Introduction: Rental History and Trends in London
There has been a rapid shift to private renting in Britain in the recent past. This is highly attributed to the constraints in the mortgage market as well as a decrease in the total deposits for most people reducing their economic ability of homeownership (Baum et al., 2011). Unfortunately, there is an acute shortage of information on rental demands, affordability and the associated investment returns. It is however notable that there has been a rapid increase in rental stock in the UK by 42% in a period of five years ending 2012. This shift to private renting is expected to accelerate even more to reach 5.9 million rented households by 2016. The private sector is expected to meet this high demand estimated to be around £200 billion. However, this may not be actualized given the constraints in accessing funds by small developers who make up most of the population (Savills Research reports, 2012).
Market and Portfolio Appraisal and Analysis
This paper intends to consider an investment portfolio of buy to rent apartments. The portfolio in consideration takes into account investment in 1-bedroom, 2-bedroom or 3-bedroom apartments in East London. The affordability, market, returns (rental yield) as well long-term return on investment of all the options will be analyzed in deciding which of the apartments to invest in. These factors are discussed in the following paragraphs as the paper seeks to analyze the London property market with the aim of justifying the viability of the investment choice made as well as its location.
The issues revolving rental affordability in London can only be effectively addressed when the supply of private rented housing relatively meets the demand for houses. This means that there has to be a significant increase in new housing stock. In 2012, it is estimated that £48 billion was paid as rent throughout Britain and this is estimated to increase to roughly £70 billion in the next five years. The supply to meet this high demand is painstakingly challenging since more people are constrained to buy or build their own homes (Hutchison, 1998).
As such, rental income is expected to rise and this seems to persuade investors for long term returns. The relative investment returns compared to other short-term investments is a factor that is expected to dictate how well the demand-supply deficit will be met. Indeed, the average return on investment across the UK is an average of 5.8%. However, according to Frank Knight index 2013 this increases to 7.7% for larger investments that qualify to secure discounts and other economies of scale. However, the expected growth in investment returns is estimated to be an average of 8.2% in London in the next ten years. The London boroughs in the same period are expected to grow their returns on investment to between 7.3% and 9.1% (Savills Research reports, 2012).
Moving forward, small scale investors are more likely to bring in a balance in the income yield and capital growth prospects. However, it is the large scale investors who are likely to bridge the demand gap for rental houses. This will eventually lead to a favorable system which will have affordable rental housing (Brueggema, 2010). The current trend in rental housing also indicates that more households in rented houses will continue to dwell in rented apartments for longer. It is therefore inevitable that private rentals will also include a large number of family housing.
The imbalance between rental supply and demand has consistently led to an increase in rent. In the next ten years, this increase was projected to be around7.2% in London in 2013 as well as returns though at a lower rate. This has led to a shift in investor perception on residential property. As such, there is need for investors as well as tenants to fully understand the relationship between affordable rent and capital investment alternatives (Geltner et al., 2007).
2-Bedroom Apartments versus 1-Bedroom and 3-Bedroom Apartments
Across London, the average rent per bed falls as the number of rooms increase. The average asking rent for a two bedroom apartment in London varies from £9,000 to an extreme of £42,000. The monthly rent for a one bedroom is £533 per bed, £349 per bed for a two-bedroom and £293 per bed for a three-bedroom. This is another factor that has influenced the choice of investment taken. The gross yield of the different available choices of investment is the main factor that has influenced the option of two-bedroom apartments.
On average, one-bedroom apartments yield a higher return than two-bedroom houses. As the number of beds increases, the gross rental yields reduce. One bedroom apartments have their current gross yield rated at 7.8% across London, two-bedroom ones have a yield of 7.2%, three-bedroom at 6% while four-bedroom ones are rated at 5.1%. As much as one-bedroom apartments have a higher return, this alternative means that the only possible tenants of the houses are mainly individuals who are single. Such an inconvenience is not worth risking since it may take some time to get such tenants given the intended location.
Two bedroom apartments, on the other hand, offer more flexibility for young married couples or singles who can possibly share an apartment. The increasing rent as the number of beds decreases tends to put off tenants. This is due to the fact that for most of the renting generation in London, the rent they pay is about 53% of their earnings. As such, apartment sharing trend is becoming a common phenomenon in London and hence the two bedroom apartments are more likely to be filled faster than the one-bedroom houses. The risk of unoccupied houses is far-reaching given that the borrowed capital needs to be paid back in the first year of completion of the apartments. The three-bedroom apartments, on the other hand, have lower rate of rental yields at 6% which is a difference of 1.2%. Consequently, it is more prudent to invest in two-bedroom houses as opposed to one or three bedroom apartments.
It is undeniable that there is a substantial difference in terms of gross income between high value markets and low value markets (Dembinski, et al., 2003). The strongest market that yields higher returns is the mainly the smaller units in the low value markets in which tenants are mostly singles and young couples. As such, the decision to invest in two bedroom apartments is enhanced by this fact since higher returns are possible. Another opportunity also arises in buying in these low value markets.
Proximity to the city of London is the main factor that drives the disparities in the rent rates. Apart from the inability to own homes, it is apparent that another significant driver of this phenomenon is due to relocation due to employment. This accounts for 51% of the rental demand. This is a strategic reason for the target location for the proposed investment hence East London is perfectly suited for such an investment.
The choice of location is East London and specifically in the Stratford city which is strategically placing itself as London’s eastern gateway. In the local authority strategic plan, the city plans to be host to £20,000 new homes as well as £45,000 new jobs in the next ten years. Such development proposals make the area a viable location to invest in with a guarantee of returns in terms of profit as well as capital growth. In addition, the prospective returns in the next ten years is expected to the highest in London at a rate of 8.2% whereas it is expected to be 7.3%-9.1% in the London boroughs including East London (Savills Research reports, 2012).
The choice of financing the project depends on a number of factors. These include the degree of risk, the time span to obtain the required funds and the long-term cost of financing (Glynn, 2008). As such, it is important to consider the interest cover that the proposed venture will be required to repay each year. The proposed investment will be funded to a tune of £555,555. Ten percent of this will be equity capital while the other ninety percent will be funded through borrowed capital. The current rate of mortgage lending is 5.3% to be repaid in a period of 25 years. Given this is a long term investment, the collected rental yields will be the sole source of loan repayment. This has been calculated as £36,550. This is with the assumption that the loan is paid once per year and that the planned flats will be complete in the same year. The other assumption is that the flats will have immediate tenants in the same year which is possible given the location as well as the type of apartments chosen.
The source of funding chosen is cheaper compared to normal loans given their high interest rates. The long term repayment period of a mortgage allows for more flexibility in funding such a huge project. The planned flats will be five, two bedroom apartments each worth £105,000. The lending institution is expected to oversee the entire construction. The choice of capital value of the each of the apartments is also influenced by the rental yields. Two bedroom apartments with an average capital value of £100,000 have the highest rental yields at 7.8%. As the capital value rises, the rental yields decrease. For instance, a two bedroom apartment with a capital value of £200,000 has an average rental yield of 4.9% while that with capital value of over £300,000 has a yield of 4.1% or less. As such, the capital value of the apartments greatly influences the expected returns in terms rent yields as well as capital yields.
The Net Present Value of a given series of cash flows refers to the total sum of the present values of individual inflows during the lifetime of the proposed investment (Jenkins, 1999). In this case, the proposed investment will be held for the next ten years. As such, the discounted cash flows of the project are used to obtain the net present value of the investment. In this case, each of the projected cash flows is discounted back to present values. The chosen discounting rate for this project will be 10%. However, using this method may be misleading especially in the case where the investment yields negative cash flows in later stages.
The excel sheets calculated indicate the investment returns of the considered three options. The mortgage debt amount is expected to be the same since the capital available is constrained to £555,555. Consequently, the repayment amounts will be equal regardless of the option chosen. In evaluating the proposed investment, the annual debt repayment is at a rate of 5.3%. The chosen rate is the prevailing average market rate in most financial institutions for buy to let mortgages. This requires the 5 apartments to be rented at an annual rent of £12,000. This translates to £1000 per calendar month. This is the average rent in the proposed location. From the rent collected, an annual repayment of £36,550 will be paid as debt recovery. This has been spread over a period of ten years.
As at the tenth year, the outstanding debt is expected to be £371,803. The annual expected gross income is therefore expected to total to £60,000. The vacancy collection allowance has been set at 2%. Other deductions including management fees (5% of expected gross income), landlord’s insurance and maintenance fees (5% of expected gross income) will all add up to a total of £9,450. This leaves the investment with total cash inflows of £14,000.
The expected increase in rent over the ten year period is expected to be 7%. The rental yield has been set at 8% for this investment while the capital rate is 9% as at the end of the holding period. As such, the estimated value at the end of the holding period will be £965,753 and £761,980 respectively. The equity reversion method at this rate values the investment at £1,301,397 having deducted the unpaid mortgage balance as at the end of the holding period. The net present value method on the other hand gives a total of £186,154 as the present value of the expected cash flows as at the end of the holding period. The net present of the investment on deducting the initial down payment is £130,599.
In comparison, the one-bedroom apartments have a higher annual yield in terms of rental yields as compared to the proposed two-bedroom apartments due to the higher cost of one bed compared to more beds. However, it is imperative to consider how fast the apartments are likely to be rented. Given the limitations with the one-bedroom apartments, it may take some time to have all the apartments filled hence it may not be financially prudent given that the apartments are expected to service the mortgage borrowed. Three bedroom apartments, on the other hand, have a lower annual yield which will take even more to recover the borrowed capital. Two-bedroom apartments are therefore the best choice strategically and financially.
Conclusion and Recommendation
In conclusion, the proposed investment project is a viable project to undertake. This is mainly because there is no doubt about the possibility of consistent returns from the project. The houses will certainly be filled given the location as well as the set rent rates. In addition, capital returns are certain since the current research on the area as well as in the whole London suggests that rents rates are projected to rise in the foreseeable future. The demand for housing is certainly not met and this state is expected to prevail over the projected holding period.
In addition, the location chosen is undergoing significant changes. Such significant changes are intended to strategically transform East London and specifically Stratford into a city on its own. As such, it is inevitable that there will be a high influx of new residents as more jobs are created. The local authority projects that 1800 new workplaces will be built in the wider Stratford locality. This will see an estimated 46,000 new jobs created with the next ten years. The council also projects that there will be over 200 new homes which are likely to be integrated into the already existing ones. Sound financial analysis on the locality suggests a positive signal of value addition to capital investments in this part of London. With such positive expectations on the proposed locality, investors are certainly assured of good returns on long term capital investments.
In assessing the suitability of the project in financial terms, the net present value method adopted is more realistic in the valuation of the cash flows. This is because any future cash inflow is not equal to an inflow today. This means that the time value of money is taken into account in evaluating future cash inflows. In this particular investment, the net present value assumption gives a positive return which means that the expected cash inflows fully compensate the costs incurred. According to this method, therefore, it is viable to invest in the project since the returns are certain and quite impressive.
Equity reversion is basically the expected lump sum benefit to an investor at the end of an investment holding period. This amount is based on the reversion value less all the transaction costs and the outstanding debt amount (Manigart, 1997). Transaction costs include tax, any deposition costs and outstanding mortgage debt. This means that the time value of money is not taken into account in this case. This is an unrealistic assumption since the value of receivables in future cannot be equated to present value.
However, the method tries to give a rough idea on the possible trend of the proposed investment after the holding period. Though not a realistic figure, the result obtained gives an indication given the projected cash flows on possible loss on resale value at the end of the period. In the case of the proposed investment, the equity reversion method gives a positive figure at the end of the holding period. This suggests that the project proposed is a viable investment worth undertaking. Since both approaches have a positive indication regarding the project, it is certainly worth to invest in. finally, it is financially prudent to hold the apartments for the ten years analyzed and more since the returns on the investment tend to be increasing given the surge on prices in the London property market which is expected to continue in the foreseeable future.
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Hutchison , N.E., 1998. Housing as an Investment?: A Comparison of Returns from Housing with Other Types of Investment. Journal of Property Finance, 5(2), p.47-61.
Jenkins, G.P., 1999. The Appraisal of Investment Projects: A Teaching Approach. Journal of International Development, 6, p.115-122. Available at: http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18328830&site=bsi-live.
Manigart, S. et al., 1997. Venture Capitalitstsʼ Appraisal of Investment Projects: An Empirical European Study. Entrepreneurship: Theory & Practice, 21(4), p.29. Available at: http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=730752&site=ehost-live
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