HMO returns outstrip buy-to-let

Sarah Davidson

July 6, 2015

Research from Platinum Property Partners showed that buy-to-let outperformed all other asset classes including equities and gilts but that within that, HMOs rented to young professionals and key workers delivered much better returns even than standard buy-to-let properties geared with a 75% loan-to-value mortgage.

UK equities – as measured by the FTSE All Share Total Return Index – was the best performing asset class after buy-to-let with a total return of 46% over 2010-14 followed by commercial property at 41%.

Returns from UK government bonds (gilts) were significantly lower at 23%. Unsurprisingly given the low interest rate environment, the worst returns came from cash (as measured by one month Libor) which returned only 2% between 2010 and 2014, failing even to keep pace with inflation.

Each £1,000 invested in HMOs in 2010 would have grown to £2,080 by 2014, while for a standard buy-to-let property this would have reached £1,770: a difference of £310.

Average gross yields for the 2010-14 period for HMOs were 12.4% compared to 5.0% for a standard buy-to-let property.

The average price paid for a standard buy-to-let property in 2010 was £166,726, with an equity investment of £46,683. This resulted in a total return of £35,817.

The average initial investment in an HMO was much larger: the typical price paid in 2010 was £213,988 (with equity investment of £118,508).

This reflects the larger size of a typical HMO and the higher refurbishment costs usually required to convert an ordinary property into a high quality HMO – for example, installing ensuite bathrooms. However, despite the higher investment, HMO investors received a considerably higher return over four years: £127,781 on average.

Steve Bolton, founder and chairman of Platinum Property Partners, said: “Buy-to-let has proven itself to be the top performing investment over the past four years, with returns from bricks and mortar investments outpacing other asset classes like stocks and shares considerably.

“One of the main reasons for this is the HMO investment is intrinsically geared towards maximising rental income.

“HMO properties are strategically converted and refurbished to increase the size of communal areas and number of rentable bedrooms, therefore allowing for a higher number of tenants on individual rather than shared tenancy agreements. This results in greater returns for landlords despite the higher price initially paid.

“However, HMOs aren’t all about benefitting landlords: they also fulfil a growing social need for high quality rental properties that are affordable for tenants.

“The cost of renting a room in an HMO is far lower than renting a one bedroom flat. For the UK’s increasingly mobile workforce, who are delaying putting down roots for longer, it makes financial sense to live in a high quality HMO and still be able to save for long-term goals rather than spending all of a pay packet on rent.”

For the buy-to-let market as a whole, returns between 2010-14 were strongest in London and fell the further the distance from the capital. For example, average buy-to-let returns in Greater London during 2010-14 were 142.2%, compared to just 40.2% in the North East.

However, HMOs follow a different trend. While London still led the way (with total returns of 143.8%), the northern regions still achieved strong returns.

In the North East, HMO returns were 133.1% – more than three times the average buy-to-let. Similarly, HMOs in the North West achieved total returns of 120.2% compared to 84.8% for a standard buy-to-let.

A large part of the explanation for this trend lies in the breakdown of returns between net income and capital.

Over the four year period between 2010 and 2014, 52 percentage points of the total return of 77% for standard buy-to-let came from net income, with the remaining 25 percentages points coming from capital gains.

For HMOs of the total return of 108%, 76 percentage points came from net income with 32 percentage point from capital gains. So the return from net income alone was 46% higher for HMOS.

For standard buy-to-let properties, the return generated from net income varies only modestly across the UK (see table 4 below). For example, in the South East net income returns are 35.5% compared to 56.0% in the North West.

However, the difference in capital gain ranges much more widely, from – 13.4% in the North East to 95.0% in Greater London. This demonstrates the volatility of capital gains and comparative reliability of returns from net income: indeed, from 2010-2012 on average, investors were sustaining capital losses.

For HMOs, the regional variation in returns from net income is higher, with the northern regions producing substantially better average net income returns than the rest of the country – for example, 134.9% in the North East compared to 77.5% in the South East.

The initial investment is also smaller in the northern regions as average house prices are lower. This explains the regions’ strong overall returns despite more subdued house price growth.

A key characterisation of HMOs is the maximisation of income from a given size of property, making HMOs attractive for those looking for an income but also, because of the uncertainty of capital gain, for those seeking reliable returns.

Bolton added: “There has been an intense focus on house prices since the 2008 recession, and as the housing market has recovered many seem to believe that capital gains are the biggest contributor to overall returns when investing in property.

“It is true that capital appreciation has a role to play: however, the housing market is notoriously volatile, as evidenced during the recent financial crisis when short-term capital gains were completely eradicated.

“Net income provides far steadier returns, and consistently growing consumer demand for rental properties suggests this trend won’t change any time soon.”

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