Working out what you can afford

Be realistic

Although house prices in Britain rose by an astonishing 15% per annum between 1999 and 2004, the long-term trend is unlikely to provide such a good rate of return on your investment. If you decide on a buy to let investment, you must be realistic about long-term price rises – bear in mind that housing markets can bust as well as boom, potentially leaving you with negative equity.

Yields

At it's simplest, the yield is the rate of return that you earn on an investment. In the case of buy to let, this is calculated by taking total annual income (rent paid per week multiplied by number of weeks occupied) and dividing by the cost of the property. The yield is expressed as a percentage, this being the the percentage of the property's value made annually in rent.

Here are a couple of worked examples:

3-bed house in Tower Hamlets, London
Purchase price: £240,000. Let's assume there is a tenant in the property for the full 52 weeks of the year: Weekly Rental Income x 52 / Property Value = Yield £250 x 52 / £240,000 = 0.0542 So the yield would be 5.42%.

2-bed house in Bradford
Purchase price: £50,000. Again assuming year-round occupancy: £120 x 52 / £50,000 = 0.1248 So the yield is 12.48%

In 2006, the average yield rose to £9,600 on UK buy to let properties. (Source: Paragon Mortgages) But although rents went up, a general slowing of the housing market meant that the average annual return on investment property remained steady. There is regional variation - in north-west England and Yorkshire, high performing investments have yielded returns of up to 40%. The national average is 9.7%.

What could reduce my yield?

Factors which adversely affect the yield (and therefore things to avoid or minimise) include:

• Void periods, i.e. intervals between tenants when no rent is paid. The UK average is two months per year. Try to minimise the length and impact of void periods, and/or take out insurance which covers you for non-occupancy. In the two examples above, a void period of 10 weeks per year would see the yield of the London house plummet from 5.42% to 4.33% and the yield on the Bradford property would drop from 12.48% to 9.98%. Make use of an on-line Property Yield Calculator to determine the yield of a property you might be considering, and the impact of non-occupancy.

Long-term investment versus short-term gains

A property in London, for example, is likely to have a lot of capital tied up in it as equity. The yield is low in the first example above, but while the housing market in London continues to boom, it represents a good investment even though the rental income is very low. Conversely, equity will be low on the terraced house in Bradford with a price tag of £50,000. For this property, the benefit is the high positive monthly cash flow – useful if you need money now rather than just to boost your pension fund. Your circumstances will determine whether you should focus on investment potential or cash flow.