What are your true returns on equity?

For many landlords, the biggest challenge today isn’t taxation, interest rates or even the Renters’ Rights Act; it’s deciding what to do next.

Most instinctively feel that standing still is probably the wrong answer because the environment has changed too much for that. Equally, selling everything rarely feels right either. After spending years, and often decades, building a portfolio, many landlords find themselves caught somewhere in the middle. They know something needs to change, but they are far less certain about what that change should be.

That uncertainty is hardly surprising.

The traditional buy-to-let model has been squeezed from multiple directions at the same time. Compliance obligations continue to increase, taxation has become less favourable, and mortgage costs remain significantly higher than many landlords became accustomed to during the era of ultra-low interest rates. The Renters’ Rights Act represents yet another shift in the relationship between landlords, tenants and the State. None of these developments, taken in isolation, are necessarily enough to force a decision. Together, they have caused many landlords to step back and ask whether the rewards still justify the effort involved.

The problem is that investment decisions are often made without reference to one of the most important measurements available: return on equity.

Most landlords know how much rent their properties generate, roughly what their portfolios are worth and can tell you whether their overall cashflow has improved or deteriorated over recent years. However, relatively few have analysed the return being generated on the equity tied up in each individual property, and a profitable property and an efficient use of capital are not necessarily the same thing.

A property purchased twenty years ago may have performed exceptionally well. It may have doubled or trebled in value and the tenant may have remained in occupation for years. Viewed from a traditional buy-to-let perspective, it may appear to be a success story. However, what is often overlooked is the amount of equity now tied up within that asset and the return being generated on it.

A landlord with £50,000 of equity in a property producing £10,000 of annual profit is in a very different position from a landlord with £300,000 of equity producing exactly the same income. The rent is identical. The profit is identical, but the return on equity is not, and this is where the analysis often becomes interesting.

The vast majority of landlords have never sold a property because the return on equity fell below a predetermined target. Instead, they sell because something happens. Examples include a troublesome tenant, a major repair bill, an expensive compliance issue, a refinancing problem, a tax change or a new piece of legislation. The event becomes the catalyst for action, yet those events often act as triggers rather than causes.

The more important question is whether the property was generating a sufficient return on the equity tied up within it to justify dealing with those issues in the first place. After all, every property investment involves some level of hassle, risk and uncertainty, but the question is whether the rewards remain proportionate.

Calculating true returns on equity is not always straightforward because gross rent is only the starting point. Maintenance, insurance, accountancy fees, compliance costs, management charges, refurbishment expenditure, void periods and bad debts all have an impact. Leasehold properties introduce service charges and ground rents. HMOs and serviced accommodation frequently incur substantially higher operating costs than standard residential lets. Finance costs can then transform the picture again, particularly where Section 24 restrictions affect the taxation of rental profits.

In our experience, operating costs before finance costs often consume between 25% and 30% of gross rent for standard rental properties. Leasehold properties are frequently higher with ground rents and service charges eating away profits by around £2,000 extra every year. HMOs and serviced accommodation costs can exceed 40% once all operating expenses are properly taken into account, e.g. utilites and extra wear and tear. These figures often surprise landlords who have never previously analysed their portfolios on a property-by-property basis.

The results can be striking.

Some properties generate returns on equity of 20% or even 30%. Others produce returns that are far lower than their owners imagined. In some cases, once finance costs and taxation are properly accounted for, landlords discover that substantial amounts of equity are tied up in properties generating remarkably modest returns for the capital, effort and risk involved, and in more cases than you might imagine, we see properties that are actually costing money to keep rather than making a positive return on equity at all from a cashflow perspective.

For landlords approaching retirement, that distinction can be particularly important because the focus shifts towards creating reliable income, reducing complexity, improving liquidity and ensuring that decades of accumulated wealth are working as effectively as possible.

Perhaps the most revealing question of all is this: if you had the amount of equity currently tied up in a particular property sitting in cash today, would you choose to invest it back into exactly the same asset under exactly the same terms?

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