I've split out a case study I developed on another thread.
In this specific thread I want to set out a framework for evaluating the financial decision of whether to purchase an investment property.
In this analysis the key factor, in terms of personal situation, is whether you need to borrow to purchase or if you have sufficient savings.
Let's assume the following realistic scenario:
A house costs €250k
Rent is €12k p.a.
Deposit Savings rate net of dirt is 2%
Mortgage interest on buy to let is 5.5%
Individual's marginal tax rate is the higher level (52%)
For simplicity I'll initially ignore a couple of factors which probably should be taken into account in more detailed decision making e.g. costs of owning (repairs, etc), rent inflation, etc.
We'll also assume that this is a buy to hold decision rather than a short term speculative play.
1. Property investment versus savings
The key factor is how net of tax rents compare to net of tax interest on savings
In this case buying property is a marginal winner as €5.76k* collected net of tax rent exceeds €5k in savings interest forgone.
2. Is it worth borrowing for property investment
The key factor is how net of tax rents compare to cost of borrowing
In this case buying property is a clear loser as €11.1k** collected net of tax rent falls short of €13.75k in interest repayments.
*€12k rent after 52% tax
**€12k rent after 52% tax, allowing for 75% interest offset
Developing the scenario
If we build in a couple of more realistic assumptions e.g. rents increase @1.5% p.a. and owner has €2500 p.a. in costs, we get the following:
Scenario 1: Buying reduces net income initially but provides a greater income in the long run (decision is to buy)
Scenario 2: Rent falls well short of interest repayments and will take over 25 years to exceed them (decision is don't buy)
Obviously there are many other factors / risks to consider, but this method provides an initial framework to make a decision.
As can be seen, it is very dependent on whether you are a borrower or saver and it is also hugely sensitive to deposit savings rates, mortgage interest rates, taxes on savings, taxes on rents, marginal tax rates and long term expected growth in rents.
All this before even getting into the drag of being a landlord!
Simple Mathematical rule of thumb
In each circumstance we are effectively targetting a ratio of rent to market value that is the tipping point for the decision to buy.
In the scenario I have chosen the ratio of rent to market value is 4.8% (€12k/€250k). Allowing for ownership expenses of €2.5k, the effective rate is 3.8% (€9.5k/€250k). This drops to 1.8% if the marginal tax rate is 52% and you have no mortgage. For the scenario we have considered, it stays close to the 3.8% level if you do have a mortgage (i.e no tax is due).
A return of 2% is available on savings, whilst a mortgage costs 5.5%. If there is expected rent inflation, you can simply deduct the level of inflation from the interest rates to arrive at an effective "real" interest rate. In this case 0.5% on savings and 4% on the mortgage.
The simple rule of thumb then becomes 'purchase if the effective rental yield exceeds the real interest rate'.
For the person with savings the 1.8% rental yield net of tax comfortably beats the 'real interest rate net of tax' of 0.5%.
For the borrower the 3.8% rental yield falls short of the 'real interest rate net of tax' of 4%.
In this specific thread I want to set out a framework for evaluating the financial decision of whether to purchase an investment property.
In this analysis the key factor, in terms of personal situation, is whether you need to borrow to purchase or if you have sufficient savings.
Let's assume the following realistic scenario:
A house costs €250k
Rent is €12k p.a.
Deposit Savings rate net of dirt is 2%
Mortgage interest on buy to let is 5.5%
Individual's marginal tax rate is the higher level (52%)
For simplicity I'll initially ignore a couple of factors which probably should be taken into account in more detailed decision making e.g. costs of owning (repairs, etc), rent inflation, etc.
We'll also assume that this is a buy to hold decision rather than a short term speculative play.
1. Property investment versus savings
The key factor is how net of tax rents compare to net of tax interest on savings
In this case buying property is a marginal winner as €5.76k* collected net of tax rent exceeds €5k in savings interest forgone.
2. Is it worth borrowing for property investment
The key factor is how net of tax rents compare to cost of borrowing
In this case buying property is a clear loser as €11.1k** collected net of tax rent falls short of €13.75k in interest repayments.
*€12k rent after 52% tax
**€12k rent after 52% tax, allowing for 75% interest offset
Developing the scenario
If we build in a couple of more realistic assumptions e.g. rents increase @1.5% p.a. and owner has €2500 p.a. in costs, we get the following:
Scenario 1: Buying reduces net income initially but provides a greater income in the long run (decision is to buy)
Scenario 2: Rent falls well short of interest repayments and will take over 25 years to exceed them (decision is don't buy)
Obviously there are many other factors / risks to consider, but this method provides an initial framework to make a decision.
As can be seen, it is very dependent on whether you are a borrower or saver and it is also hugely sensitive to deposit savings rates, mortgage interest rates, taxes on savings, taxes on rents, marginal tax rates and long term expected growth in rents.
All this before even getting into the drag of being a landlord!
Simple Mathematical rule of thumb
In each circumstance we are effectively targetting a ratio of rent to market value that is the tipping point for the decision to buy.
In the scenario I have chosen the ratio of rent to market value is 4.8% (€12k/€250k). Allowing for ownership expenses of €2.5k, the effective rate is 3.8% (€9.5k/€250k). This drops to 1.8% if the marginal tax rate is 52% and you have no mortgage. For the scenario we have considered, it stays close to the 3.8% level if you do have a mortgage (i.e no tax is due).
A return of 2% is available on savings, whilst a mortgage costs 5.5%. If there is expected rent inflation, you can simply deduct the level of inflation from the interest rates to arrive at an effective "real" interest rate. In this case 0.5% on savings and 4% on the mortgage.
The simple rule of thumb then becomes 'purchase if the effective rental yield exceeds the real interest rate'.
For the person with savings the 1.8% rental yield net of tax comfortably beats the 'real interest rate net of tax' of 0.5%.
For the borrower the 3.8% rental yield falls short of the 'real interest rate net of tax' of 4%.