Cash on Cash Return - Part II - Forced Appreciation

November 05

In the newsletter last month, I spoke about Cash on Cash Return (CCR) as the critical metric to analyse when considering a property deal. I also spoke about how difficult it was to achieve a good CCR buying normal properties at market value, or even a bit below, and letting them in the normal way.

The good news is that there are two, distinctly different, approaches to dramatically improving CCR. Both, however, take rather more time and effort than simply finding a ready-to-let property and dropping the keys off with the letting agent.

This month, I am going to concentrate on the first...

It is something that I have done much more in the last few years than I ever did in the 1990s - and this is to by properties that are NOT ready to let, but instead properties that will need some work done to them. Or, to put it in financial terms, to buy properties which have the potential to add value.

At the London Property Investor Show in September, I saw several presentations as well as giving several. One slide that particularly stuck in my mind was by Ranjan Battacharya.

You can read more about Ranjan and his free course here.

The slide he put up was very simple. It said that there are THREE ways to make money out of Buy To Let, and that most people only consider two of them. I am going to tweak his order, and change the wording slightly.

• 1: Cashflow
• 2: Capital
• 3: Cashback

1: Cashflow is what we are familiar with as landlords. Tenants pay us a monthly fee (rent) in exchange for the right to use the property.

2: Capital growth is what has made many of us wealthy over the past ten to twenty years. The nominal value of properties - that is to say, the number of present-day pounds required to buy them - has gone up dramatically. (Have a look at the article I wrote in February 05 about the money illusion to see why I stress the word NOMINAL.)

However, as we well know, average yields have gone down dramatically over the last five years, and what was perhaps a relatively easy way to make cashflow back in 1995 is now terribly difficult.

Capital growth is notoriously difficult to predict (This time last year, November 04, I wrote an article called prediction, prophecy and gambling about this.

What everyone seems to agree on is that the next few years are very unlikely to see major booms, and the days when we achieve 15 per cent annual growth are behind us. (I am sure they will return at some point, but I do not see it happening in the next 5 years.)

3: Cashback is the third possibility. I should stress immediately that I am NOT talking about, nor was Ranjan talking about the fancy financing deals that allowed massive leverage by giving an under-the- table cash back at time of completion as a way to trick lenders into giving a higher advance.

Instead, I am talking about the less spectacular, but more reliable method of Buy -> Refurbish -> Refinance.

Let us go back to the example of last month. We bought a property for 160,000, and let it out for 800 per month.

Taking into account the costs of purchase (legal, and SDLT), and assuming we could get an 85 per cent mortgage, we had to put in 26,300 in cash. In return, after voids and costs, we ended up with a net annual LOSS of 663, after mortgage payments. This was a CCR of minus 2.5 per cent.

This is a quick summary - it may be worth re-reading the article.

However, we are now going to consider the finances for a refurbished property.

Consider the same property, which is average condition was worth 160,000. Imagine that it needs a complete refurbishment but more importantly, you have established that it would be possible to build a small extension, perhaps a loft conversion, giving an extra bedroom.

Imagine that, because of the poor condition, the fair market value was only 120,000. A few years ago, properties in lousy condition went for almost the full value of a good condition property, as people believed that making money out of wrecks was easy, and bid up prices. Fortunately, the hysteria seems to be subsiding, and it is possible to pick up bargains again. (Not without hard work.)

A key advantage here is that this purchase price of 120,000 take us just under the new SDLT threshold, so there is a tax saving at time of purchase!

Imagine also that, after 24,000 of construction work and paying interest while the property is being refurbised then the enlarged property will let out, not for 800 per month, when it was smaller, but for 1,000 per month. Assuming the same levels of commission and voids as before, then this gives an annual net rent of 9,371.

Based on the same 85% mortgage, the total cash in is now 42,700 (the lower purchase price and saving on SDLT being more than balanced out by the need to put in 24,000 of cash to finance the refurbishment.

On the bright side, however, the increased rent, coupled with the lower borrowings (the flip side of the higher cash injection) means that the cash generated after interest payments is now 3251 per year, or a CCR of 7.6%

Whichever way you look at things, this 7.6% CCR is way better than the minus 2.5% CCR that we achieved buying a property that was ready to let, and acting in the normal way.

However, this is where cashback comes into its own. Before the extension, the property was worth 120,000. In good condition, it would have been worth 160,000. However, with the loft conversion, it is now worth 180,000. You then approach a mortgage company, and ask to refinance the property. 85% of the new value is 153,000, however you decide not to borrow too much, since you want to ensure your good cashflow, so you ask to borrow only 140,000. (A 78% loan to value.)

The interest on this (at the same 6%) comes in at 8,400 a year, so your new net rent of 9,371 (after voids and fees) gives you 971 a year in positive cashflow.

The refinance has loaned you 140,000, but obviously 102,000 has to go straight to paying off the original mortgage, leaving you with 38,000 cash back.

Compared to the 42,700 you had to put in this means that you only have 4,700 of your original cash left in the deal, and a CCR based on that figure is 20.7%.

More importantly, you have most of your working capital back, and are able to concentrate on finding the next deal.

For what it is worth, had you, in fact, decided to apply for the whole 153,000 in refinancing, then you would have been trading off cashback for cashflow - you would have not only paid off your original cash input, but been left with 8,300 in ready profit. On the downside, your ongoing cash flow would only be about 200 per year, so effectively you would have given up the passive income in exchange for a bigger working capital pot.

The downside to working this way? It takes a LOT more effort, and involves taking on a lot more risk. Estimating rents can be hard - estimating building costs, and more importantly, keeping projects on track, can be harder. However, the profit potential is far, far, greater.

This is just the feature article from the November 05 newsletter. Subscribe for market comment, forthcoming events, and more.

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