Case study: What is this £3.4 million property portfolio really earning?

Every year or two, I carry out a detailed review of my own property and investment portfolio.

The exercise is not confined to checking whether my properties have increased in value or whether the rents still cover the mortgages. I want to understand how much equity is tied up in each asset, what cashflow that equity is producing, how sensitive the results are to refinancing, and whether some of my capital might be more productive elsewhere.

This is broadly representative of the analysis Property118 consultants can undertake for clients, particularly where landlords are considering incorporation, refinancing, retirement, succession planning or a gradual reduction in their exposure to property.

The following anonymised case study illustrates why this type of review can produce a very different picture from the one suggested by headline portfolio values.

The portfolio at a glance

The clients were a married couple with two children. Other family members or employees were already involved in the rental business, partnership accounts were being prepared, and the rental income and expenditure were pooled through a dedicated business bank account.

The portfolio comprised 20 properties spread across England, Scotland and Wales. Most were residential, although four were commercial properties. Nineteen were held personally and one was already owned by a limited company.

The headline figures were as follows:

A £3.4 million portfolio producing nearly £209,000 of annual rent sounds substantial, and it is. The figure that interested me most, though, was not the gross rent or even the £1.07 million of apparent equity. It was the cashflow return being generated by that equity.

What was the portfolio producing at current interest rates?

For the purposes of this initial analysis, non-finance operating costs were estimated at 25% of gross rent. This allowed approximately £52,185 a year for repairs, management, insurance, compliance, voids and other property expenses.

After deducting these costs and the existing annual mortgage interest of £73,100, the estimated cashflow before tax was approximately £83,455 a year.

Measured against apparent equity of £1,071,000, the portfolio was therefore producing a cashflow return on equity of approximately 7.8% (before tax).

Whether that represents a satisfactory return depends on the owners’ objectives, workload, appetite for risk and available alternatives. There is no universal percentage at which a property should automatically be retained or sold.

The calculation nevertheless gives the owners something meaningful to evaluate. Without it, they might simply conclude that a profitable portfolio containing more than £1 million of equity must be performing well.

The current result depended heavily on inexpensive borrowing

The annual mortgage interest of £73,100 represented an average interest cost of approximately 3.13% across the portfolio.

That is a significant point because the current cashflow was being supported by finance arrangements that might not be available indefinitely.

We therefore stress-tested the portfolio using an assumed mortgage interest rate of 6%. This did not mean that every mortgage would necessarily be refinanced at that rate or at the same time. The purpose was to understand what might happen as the existing loans matured and were replaced.

At 6%, annual mortgage interest would rise to approximately £140,040. After allowing for the same operating costs, estimated cashflow before tax would fall from £83,455 to only £16,515 a year.

The cashflow return on equity would reduce from approximately 7.8% to just 1.54% (before tax).

Nine of the 20 properties would become individually cashflow negative under the assumptions used.

The portfolio had therefore not suddenly become a bad investment, but its resilience looked very different once the cost of refinancing was taken into account. Around 80% of its current pre-tax cashflow could disappear if the average interest cost rose to 6%.

Portfolio averages concealed very different results

The next stage was to examine each property separately.

One commercial property in Wales was worth approximately £115,000, generated £12,000 a year of rent and had mortgage debt of £83,000. After allowing for operating costs and existing interest, it produced estimated annual cashflow of £7,000.

With only £32,000 of equity tied up in the property, its current cashflow return on equity was approximately 21.9%. It would also remain comfortably cashflow positive if mortgage interest increased to 6%.

Another property was worth approximately £275,000 and contained £130,000 of equity. It produced annual rent of only £11,400 and estimated current cashflow of £4,450.

Its cashflow return on equity was approximately 3.4%, and it would become marginally cashflow negative under the 6% stress test.

The second property contained considerably more equity and might have appeared to be the stronger asset when viewed solely from the balance sheet. The first property was using the owners’ capital far more productively.

Sometimes the finance is the problem, not the property

Another commercial property was worth approximately £140,000 and had a mortgage balance of only £40,000. It generated £12,600 of annual rent and contained around £100,000 of equity.

Its mortgage interest was £4,800 a year, equivalent to approximately 12% of the outstanding borrowing.

Under the existing finance arrangement, its estimated cashflow return on equity was only 4.65%. Refinancing the £40,000 mortgage at 6% would improve annual cashflow from approximately £4,650 to £7,050.

A superficial review might have identified this property as an underperforming asset that should be sold. The detailed analysis suggested that the property itself was not necessarily the problem. The unusually expensive borrowing and low LTV was suppressing the return.

This is why decisions should not be based solely on gross yield or current cashflow. Refinancing, rent reviews, management changes and selective capital expenditure may materially alter the outcome.

High returns on equity can also be misleading

A different residential property was worth £125,000 and carried mortgage debt of £110,000. It contained only £15,000 of equity but produced estimated current cashflow of £1,400.

That represented a return on equity of approximately 9.3%.

The return appeared attractive until the borrowing was examined more closely. The existing mortgage rate was approximately 2.8%. At an interest rate of 6%, the property would produce an estimated annual cashflow loss of £2,100.

The apparently strong return was largely a consequence of the small amount of equity left in the property and the exceptionally cheap borrowing. It did not indicate that the asset was particularly resilient.

Property should be compared with alternative uses of capital

The purpose of calculating cashflow return on equity is not to persuade landlords to sell their properties. It is to identify what their capital is currently producing and to compare that result with other available uses of the money.

I apply the same discipline to my own portfolio.

Property remains an important part of my personal investment strategy, but I do not believe that every pound of my capital must remain invested in property indefinitely. Some of my liquid funds are invested in fixed-term, fixed-coupon institutional bonds.

The investments I currently hold pay contractual annual coupons of 8% and 10%, with the income paid quarterly. They have fixed repayment terms, so I know the scheduled duration of each investment when I commit the capital.

I am not suggesting that these investments are directly comparable to property or suitable for every reader. A fixed coupon does not eliminate issuer risk, and the repayment of capital depends on the issuer meeting its contractual obligations. Fixed-term bonds do not provide the same potential for rental growth, property appreciation or active value creation, and the capital is usually  inaccessible during the agreed term.

The comparison is, nevertheless, still commercially relevant because every investment decision carries an opportunity cost.

This portfolio in this Case Study contained approximately £1,071,000 of apparent equity and was producing estimated current cashflow of £83,455 a year. That equated to approximately 7.8%.

An 8% annual return on £1,071,000 would amount to £85,680, while a 10% return would amount to £107,100. These figures do not include taxation, capital growth or differences in investment risk, so they should not be treated as a like-for-like comparison.

They do, however, demonstrate why landlords should periodically ask whether the return from managing a large, leveraged and regulated property business remains proportionate to the capital, work and risk involved.

The comparison became more striking under the 6% mortgage interest stress test. Estimated property cashflow (before tax) fell to only £16,515 a year, equivalent to approximately 1.54% of the equity tied up in the portfolio.

A landlord might reasonably decide that the responsibilities and risks of the portfolio were worthwhile for a pre-tax cashflow return of 7.8%. The same landlord might reach a different conclusion if the return fell to 1.54%.

Apparent equity is not the same as investable cash

The owners could not simply sell the portfolio and place £1.071 million into another investment.

Our intentionally severe disposal model allowed for selling costs equivalent to 15% of property values, capital gains tax at the highest applicable rates, no annual exempt amounts and no personal reliefs.

On those deliberately pessimistic assumptions, selling the entire portfolio and repaying the mortgages might produce net proceeds of approximately £426,610.

This was not intended to calculate the exact tax cost of a disposal. The actual outcome would depend on legal ownership, acquisition costs, capital improvements, available reliefs, each owner’s tax position and the timing and sequence of sales.

The calculation was designed to expose the gap between headline property equity and the amount that might actually become available for reinvestment.

Nevertheless, even using the reduced figure of £426,610, an annual return of 8% would produce approximately £34,129, while 10% would produce approximately £42,661.

Both figures exceeded the £16,515 of estimated property cashflow under the 6% refinancing stress test. This did not prove that the portfolio should be sold. It showed that the question deserved more detailed consideration.

The answer was unlikely to be selling everything or retaining everything

The analysis suggested that a selective strategy might produce a better outcome than treating all 20 properties in the same way.

The strongest cash-generating properties could potentially be retained. Properties with expensive mortgages should be considered for refinancing before concluding that they were fundamentally poor investments. Assets containing substantial equity but producing weak returns required closer examination to determine whether rents could be improved or capital could be released and redeployed.

The appropriate balance would depend on the clients’ ages, income requirements, retirement plans, attitude to risk, family circumstances and desire to remain actively involved in property.

Where incorporation fits into the strategy

The clients had initially approached the question from an incorporation perspective.

The portfolio included personally owned assets, one company-owned property, residential and commercial property, three different UK tax jurisdictions and one property in which the client held only a 50% interest.

Partnership accounts were being prepared and income and expenditure were pooled, although there was no formal partnership agreement documenting ownership of capital and profit-sharing arrangements.

All of these matters would require careful examination before recommending that any part of the business should be transferred into a company.

Incorporation may improve after-tax cashflow, create refinancing flexibility, assist succession planning, support business continuity and provide a structure through which future generations can participate. These are potentially valuable outcomes.

Transferring an inefficient portfolio into a company does not, by itself, make the underlying properties more efficient.

The clients first needed to decide which properties they wanted to retain, which mortgages should be refinanced, how much exposure to property they wished to maintain and how the business should eventually pass to their children.

The company structure could then be designed to support the commercial strategy selected by the clients.

This is what a strategic assessment is intended to achieve

Property118 consultations are not designed to produce a predetermined recommendation that every landlord should incorporate.

Its purpose is to help clients understand what they own, what each property contributes, how the portfolio might perform under different financing conditions and which combination of retention, refinancing, disposal, incorporation and diversification best supports their objectives.

This is similar to the analysis I undertake for myself every year or two. The investments, priorities and acceptable risks will differ from one person to another, but the underlying questions remain broadly the same.

How much capital is tied up? What income is it producing? What could change? Is the return still sufficient? Are there better uses for part of the capital? How should the assets be structured for retirement, succession and future management?

Property118 consultants are not regulated financial advisers and do not recommend particular investment products. We do, though, work closely with FCA-regulated advisers and are happy to introduce clients to them where regulated investment or pension advice forms part of the wider strategy.

Our role is to help landlords understand the property business they already own, identify the commercial choices available to them and coordinate the appropriate professional advice where necessary.

For the clients in this case study, the important question was not simply whether 19 personally owned properties should be transferred into a company.

The real question was how a £3.4 million property business containing more than £1 million of apparent equity could be reorganised to produce the income, flexibility and succession outcomes the family actually wanted.

Incorporation might form an important part of the answer, but it should support the strategy rather than replace it.

The above anonymised and illustrative case study uses simplified assumptions and rounded figures. References to my personal investments are included to explain my own approach to capital allocation and do not constitute financial advice, a recommendation or an invitation to invest. Fixed coupons and repayment of capital depend on the issuer meeting its contractual obligations. 

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