how to calculate roi for rental properties

What Is a Good Return on Investment (ROI) for a Buy-to-Let Property in the UK?


The answer is, it depends how much of your own cash you use to purchase the property. And the more cash you use, the worse your return will be.

Working out your return on investment (ROI) for a rental property is essential to making financial decisions. This calculation tells investors if buying, letting and selling a prospective property is a better investment than, for example, stocks.

Your return on investment should not be confused with your rental yield. Think of the ROI in the same terms as any other investment you might have – the total return you get from the money you put in.

Formula for a Rental Property ROI Calculator

Here’s how to calculate ROI for a rental property. 

First, calculate your annual rental income. Then subtract your expenses, including any mortgage payments, management fees, repairs and Gas Safety Certificates, periods without a tenant, and so on. You must then divide this net figure by the amount of cash you invested into the property, then multiply by 100 to get the final percentage ROI figure.

Note the cash that you invested into the property is hard cash and will not include a mortgage. Let’s say you purchase a house for £150,000 using a buy-to-let mortgage of £100,000 and £50,000 cash. Your cash investment for ROI purposes is, therefore, £50,000.

ROI example with a mortgage

Using the above £150,000 property, we can work out your ROI had you purchased outright or taken the mortgage route. With the £100,000 mortgage, the figures might look like this:

Annual rent: £8,400

Annual costs, including mortgage repayments: £4,000

Net annual profit = £4,400

Purchase price: £150,000

Mortgage used: £100,000

Cash invested: £50,000

ROI is the net annual profit of (£4,400) divided by your cash invested (£50,000) x 100 = 8.8%

ROI example without the mortgage

This time we use the same property but assume it was a cash purchase. The calculation is now as follows:

Annual rent: £8,400

Annual costs without a mortgage: £1,500

Net annual profit = £6,900

Purchase price: £150,000

Mortgage used: £0

Cash invested: £150,000

ROI is now net annual profit of (£6,900) divided by your cash invested (£150,000) x 100 = 4.6%

You can see that your ROI is much lower in the second example without a mortgage (4.6%) compared with the first example where you invested less with a mortgage (8.8%).

What ROI Can Landlords Expect?

As we learned from our £150,000 property above, the ROI can change drastically depending on your investment. But what is a good ROI for a rental property, given that the two ROIs in our example are so different?

The most crucial point is that your ROI needs to be positive. It means you are making money, and that must be a good thing. Whether you consider your positive ROI to be good rather depends on what you are trying to achieve.

For those of you looking at a long-term investment, maybe hoping a rental will contribute towards a future pension, you will be okay with a lower ROI in the short-term. Perhaps you have a repayment buy-to-let mortgage which will be paid off within 15 years when you hope to retire. When you come to work out your ROI then, it will be considerably improved. When we look at your new ROI calculation, the figures change because mortgage costs are no longer a factor. Like this:

Annual rent: £8,400

Annual costs, now without the mortgage repayments: £1,500

Net annual profit = £6,900

Purchase price: £150,000

Mortgage used: £100,000

Cash invested: £50,000

ROI is now net annual profit of (£6,900) divided by your initial cash invested (£50,000) x 100 = 13.8%

By any stretch of the imagination, that’s a decent ROI. In reality, of course, you would be far better off in this example, because you have now built up all the extra capital in the property (the extra £100,000 now the mortgage is paid off). Plus, you enjoy any upward price movement should you come to sell – although you would be subject to capital gains tax.

Buy to Let Compared to Other Types of Investment

Our examples paint a rosy picture – investing in buy to lets will generally give you a healthy return, depending on how much actual cash you invest and what your annual costs are. But even our lowest ROI, the figure of 4.6% for the landlord who was a £150,000 cash purchaser, can be considered healthy.

How, then, do these figures compare to other investments you might consider making instead? Here are some of the alternatives:

Cash in the bank

There was once a time when if you had a nest egg, you could leave it in a bank savings account and make a nice return on your investment. In the 1980s you might get on average 8% interest a year, a tidy sum and you didn’t have to worry about finding tenants and the upkeep of a rental property.

In 1990 the figure went as high as 13.56% – a boon to those with cash to put in the bank. However, since then, we know the interest rate has fallen ever since, and you will be lucky to get much over 1.5% now. Buy to let is by far a better choice in this case.

Investing in shares and managed funds

We would need a crystal ball with this investment choice. It’s entirely possible your shares and investment funds could make an ROI of 10% or higher. But equally, if the market takes a turn for the worse, it could be much lower, or even into negative. You must also consider the management fees – they can be punitive and must be paid before you work out any real ROI.

Pension

Putting your funds into a pension might well have been prudent generations ago, but it’s not so clear now. There’s a double tax whammy to consider – tax breaks for building your pension pot are under pressure, and who knows what the tax regime has in store for you when you try to take your pension in years to come?

Diversity of investments

Decisions, decisions. But perhaps the sensible route is to diversify, to minimise being exposed to one negative set of circumstances. Suppose you can build a property portfolio, which will bring a positive ROI for years to come, and balance it with a traditional pension and maybe some side investments. In that case, you should be comfortable and not be hit by any sudden turn of events.

Income tax

The above examples show your ROI before any tax is deducted. Income tax must be taken into account when assessing an investment. Your rental profit will be subject to your marginal rate of tax. 

If you’re already a higher-rate tax payer, or your rental profit will push you into that bracket, you may find yourself paying 40% or 45% on your profit. If, however, you have no other income, you may be able to accommodate all your rental profit within your personal allowance.

Income from rental properties is taxed in a very similar way to earned income. For stock and shares, however, it is quite different. You don’t pay income tax – you pay Capital Gains Tax (CGT) and can expect to pay nothing if your gain is less than £12,300 and just 10% (basic-rate payer) or 20% (higher or additional-rate payer) on anything above that (figures correct Nov 2020).

Capital Growth and Selling Your Property

If you have built up a portfolio of property investments, you might wish to sell one or more of them to reinvest the cash elsewhere – perhaps to top up your pension or to put into low-risk funds as you approach retirement.

Make sure you consider the cost of any capital gains tax you must pay when you sell. If you have had the property for some years, you will be very unlucky to see negative growth (i.e. the house price has fallen). Chances are, you will get back much more than you paid for it. Capital gains tax for properties is currently charged at 18% for basic rate tax payers and 28% for higher and additional payers. 

Value of Investing in Property

Calculating ROI will show you what a good investment property is. The returns are stable and positive in just about every circumstance, plus you get to sell the property – perhaps for a large profit – at the end. 


Notable Replies

  1. Avatar for Colin3 Colin3 says:

    always assuming no void periods and no bad payers

  2. Avatar for Cath2 Cath2 says:

    Not sure I agree with this bit…" For those of you looking at a long-term investment, maybe hoping a rental will contribute towards a future pension, you will be okay with a lower ROI in the short-term. Perhaps you have a repayment buy-to-let mortgage which will be paid off within 15 years when you hope to retire. When you come to work out your ROI then, it will be considerably improved. When we look at your new ROI calculation, the figures change because mortgage costs are no longer a factor".

    You have paid the mortgage off, albeit with funds from the rental, so your capital invested is still £150,000 because you could have spent that money on something else (eg another property).

    For investment comparison you should also look at it based on the current value (less tax) too because you need to compare it to what else you could do with the money (the opportunity cost). If your profit is, say, £10,000 pa, the return based on the Openrent calcs would be 20% Let’s say you’d net 250k after tax if you sold it, that calc would give you a 4% return. Obviously, there is the potential for capital growth to take into account too, but, at that stage, £250k is what you actually have invested in the property, regardless of what you put in to start with.

  3. Avatar for Cath2 Cath2 says:

    Ummm, no it won’t

    To put some simple figures on it…

    Say I have a house worth £100,000 with a £75,000 mortgage and make a profit of £1,000.

    I have £25,000 invested in the house so the ROI on that is 1000/25000 = 4%

    Now say I pay the mortgage off and my mortgage interest was £150 per month. I now have a profit of £2,800, but my capital invested is £100,000. So my ROI is now 2800/100000 = 2.8%

    I would only be better off paying off the mortgage if my mortgage rate was higher than the the ROI - in which case, you’d probably have to question whether you had a viable rental property anyway.

  4. Avatar for Nigel1 Nigel1 says:

    I should really stop posting, as this entire forum seems to be a troll-training ground!
    But, I love maths problems…

    Essentially RoI/RoC calculations are simple…

    • RoI = Profit / investment_cost
    • Profit = change_in_assets - change_in_debts

    There are two assets

    • The house
    • A cash balance

    There is one debt

    • The mortgage

    Change in debts
    Calculating the debt in the mortgage is easy, as it is simply the amount of money it would take to cancel the mortgage (including early repayment costs). This cost and arrangement fees will mean that you will generally start with a “debt” greater than the cost of the house.

    Change in assets
    Estimating the value of the house is harder (obviously), but you could make some assumptions

    • It will increase due to natural tendency to rise. Possibly the rate of pay-rises, say 3% a year.
    • It will decrease due to depreciation (wear and tear).

    Depreciation
    Accounting for depreciation is an art-form, and is covered by many different accounting principles. All of which I’m ignoring… As an example, I will keep it simple.

    • “I will fit a new kitchen costing £10,000 every 10 years”. I expect to spend £2000, maintaining the kitchen per year" … 12,000/10 = £1,200
    • “I will fit a new bathroom costing £5,000 every 10 years”. I expect to spend £4000, maintaining the bathroom per year" … 9,000/10 = £900
    • and so on…

    If you do this per room, and include things like electrical-items, etc, you can come up with a realistic figure for depreciation.

    Cash assets
    In essence simple, money in - money out.

    • As maintenance costs are included in the depreciation, you don’t include maintenance here.
    • Remember your property will not be rented 100% of the time.
    • Include insurance/agency fees.
    • You should include the interest cost of your mortgage offset by any current account interest.

    NOTE: Treat maintenance costs as “purchasing depreciation”.

    A simple example over 25 years : using fake figures
    Assumes …

    • rent = £1000 pcm
    • mortgage interest = £600 (annualized)
    • it’s unrented 20% of the time
    • sundry costs = 300/year (insurance/agency/etc, I suspect this is too low)

    Starting with £50,000, spending half on a deposit and keeping half to cover costs.

    • Initial assets
      – £250,000 (house)
      – £25,000 (cash)
    • Initial debts
      – £230,000 (mortgage)

    Expected end position

    • Assets
      – £500,000 (house)
      – -£50,000 (depreciation - say 2 kitchens and 2 bathrooms, etc)
      – £27,500 (cash)
    • Debts
      – None

    Profit over 25 years = £202,500(change in assets) + £230,000 (change in debts) = £432,500
    Profit adjusted for inflation = £233,286

    • £9,331 per year profit
    • £9,331/£50,000 = 19.7% (RoI)

    Notice though, that whilst the RoI is good, my assumptions would lead to a cash-negative position. You would need to put more money in over the years, just to keep afloat.
    To make this work in reality, you would need more than £25,000 starting cash, maybe £50,000, which drops the RoI to around 12%.
    Compare this to a RoI of around 10% on the FTSE.

    The learning lesson maybe that you need deep pockets to be a landlord, but you can expect good rewards. This example shows that you probably will make a cash loss for the early years.

  5. Buy to let mortgages generally require 145% rental cover at a 5% interest. This often requires a 40% deposit, in areas where propert is cheaper relative to rents a minimum deposit of 25% is required so you wouldn’t get close to your level of mortgage. 20% empty is unrealistic over long term given housing crisis. I have had 3 rentals for 6 years and my total empty period across all of them is 4 days in 6 years. 5% is more realistic.

    You do need deep pockets to start for deposit, stamp duty, getting property ready to be rented etc, but should be profitable from the start, although can be years you would make a loss if doing lots of maintenance and have a big mortgage.

Continue the discussion at community.openrent.co.uk

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This article is not intended to form legal or investment advice. Investments in property are not guaranteed and can decrease in value as well as increase.

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