What cashflow return on equity makes a rental property worth keeping?

At what cashflow return on equity does being a landlord stop being worth the hassle?

It is not a question many landlords ask themselves because, traditionally, property investment has never really worked that way. Most of us were taught to concentrate on rental yields, rising property values and the long-term accumulation of wealth. As long as the rent covered the mortgage and the property increased in value over time, the assumption was that holding on was almost always the right decision.

The landscape has changed considerably since then. Owning rental property has become far more demanding than it was twenty or thirty years ago. Compliance obligations continue to grow, taxation has become less favourable, financing costs remain significantly higher than many landlords became accustomed to, and there seems to be a constant stream of new legislation requiring yet more time and attention. None of this means that residential property has become a poor investment. It does, however, raise a perfectly reasonable question about the level of return required to compensate for the increasing burden of ownership.

This is where I think many landlords are looking at the wrong figures.

Rental profit tells you whether a property is generating surplus income. Gross and net yields help compare one property with another. Neither, however, tells you whether the capital tied up in that property is still working hard enough to justify remaining invested.

To answer that question, I believe the more meaningful figure is cashflow return on equity.

Imagine a property worth £500,000 with an outstanding mortgage of £150,000. The landlord therefore has £350,000 of equity tied up in that investment. If, after allowing for mortgage interest, repairs, insurance, compliance costs, maintenance, voids and every other expense, that property generates £17,500 of annual cashflow, the return on that £350,000 of equity is just 5% per annum.

5% may sound perfectly respectable until you ask yourself a different question. If you did not already own that property today, would you willingly invest £350,000 to achieve a 5% annual cashflow return whilst accepting all the responsibilities, risks and regulatory burdens that accompany residential letting?

That is a very different question, and one that many landlords have never properly considered, or may not even be aware that it’s possible to receive an 8% fixed annual coupon on a listed 6-year passive investment bond, or a 10% fixed annual coupon from a similar two-year fixed rate bond from an unlisted triple A rated company.

The answer will naturally vary from one investor to another. Someone approaching retirement may be perfectly content with a relatively modest return if they value the security and familiarity of bricks and mortar. Others may conclude that once their equity reaches a certain level, they would expect a substantially higher annual cashflow before continuing to accept the time commitment and responsibility that comes with being a landlord.

There is no universally correct answer. The important point is having a benchmark. Without one, it becomes remarkably easy to continue owning properties simply because you have always owned them, rather than because they continue to represent the best use of your capital.

Selling is, of course, not without cost. Capital Gains Tax, estate agency fees, legal expenses and mortgage redemption charges all reduce the amount available for reinvestment, and those costs should never be ignored. Equally, they are generally one-off costs. Continuing to hold an investment that no longer meets your own minimum return requirement can become far more expensive over the following ten or twenty years than crystallising those costs today.

For me, this is one of the most valuable exercises any landlord can undertake. Rather than looking at a portfolio as a whole, calculate the cashflow return on equity for every individual property. The results are often surprising. Some properties continue to earn their place within the portfolio, while others consume a disproportionate amount of equity for relatively modest returns.

I suspect every landlord has a different answer to the question I posed at the beginning. Some may be perfectly satisfied with a 5% annual return on equity because they are still banking on capital appreciation and don’t need the extra income. Others might require 10%, 15%, 20% or or considerably more before deciding that continuing to own the property is worthwhile.

I’d genuinely be interested to know where you would draw the line.

FURTHER THOUGHTS

If you’ve never calculated the cashflow return on equity, that’s one of the first things we do during a Property118 consultation. The results often surprise even very experienced landlords.

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