Buy-to-Let Index Q2 2014

The Model Works 16 July 2014

"Our buy-to-let profitability index shows that five year geared buy-to-let investors continue to see
healthy profits, leveling off at 12.14%, 11.66% and 11.52% over the last three quarters". says Brian
Hall from The Model Works. "After several tumultuous years we can begin to take stock and look at
the key factors that will affect future profitability. This will require new profitability measures."
Our index uses Bank of England, Nationwide and Association of Residential Letting Agents data to
calculate the historic returns over 25, 20, 15, 10, and 5 year periods, for a cash buyer or a geared
investor, with a repayment or an interest only mortgage, selling today.
Accurate New Buy-to-Let Profitability Measures
To understand buy-to-let profitability we a need a new vocabulary. For example, the term 'yield' is so
loosely defined that lenders can make extravagant profitability claims. A better measure would be
the 'net effective yield' which together with 'capital gain' are the key profitability drivers.
Whereas the yield is calculated as the gross rent today divided by the value of the property today, the
net effective yield is the rent today, minus costs, divided by the original purchase price.
The graph below demonstrates the quarterly net effective yields and percentage capital gains for a
geared investor over a ten year investment, when selling the property today:

The net effective yields take into account the benefits a landlord receives from buying when property
prices are low. The net effective yield for a landlord buying a property today is very different from
one buying ten years ago, whereas there is no difference with the gross yield calculation.
The net effective yield also take into account gearing and mortgage and deposit rates to create a
more complete measure overall. A highly geared investor will benefit from periods of high property
price inflation and low interest rates. This is why the returns were historically so substantial.
But a highly geared investor will be hardest hit when these factors reverse. This is what is happening
in latter part of the graph. Note that the net effective yield remains relatively constant, even as
capital gain falls away, because it is based on a property bought in 2004 and not 2014. Low interest
rates have also been vital in bolstering the net effective yield by keeping acquisition costs low.
"Understanding these key profitability drivers is critical for any landlord considering expanding their
portfolios, into an overinflated market, with uncertainty about interest rates and property prices"
says Hall. "If lenders continue to publish questionable profitability numbers, perhaps the authorities
should step in and demand these lenders provide a net effective yield table along with the APR".
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Capital Gain Net Effective Yield
Buy-to-Let Index Q2 2014


The Model Works 16 July 2014


Repayment Geared Investor


5 Years 10 Years 15 Years 20 Years 25 Years
Purchase Price 128,732 120,796 55,618 39,027 49,039
Opening Balance -34,114 -32,011 -14,183 -9,952 -12,505
Closing Balance -41,194 -49,900 2,704 15,495 -18,356
Selling Price 153,490 153,490 153,490 153,490 153,490
Redemption Amount -86,641 -69,573 -24,582 -10,368 -759
Closing Equity 66,849 83,916 128,908 143,122 152,731
Final Balance 59,768 66,027 145,795 168,568 146,880
Return (100% = Break Even) 175.20% 206% 1028% 1694% 1175%
Compound Rate of Interest 11.87% 7.51% 16.81% 15.20% 10.36%

Interest Only Geared Investor


5 Years 10 Years 15 Years 20 Years 25 Years
Purchase Price 128,732 120,796 55,618 39,027 49,039
Opening Balance -34,114 -32,011 -14,183 -9,952 -12,505
Closing Balance -29,919 -29,814 15,600 27,575 2,015
Selling Price 153,490 153,490 153,490 153,490 153,490
Redemption Amount -98,480 -90,597 -42,548 -29,856 -37,515
Closing Equity 55,010 90,597 110,941 123,634 115,974
Final Balance 59,205 65,089 140,724 161,160 130,494
Return (100% = Break Even) 173.55% 203% 992% 1619% 1044%
Compound Rate of Interest 11.66% 7.35% 16.53% 14.94% 9.83%

Cash Buyer


5 Years 10 Years 15 Years 20 Years 25 Years
Purchase Price 128,732 120,796 55,618 39,027 49,039
Opening Balance -132,594 -124,420 -56,731 -39,808 -50,020
Closing Balance -108,011 -73,500 9,501 35,026 33,196
Selling Price 153,490 153,490 153,490 153,490 153,490
Redemption Amount - - - - -
Closing Equity 153,490 - 153,490 153,490 153,490
Final Balance 178,072 204,409 219,721 228,323 236,706
Return (100% = Break Even) 134.30% 164.29% 387.30% 573.57% 473.22%
Compound Rate of Interest 6.08% 5.09% 9.45% 9.13% 6.41%


Gearing 75% LTV, arrangement: 2% of mortgage, provisions for arrears, voids and management, maintenance and
insurances: 2.5%, 5.75% and 15% of rent, interest at B0E rates, property prices from Nationwide, yields from ARLA


Buy-to-Let Index Q2 2014


The Model Works 16 July 2014

Methodology
The Model Works Buy-to-Let Profitability Index provides a simple, quantitative assessment
of the returns on investment in the private rental sector over time.
The index provides profitability data for:
5, 10, 15, 20 and 25 year investment periods
Cash buyers and geared investors with:
A range loan to value ratios
Mortgage types:
o Repayment
o Interest only
The index is published quarterly and provides profitability data back to 1983.
Future releases will include mortgage interest tax relief and capital gains tax calculations and
produce data on a regional basis.
In addition to the index, which provides historic data, a model based on systems thinking
principles will be published to project future outcomes.
This paper documents where the data is sourced and how the index is calculated.

Overview
The index is founded on the following source data:
House prices from the Nationwide Building Society
i

Mortgage rates from the Bank of England
ii

Deposit rates from the Bank of England
iii

Rent and void levels from ARLA
iv

Stamp Duty rates from HMRC
v

Mortgage repayment and balance calculations are from Mortgages Exposed.vi
The index incorporates additional allowances for:
Mortgage arrangement fees set to 2% of loan
Provisions for arrears set to 2.5% of rental
Management fees set to 15% of rent

Buy-to-Let Index Q2 2014


The Model Works 16 July 2014

Structure
The index is based on two linked sets of calculations:
Capital Gain
Cashflow
The Index works back from the selling date. For example, if the selling date is Q2 2012 and
the index is calculating a five-year investment, the period under review will commence at Q2
2007. The calculation will take the average property price at this purchase date and any
stamp duty and acquisition costs that apply at that time. This will create a negative balance
on the buy-to-let investors account.
Rental income and deductions, including mortgage repayments, are calculated quarterly and
applied to the buy-to-let investors account, before the appropriate interest rate is applied
to the resulting debit or credit balance. Finally the index identifies the property price as well
as any selling costs, including the cost of redeeming any mortgage, at the selling date and
calculates the resulting closing balance. If the closing balance is greater than the opening
balance, this signifies a profit and the compound rate of return over the period is then
calculated. If the return is negative, then the word Negative is entered.

Comparisons
The Model Works Index differs from other buy-to-let indices in several ways. Most indices
concentrate on the net rental yield. A typical calculation will simply divide the annual rental
income by the initial property price to produce a yield figure, but this is inadequate on
several counts and the calculation excludes:
Mortgage repayments and the opportunity costs of using funds that could be
invested productively elsewhere are not incorporated
A raft of other acquisition, maintenance and management costs, voids and arrears
costs and selling costs are not taken into account
Generally other indices are far more optimistic and less volatile than that of The Model
Works, which takes more factors into account and applies true historic data rather than
assumed values.


i
Regional quarterly series by buyer type - First Time Buyers (Post 1983)
ii
Post 1995 IUMTLMV, Bank of England, monthly, combined bank and building society (from 1983 to 1995 BSA Yearbook
2011-2012 New Mortgage %)
iii
Post 2009 BoE IUMB6RH, Monthly interest rate of UK resident banks (excl. Central Bank) and building societies' sterling
fixed rate bond deposits from households (in percent) not seasonally adjusted - 2 year (1996-2009 - BoE IUMWTFA, Monthly
interest rate of UK monetary financial institutions (excl. Central Bank) sterling fixed rate bond deposits from households (in
percent) not seasonally adjusted, 1995 - UMWTTA, Bank of England, monthly, sterling time deposits rates, from 1983 to 1995
BSA Yearbook 2011-2012 Ordinary Share %)
iv
Association of Residential Letting Agents - Buy to Let Review
v
www.hmrc.gov.uk/stats/stamp_duty/00ap_a9.htm
vi
www.mortgagesexposed.com/Book_Contents/Other_Formula.htm