We are in a low interest environment

When I say low interest I mean below 8% base rate and 9.5% actual borrowing rate. Now you may think this is high but this was what deals were be struck at back in 1997 when I first started. Back then you could buy a studio flat within the M25 for less than £30,000 and rent it out at £350 per calendar month. Looking at this equation the profit would have been:

Rent £350

£30,000 purchase

Mortgage@85% Loan To Value @ 9.5% Interest only £202

Service Charge £40

Profit £108

Now this does not seem much. Looking at the gross yield its:

£350 x 12 = £4,200 = 14% yield

Purchase £30,000

Which is fantastic and lets look at the return on cash:

£108 x 12 = £1,296 = 29% ROCE

£30,000 x 15% £4,500

So borrowing at 9.5% interest rates back in 1997 was a good thing EVEN though rates were so high! So even at a 9.5% borrowing rate you can still get a 29% return on your money. If you had left the money in the bank you would have received only 8%. So by borrowing and investing in property you more than treble your return. The key to all of this is that the gross yield is in excess of 12%.

Correlation between Yield & ROCE & Interest Rate

So why do I say 12% yield. I'll be honest with you. The main reason is because its easy to calculate whether a property is a 12% yielder. Let me show you:

If you see a property advertised for £50,000 and it's a 12% yielder it should rent out for £500 pcm. i.e. you knock off the two zeros of the purchase price and it gives you the expected rent. So if you find out that it rents out at £600 pcm you buy it without looking at it! If you find out it rents out at £300 pcm you put the property out of your mind - no matter how pretty the property is!

Now for the science. Look at the following table. It details the ROCE based on the yield and interest rate being charged. I've assumed full occupancy, no repairs and £10pcm buildings insurance.

ROCE Based on Yield & Interest Rate (85% Gearing)
		YIELD
		4%	5%	6%	7%	8%	9%	10%	11%	12%
INTEREST RATE	5%	-2.5%	4.2%	10.9%	17.5%	24.2%	30.9%	37.5%	44.2%	50.9%
	6%	-8.1%	-1.5%	5.2%	11.9%	18.5%	25.2%	31.9%	38.5%	45.2%
	7%	-13.8%	-7.1%	-0.5%	6.2%	12.9%	19.5%	26.2%	32.9%	39.5%
	8%	-19.5%	-12.8%	-6.1%	0.5%	7.2%	13.9%	20.5%	27.2%	33.9%
	9%	-25.1%	-18.5%	-11.8%	-5.1%	1.5%	8.2%	14.9%	21.5%	28.2%
	10%	-30.8%	-24.1%	-17.5%	-10.8%	-4.1%	2.5%	9.2%	15.9%	22.5%

If you look at the 5% interest rate row (which is the approximate buy to let borrowing rate currently) you can see the ROCE increases with yield. If you look at even closer you will see that with every 1% increase in yield the ROCE increases by between 6.6% and 6.7%. It actually increases by 6.667% but due to rounding it is either 6.6% or 6.7%. This means for every 1% increment in yield your ROCE increases by 6.667%.

This is why yield is important. Its easy to think ‘oh there's not much difference between an 8% yielding property and a 9% yielding property' but there is - 6.667% ROCE!

So why do I say 12% yield? Well look at the 12% yielding column. At current interest rates of 5% your ROCE is 50.9% which is very nice. But at interest rates of 10% your ROCE is 22.5% which is still very nice even though you are in a high interest rate environment. If you had bought at 8% yield, which is still quite a respectable yield, your ROCE is -4.1% i.e. loss making. This assumes full occupancy and no repairs! In a rising interest rate environment investors that have bought between 4% and 6% yields will be forced to sell, as they will hold a liability (as it will cost them money to hold) rather than an asset (supposed to put money in your pocket) which is what they first thought they were buying!

Okay, so we've established that a 12% yield threshold is what we should be aiming for, but what about the level of borrowing? Well look at the same table above but this time only 50% level of borrowing:

ROCE Based on Yield & Interest Rate (50% Gearing)
		YIELD
		4%	5%	6%	7%	8%	9%	10%	11%	12%
INTEREST RATE	5%	2.8%	4.8%	6.8%	8.8%	10.8%	12.8%	14.8%	16.8%	18.8%
	6%	1.8%	3.8%	5.8%	7.8%	9.8%	11.8%	13.8%	15.8%	17.8%
	7%	-4.1%	-2.1%	-0.1%	1.9%	3.9%	5.9%	7.9%	9.9%	16.8%
	8%	-5.8%	-3.8%	-1.8%	0.2%	2.2%	4.2%	6.2%	8.2%	15.8%
	9%	-7.5%	-5.5%	-3.5%	-1.5%	0.5%	2.5%	4.5%	6.5%	14.8%
	10%	-9.2%	-7.2%	-5.2%	-3.2%	-1.2%	0.8%	2.8%	4.8%	13.8%

Looking at the 5% interest rate row we can see that the ROCE for a 12% yielding property is 18.8%. Compare this to the ROCE for 85% gearing above of 50.9%. You can see that if you raise your borrowing by 35%, i.e. from 50% to 85% gearing, you almost triple your ROCE!

Now look at the ROCEs for a borrowing level of nil, 50%, 85% & 100% for a 12% yielding property.

Interest Rate	Nil	50% LTV	85% LTV	100% LTV
5%	12%	18.8%	50.9%	∞
6%	12%	17.8%	45.2%	∞
7%	12%	16.8%	39.5%	∞
8%	12%	15.8%	33.9%	∞
9%	12%	14.8%	28.2%	∞
10%	12%	13.8%	22.5%	∞

So we can clearly see that the ROCE increases rapidly the more we borrow. If we do not borrow all we can expect to make on the ROCE is the yield itself - which is not that exciting. We can see that the ROCE is higher for 50% gearing and even higher for 85% gearing. We can also see that it grows from 50.9% at 85% gearing to infinity at 100% gearing. It seems strange that this extra 15% level of borrowing would make such a difference - but it does!

Okay, I want you to follow this one simple rule and then you're ensured a steady path to property millionairedom:

IF THE YIELD IS IN EXCESS OF 12% THEN BORROW THE MOST YOU CAN!

Look at this graph:

You can see that the closer you get to 100% LTV financing your ROCE tends to infinity. So if you want to maximise your ROCE you should aim as close as you can to 100% financing.

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