Posted by Simon Misiewicz on 2nd April 2014
Would you drive a car if it had no speedometer or fuel gauge?
Would you spend money if you did not know your bank balance?
I believe that people are working very hard in their daily lives and in their businesses to make more money and pay less tax. As the late Stephen Covey said “People need time to stop and Sharpen the saw. The problem is that a lot of property investors are not keeping track on their property finances and therefore do not know how they are preforming.
You may even see property investors that talk about due diligence as though it means something. You would not pay for a prescription from a doctor and take the medication without checking if it was doing any good. So, why do people carry out great pieces of work on their due diligence if they do not measure the results after?
You may know property investors like this.
There are ways of ensuring that you treat your properties like a business. I firmly believe if you use these measures, you could buy fewer properties and yield better results than you thought possible.
Welcome to the Optimise world of Key Performance Indicators (KPIs). Here are the five measures that I believe are the most important to ensure that you make more money on your property portfolio. Note that there is not one shred of information about tax.
• Return On Investment (ROI)
• Rent Yield
• Interest Cover
• Maintenance % of rental income
• Voids % of rental income
Return On Investment or (ROI)
ROI is my preferred measure. It takes into consideration the amount of profit that you make against the amount that you have personally had to invest into the property.
Lets say that you make £2,000 profit from your property and you invested £20,000. You can see that £2,000 divided by £20,000 is 10% ROI.
It is not the easiest measure because you need to understand the actual profits on a rolling 12 month basis. However you can use this measure to review a) how your existing properties are doing and b) set a minimum ROI based on current performance.
For more details see the URL (1) in references.
Rent yield is a measure that compares the annual rental income (less bills if you run a HMO) against the purchase price. For example you know that a property will give you £500 net rent per month and you will therefore have an income of £6,000. If the house cost is £100,000 then you have a rent yield of 6%.
This is a “quick and dirty” measure and should not be the main part of your due diligence process. That said it is an easy way to understand if one property is worth looking at in more detail than another.
I use a benchmark of 10%+ rental yield (else I will not look at it). The downsides of this formula is that it is not ROI and is not comparing the amount of money that you need to invest in the property, such as a large refurbishment project. However, I would assume that the purchase price does take into consideration the condition it is in.
Interest cover is the profit (adding back the mortgage interest) divided by the mortgage interest itself. Even for me, reading this statement would lead my imagination to burn itself out.
It is therefore better that I come up with a clear example.
£6,000 rental income
£3,000 profit before mortgage interest
£2,000 mortgage interest
In this example we can see that dividing the profit before interest by the mortgage interest gives us 1.5:1 ratio.
£3,000 profit before interest
£2,000 mortgage interest
This shows that interest can go up by another 50% before this property becomes a loss maker. This is a key measure because as we know mortgage interest charges increase and decrease over time. Which way do you think mortgage interest rates will go? How will the effect your profitability?
I use a ratio of 2:1. This means that mortgage interest charges would need to increase by twice the amount before I start to lose money. If interest rates are at circa 5% and some of us are old enough to remember the 1980s when mortgage interest charges were in double digits.
Maintenance % of rental income
A lot of property investors that I do work for carry out some sort of due diligence. It is not surprising that there is variation of % of that they think will be maintenance cost of rental income.
The main cause of this variation is down to:
• The type of property
• The type of tenants
• The quality of goods put in
• The condition of the property
• Many others but we will focus on the above.
I believe that HMOs with students will cost more money than a middle aged family. I am going to generalise here and I suspect that people will have different views. That is OK with me.
Students are generally less careful and often take a little less pride in their environment especially when it is shared and they see it as a short term base until next semester. Therefore their attention to bags being scrapped along the walls, food trod into the carpets, broken kitchen doors as they are slammed in a drunkard state is usually going to be minimal.
The result of this is more maintenance costs each year. Clearly there will be more revenue from students but I suspect that because they live in the property for just one year that the maintenance work is going to be a little more frequent than LHA tenants that live in the property for a longer time.
Rubbish in rubbish out. If the standard of the property was of poor standard then people living there will treat it as such. They may be less careful of closing the doors on a kitchen cabinet. Given the carcass and doors are cheap then there is more chance of these needing repair. The same applies to cheap shower cubicles and living room furnishings.
Buying cheap is good for now but can cost you a lot more money in the future. Invest wisely and ensure that products have warranties that can be easily managed. Do not buy warranties where a cooker needs to be sent back for three weeks. This is a waste and you would be better placed to buy a new one.
Voids % of income
If you have a property that is empty then you have a void. If you have voids then you have less rental income and ultimately less profit.
The issue with this ratio is that it is easy to calculate for due diligence (a lot of property investors we do work for use 10% to 15%) but it is less easy to do when the property is up and running, or is it?
I find that it is easy because I compare the amount of money I should have received against the money I actually received. If I wanted £6,000 rent but only got £5,000 I know that I am £1,000 short of the £5,000.
£6,000 predicted rent
This gives me a ratio of 01.67 or 16.7%. This is a lot of voids and should be managed. To find out more about what causes voids and what can be done about it please read the blog referenced. (2)
Applying the treatment
What gets measured, gets done. All you now need to do is start inputting your receipts, both income and costs into some sort of accounting system like Xero or a spreadsheet of your design.
To learn more about Xero please see item referenced. (3)
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