental yield. Also, it’s worth saying that rather than placing too much weight on one particular year, you should make sure to look at the averages over several years. 

Time Weighted Rate of Return (TWRR)

How do we calculate the average return achieved? In order to do this, we need to calculate what’ s known in the investment industry as the time weighted rate of return (or TWRR). The TWRR is a measure of the compound rate of return achieved. It breaks up the return achieved into separate intervals and calculates the geometric mean of all these returns. We calculate TWRR as follows.

Where is the return achieved in year 1, is the return achieved in year 2, and is the return achieved in year n. As such, this formula can be extended to cover as many periods as needed. In the general formula above, this is over n time periods.

How to use the TWRR We can use the time weighted rate of return (TWRR) to calculate multi-year average returns for any of the metrics considered in this chapter. For example, at the property-by-property level, we could use the TWRR formula to calculate an average for the gross yield, cap rate, return on investment, capital growth or total return. At the total portfolio level, we can use the TWRR technique to calculate an average return on capital employed (ROCE) or an average return on equity (ROE) across any time period of interest to us. It’s really up to you how you use it and for which performance metrics. 

Chapter 8: Property Management KPI’s

If you invest in high-quality properties in nice locations and if you vet tenants carefully, you should experience a relatively low level of rental arrears and losses related to damage. Make sure you screen tenants carefully through your reference checks and absolutely do not give someone the benefit of the doubt. If they have bad credit history, you should insist on a guarantor or better still look for another tenant.

Here’s a quick list of ideas and some areas where you might be able to generate extra income from your investments. Parking – Depending on supply and demand in the local area, you could charge anywhere from $50 to $150 per month for parking. On the supply side, you could buy a space yourself or you could rent one from someone else. Monthly pet rent – Pet owners often have a more limited choice of accommodation, as lots of landlords will not accept pets of any kind. As such, pet owners will pay more rent. You could charge $25 to $50 a month, depending on the pet. Cleaning service – You could write to tenants and offer them a cleaning service for a fixed fee each week or month and then arrange for this to be provided by a local cleaner. If the fee you charge the tenant is greater than the cost of hiring a cleaner to provide this service, then you’re in the money. Laundry service – You could offer a laundry service for a fee, perhaps a pick up and return dry cleaning service. Again, you could charge a fee, then cut a deal with a local dry cleaner. Moving in and out – There might be opportunities for renting out storage space or supporting tenants in the move. Buy-out fees – You could perhaps, subject to the tenant fees ban, charge one month’s rent for lease breaks.

In the list below, I’ve suggested some areas where you could consider setting some non-financial KPIs.

Tenant satisfaction

You could design a tenant satisfaction survey, e.g. using SurveyMonkey, and monitor these tenant satisfaction scores over time.

Time to complete repairs

One of the biggest frustrations for tenants is landlords who don’t respond quickly. Why not set yourself a KPI around the number of days taken to respond to requests and complete repairs.

Suggestions box

Write out to your tenants and ask for their suggestions and about any niggles or frustrations they have.

New tenancy set up

You can set yourself KPIs around having tenancy agreements in place, deposits registered, the correct documents issued at the start of each tenancy to help you meet the minimum legal requirements.

Safety testing

You’ll need to make sure all the safety testing requirements for your properties are carried out in a timely manner. This will include things like gas and electrical safety checks. Set yourself some KPIs around these.

Environmental impact EPC rating

There is evidence that ecofriendly properties with lower environmental impacts attract higher capital growth and rental income. Set a minimum EPC rating for your properties and use this as a KPI over time.

Tenant quality Inspections

Use inspections to understand how well tenants are looking after your properties. Set yourself some KPIs, e.g. that all tenants are achieving a minimum inspection rating of ‘satisfactory’ with no major damage.

Incidents of damage

Monitor the number of incidents of damage and set yourself a KPI around this. If there are too many incidents, you will need to figure out why and what you can do about this.

Chapter 9: Portfolio Risk Management

Running a property rental business exposes an investor to all kinds of risk. There are property specific risks, such as tenants defaulting on their rental payments or causing damage to your property. There are also external risks, like changes in market rents or interest rates. And how you manage these risks over the long term will impact on the success of your investments. Risk management is the process of identifying, quantifying and controlling these risks. 

The top five risks for property investors

1) Liquidity risk

Liquidity risk is the risk that a business cannot meet its short-term obligations. That is, it’s the risk that the business runs out of cash and cannot pay those people or businesses that it owes money too. For a property rental business, the principal risk is that your investment portfolio turns cash flow negative and you don’t have a sufficient amount of liquid assets set aside to cover the cash outflow. Individual properties can turn cash flow negative over the short or medium term for a variety of reasons, such as a tenant defaults and stops paying their rent an unexpected large repair, e.g. a boiler replacement an extended void period, possibly with expenses.  

As property investors, our only option is to hold a cash reserve to cover such expenses. This may include a cash reserve for repairs, tenant defaults, and normal property expenses.

One way to calculate the required reserve fund is as follows:

As a rule, we’re going to set the size of the reserve fund equal to the amount we’d need to be 99% certain we will have enough cash in the next twelve months. We’ll also assume that the risk of a single tenant defaulting in any given year is 10%. You can check these probabilities using an online calculator for a binomial distribution, which is the mathematical name for the model we’re using here. If you type something like “binomial distribution online calculator” into your favourite search engine, you’ll find a range of these tools online. Simply input 0.1 as the ‘probability of success’, which here is the probability of one of our tenants defaulting. In addition, you can input the number of properties in your portfolio. Then, depending on the calculator you’re using, you can read off the probabilities and cumulative probabilities.

When you’ve only got a small number of properties in your portfolio, you might be more relaxed on this point, e.g. if you feel you could add in some extra cash from elsewhere should you need it. However, as your portfolio grows in size, you’ll need to be more systematic in the way that you manage this kind of liquidity risk. For a large portfolio, there’s almost no chance you could add the extra cash needed if things do go wrong – the size of the problem has increased relative to your other earnings. At this level and size, you’ll need to make sure your portfolio is self-sufficient. This kind of tenant default model can help here.

2) Interest rate risk

Interest rate risk is the risk that the profitability of a business changes due to changes in interest rates in the economy. In the main, it’s the risk that your borrowing costs will go up and your profits will reduce as interest rates increase. There are several things you can do to manage interest rate risk. You can opt for longer fixed-rate periods on your mortgages to fix your borrowing costs for five years or more. This will reduce your exposure to interest rate risk in the shorter term and it will also give you time to rebalance or adjust your portfolio, if needed. This is especially important if your interest cover is low. Over the longer term, you can also decide to pay down some of your mortgage balances, e.g. to drop the LTV to 60% instead of 75% on a property. This might unlock a slightly lower interest rate too. The need to pay down mortgage balances to reduce interest rate risk and the desire to reinvest your profits in new rental properties will always be a source of tension in any decision making. Finally, you could save up hard and pay off the mortgage balances for one or more of the properties in your portfolio.

3) Revenue risk

Revenue risk is the risk that an event takes place which negatively impacts future business revenues. For a property rental business, the principal revenue risk is a fall in market rents for one or more of your properties. This could happen because of specific risks relating to the property itself, e.g. a certain apartment block falls into disrepute or part of a town or city becomes unfashionable. Changes in economic conditions can also impact on market rents more widely. When it comes to quantifying revenue risk, we’re better off sticking with a high-level sensitivity test. That is, we can look at the impact on profitability of a fall in market rents of a particular order. But how much of a fall would be sensible to model? A reasonable stress test to model could be a 5% fall in revenues. 

Your biggest enemy here is concentration risk. That is, if all your rental properties are located in a single area, the profitability of your portfolio will live and die by the fortunes of this one area. The antidote to this particular poison is diversification. So, unless you’re wedded to a particular area, e.g. if you manage the properties yourself, it should be part of your strategy to diversify your portfolio across a range of towns and cities. You should also aim to invest in a range of different property types,

4) Expense risk 

Expense risk is the risk that the expenses associated with running your business increase. In turn, this will decrease the profitability of your business and could push you into a loss-making position. When it comes to quantifying this risk, we’re better off sticking with a high-level stress test, as we did for revenue risk. That is, we could model the impact on profitability of an across-the-board increase of 5% or 10% in all our expenses. Your best weapon against expense risk is to be conservative in your modelling before you buy a property to make sure there’s enough cash flow and a large enough margin for safety in the deal.

5) Model risk

Finally, I just want to say a quick word on model risk. Model risk is the risk that a financial model that we’re using fails or performs inadequately. This can lead to adverse outcomes for the business. For a property rental business, the main risk is that the financial model we use to assess a potential deal and the due diligence we perform leads to an overly optimistic estimate of the profitability of a future investment. If we underestimate the expenses or overestimate the market rent, then our investment will perform much worse than expected. Over the long term, a series of bad deals has the potential to kill your property portfolio. So, remember, making a bad deal is worse than making no deal at all. Our best protection against model risk is to make sure the figures we’re using in our models are based on thorough research.

Other risks to think about In addition to the risks we’ve discussed so far, there are a variety of other risks you might want to think about. Operational risk – The risk of losses due to poor systems and procedures is something every business must contend with. For a property rental business, this would cover everything from fraud to tenant lawsuits. The risks you’re running will vary for each business and need to be managed accordingly. Also, make sure to use insurance where it’s needed. Regulatory risk – This is the risk that changes in regulations or legislation will affect your business. This is a key risk for property rental businesses, as the environment is constantly evolving. There will inevitably be changes to tenancy laws and regulations, health and safety standards and to the tax system. To stay on top of these, make sure you take the right advice.

Chapter 10: Golden Rule of Portfolio Building

What is the property cycle? The property cycle is a sequence of recurrent events, a pattern if you will, that plays out across property markets. Like other investments, property tends to follow a predictable cycle. The cycle itself has four different phases.

Recovery phase

The recovery phase Let’s start out with the recovery phase. At the beginning of this phase, prices have just fallen in a recent market crash. Prices have in fact fallen to a level where yields are high and the monthly cash flows are strong. This is because prices have fallen much more than rents. For contrarian investors with cash resources to spare, this is a fantastic time to be buying. At this point in the cycle, there will be very few buyers in the market. 

As rents and cash flows start to increase and as brave investors lend support to prices, the recovery phase starts to develop. More and more buyers acquire the confidence to re-enter the market. Property prices start to rise. This happens in the prime locations first, with early price growth being mainly in the big cities and city centre hotspots. Then it starts to ripple out.

The boom phase

The boom phase With the recovery gathering pace, the market will gradually move into the explosive boom phase. At the start of the boom, it will now be clear that prices are increasing. More investors will return to the market. The banks have now repaired their balance sheets and they are keen to lend again. This will provide a boost to the market as cheap-and-easy financing increases. House prices start to increase at a much faster pace. Prime cities and city centre locations will switch into another gear and unloved secondary locations will start to see their first price rises. Better times and an improved economic backdrop will make providers of capital more optimistic. Yields have fallen, and higher property prices have made deal cash flows less attractive, except perhaps in secondary locations. 

The mania phase

Banks have relaxed their lending criteria as far as they can go, and credit standards are what can only be described as lax. The higher prices go, the more everyone believes they will continue to do so. The vast amount of money pouring into the market keeps prices going up and up. We’re now into the last couple of years of the explosive boom phase.

The crash or slump phase

At some point, confidence starts to dip a little. Financing suddenly dries up – almost overnight it seems. Confidence evaporates completely, taking the market with it. Property prices start to plummet. Individuals and investors who are overleveraged go bankrupt. This triggers a wave of repossessions and forced property sales which add to the downward pressure on prices. After a year or two of falling prices and bad economic data, we start to see the first green shoots of recovery. Unemployment peaks and rents stop falling.

In the property market, there can be significant lead times before a new building comes on to the market to meet additional demand. How long is a typically property cycle? Long lead times in the development process are then a major driver on the supply side and influence the length of a typical property cycle. Property cycles can last anywhere between 15 and 25 years from peak to peak or from crash to crash.

The Golden Rule of property investing is to only invest in properties that provide positive cash flow.