Running the numbers on a deal: the spreadsheet most investors get wrong
Most deal appraisals are wrong in the same direction: they understate the costs and overstate the return.
A deal appraisal has one job: to establish whether the property will make money after everything has been paid for. The reason most fail at that job is not the arithmetic — it is the omissions. Acquisition costs, voids, maintenance, compliance and management are each individually small and collectively decisive.
The discipline is to build the appraisal from the costs upwards rather than from the rent downwards, and to include the costs whether or not they apply in the first year.
The costs that get left out
Each of these is real, recurring, and routinely absent from a back-of-envelope calculation. Together they typically reduce a gross yield by a third or more.
- Void periods, and the council tax and utility standing charges that continue while the property is empty
- Letting agent fees, including the tenant-find fee that recurs each time a tenancy changes
- Maintenance, realistically 1% of value a year averaged over a decade rather than the actual spend in a good year
- Compliance costs: gas safety, electrical condition report, alarms, licensing
- Service charge and ground rent on leasehold property
- Insurance, and the higher premium for a rented property
- Accountancy, if the portfolio is held in a company
- Refurbishment, and the refurbishment the next tenancy will need
Cash flow is not profit
A property can produce positive cash flow and still be a poor investment. If the rent covers the mortgage and the costs but the building is quietly deteriorating, the cash flow is being funded by deferred maintenance that will be paid later, in a lump.
The reverse is also true: a property with negative cash flow can be a good investment if the capital is growing faster than the shortfall. What matters is the total return, combining income and capital growth, measured against the capital employed.
The measures worth using
Gross yield is useful only as a filter. The measures that inform a decision are net yield, cash-on-cash return, and total return including capital growth.
- Net yield: annual rent minus all operating costs, divided by the total capital invested
- Cash-on-cash return: annual cash left after the mortgage, divided by the cash you put in
- Total return: net income plus capital growth, divided by the capital employed
- Sensitivity: how each of those changes if rates rise, rent falls, or the property is void for three months
Common questions
- What is a good cash-on-cash return?
- It depends on what else the capital could earn and on the risk you are taking. A cash-on-cash return below the mortgage rate means leverage is reducing your return, which is a signal to reduce borrowing or walk away. What matters is the comparison with your alternatives, not a universal threshold.
- How much should I allow for maintenance?
- A common planning figure is 1% of the property's value per year, averaged over a decade. That is higher than the actual spend in a good year, which is exactly why an average is used — the roof, the boiler and the redecoration arrive in bad years, and a budget based on the good years will not cover them.