Introduction
HMOs have the additional advantage of not only producing a much higher income than the same property rented as a single rental, but also the ability to be valued at not only their ‘bricks and mortar’ value, i.e. the traditional method of a building’s valuation but on its income known as yield valuation or income stream. By using the yield approach you enter the area of the commercial lender and the lenders and appraisers operating in this area act very differently than the ordinary ‘buy to let’ market with its simple checkbox standardized product approach.
Commercial lenders take a much closer look at the borrower and typically want to see the buy-to-let experience, your accounts for the past three years, interview you, and conduct a thorough review of you and your property portfolio. With commercial values you can interview and choose your own appraiser as long as he or she is on the lender’s panel.
HMO is now valued at 8% yield.
So what is the value of an HMO? As with anything, what someone will pay for it. However, you can quite easily get your property value calculated by some specialist commercial values without having to pay £250 – £1800 plus VAT for their fees. If you can figure out the value of your HMO or the value of the HMO you’re thinking of buying, you’ll know if you could remortgage for an extra down payment or maybe do a no-down-payment deal, but I’m not saying it’s going to be selling or even the HMO is worth buying. This exercise is primarily for evaluating what a lender will lend on the property, whether you are buying or remortgaging.
With established HMOs, it is a property that could be sold to investors as an HMO, i.e. a property converted to rooms (studios or apartments if it is rising in the market) and rented as such or a house that has been rented consistently to students for many years. years in an area of good demand. In such circumstances, the property may be valued based on income, commonly known as yield. Yield is the method by which commercial property has traditionally been valued and it shows how the housing market is developing that HMOs are now starting to value it the same way. In recent years, HMO yields have improved from about 12% in 2000 to 5.5% in early 2007, but interest rates rose during the year and the rest of the commercial market
the weakening is now around 8%, except for purpose-built student housing, which is still valued at a 5.5-6% yield. The decision on which return to apply also depends on the quality of the HMO.
Newly renovated studios and rooms are generally valued higher than a shared house with only rooms.
Let me explain the concept in more detail, if a property is valued at a yield of 10% and produces an income of £10,000 a year, it will be valued at £100,000 assuming there is no deduction for expenses. At an 8% return, the same income would produce a value of £125,000, a 7% return would be valued at £142,857, 6% at £166,700 and 5% at £200,000. Looking at it from another perspective, how much capital would you need in the bank to give a certain level of income at a particular interest rate? For example, if you need an income of £10k and the interest rates are 5%, you need to deposit £200k (£200k x 5% = £10k) in the bank’s savings account, at 6% £166,670, 7% £142,857 and at 8% £125,000. Now, I hope you have the concept of revenue valuation, let’s move on to the details. See later more on how to calculate performance
Earlier this year, when I had one of my properties appraised, the appraiser was considering whether to use a 7% or 8% yield. Purpose built student property is now valued at 5.50% – 6% yield. In the end, the appraiser settled on 8%, rationally being that my tenants were not as permanent as the students, and therefore required higher management! Leaving the students I’m not so sure, maybe the students have changed a lot since I left them, but I doubt it. It all boils down to what the appraiser assesses HMO properties are currently getting when they sell and student housing is top of mind now with lots of investor demand for purpose built units.
When there is a lively market, that is, many purchase values, you can get information about what is being paid for property in that sector, known as comparables, and you can be more certain as to the going rate for that type of property. There is little uniformity in the real estate market. Returns range from 3.5% for primary London office space to over 12% for secondary, ie out of town, retail and office space. Remember more than three times the performance and then less than a third of the value!
The problem is that no market is perfect, and valuing properties that are far less flexible than stocks is not an exact science. Lenders want certainty and that is the role of an appraiser. A variation of up to 20% in the real estate market is generally accepted as reasonable. That’s a big difference and we could all get rich from it. Simply ask three real estate agents to value your own residence and see what numbers they come up with.
An HMO’s income valuation is generally only used if it produces a value higher than its bricks and mortar value. Normally, no one is going to want a lower value for their property. Many values are uncomfortable with valuing residential property based on income and try to reconcile the two values by lowering the income value to be closer to the value of bricks and mortar. Therefore, choosing an appraiser who is comfortable valuing HMOs is critical. An appraiser will also want to feel comfortable with you because you are professional, competent, and above all, will remain solvent for at least another three or four years. The last thing the appraiser needs is for your properties to be repossessed and they have to justify their valuation. After 3 or 4 years in a bull market, the appraiser is less likely to come back.
Bills
Performance isn’t everything, the appraiser’s opinion of expenses can also have a big influence. Expenses are things like repairs, utilities, insurance, etc., but not mortgage interest. Appraisers tend to be confused about the treatment of bad and null debts, the more cautious ones will include them and thus increase the deduction. Some will also deduct an additional 3% for selling or buying costs. Many adjusters, when valuing an HMO, will take a standard 25% reduction for expenses, others are more cautious and have deducted more than 40% of my income to cover expenses.
loan to value
Lenders in the commercial field typically only lend up to 70% of the performance appraisal, although I have known lenders that go as high as 80% LTV. The other complication is that some lenders put a second cap on the amount they will lend by limiting loans to the value of the vacant possession. Vacant possession value is similar to the value of bricks and mortar.
Interest rate
Gone are the exotic (confusing!) variations of rates available in the ‘buy-to-let’ market. Business loans cost more, usually around 1.5% based or libor, though when you consider that standard variable rates are typically 1.6% based or libor, they may not be too bad. The other major limitation is that most lenders insist on a short repayment period, say 10 years, very few will give a twenty year interest loan. A ten year mortgage payment causes huge cash flow problems compared to an interest only mortgage, costing about twice as much per month. I don’t know how other borrowers manage, I usually end up remortgaging to reborrow the principal I’ve paid off. I’ve also found that some lenders are open to a ‘principal holiday’, meaning they will only give interest for one to four years, but you should ask.
The value
Just as values vary in how they treat expenses, they also vary in their assessment of returns or even whether they value returns. The choice of value is fundamental throughout this process. If you choose one that is over the precautions, they can often refer to themselves as “Very Professional”, if they do, don’t touch them, they will ruin any chance of getting financed for their qualified reports. Lenders are easily put off by even one negative comment. You need an appraiser who is prepared to take a business perspective. My book ‘How to Become a Multimillionaire HMO Landlord’ goes into more detail about choosing an adjuster.
How to calculate performance
Take the return and divide by 100 to produce the return multiplier, for example, 7% return = 14.29, 8% return = 12.5. Take the gross rental income for the year and deduct the expenses, usually 25% is the norm to get the net income. Multiply the net income by the yield multiplier and you get the market value of the HMO.
Example 1
An HMO that brings in £32,200 per year. If it is valued at 7% return and deducting 25% of expenses (the same 25% deduction is achieved by multiplying the gross income by 75% and for a 40% deduction multiplying by 60%).
£32,200 x 75% x 14.29 = £345,000 market value.
With a 40% deduction for expenses
£32,200 x 60% x 14.29 = £276,000 market value.
Example 2
Same HMO as example 1, valued at 8% return minus 25% for expenses
£32,200 x 75% x 12.5 = £301k market value
With a 40% deduction for expenses
£32,200 x 60% x 12.5 = £241,000 market value
HMO Daddy Quick Method
Assuming a 25% deduction for expenses, a shortcut to an 8% return is to multiply the gross income by 9.375 for a 40% deduction for expenses multiply by 7.5 and for a 7% return with a 25% deduction for expenses multiply by 10.72 or 8.57 for 40% deduction for expenses.
You get the same result.
