HMO’s have the added advantage of not only producing a much higher income than the same property let as a single let but the ability to be valued not only on their ‘bricks and mortar’ value i.e. the traditional method of valuing a building but on their income known as valuing on yields or income stream. When using the yield approach you are entering the area of the commercial lender and lenders and valuers who operate in this area act very differently to the ordinary ‘buy to let’ market with its simple tick box standardised product approach.
Commercial lenders take a much closer look at the borrower and usually want to see buy to let experience, your last three years accounts, will interview you and carryout a through review of you and your property portfolio. With commercial valuers you can interview and chose your own valuer as long as they are on the lenders panel.
HMO’s now being valued at 8% yield.
So what is an HMO worth? Just like with anything, what someone will pay for it. You can, however, quite easily calculate what some specialised commercial valuers may value your property for without having to pay £250 – £1800 plus VAT for their fees. If you can calculate what your HMO will be valued at or the HMO you are thinking of buying will value for, you will know whether you could remortgage for a further advance or maybe do a no money down deal but I am not saying you will be able to sell or even if the HMO is worth buying. This exercise is mainly to assess what a lender will lend on the property whether you are buying or remortgaging.
With established HMO’s that is a property that could be sold to investors as a HMO i.e. a property converted into bedsits (studios or flatlets if you are moving up market) and let as such or a house that has been consistently let to say students for many years in an area of good demand. In such circumstances the property can be valued on income, commonly know as the yield. Yield is the method by which commercial property has traditionally been valued and it shows how the housing market is developing that now HMO’s are beginning to be valued the same way. Over recent years the yield on HMO’s has improved from about 12% in 2000 to 5.5% early 2007 but with interest rates going up during the year and the rest of the commercial market
weakening it is now about 8% except for purpose built student housing which still is valued at 5.5 to 6% yield. The decision as to what yield to apply also depends on the quality of the HMO.
Usually newly refurbished studios and bedsits get valued more highly than a shared house with rooms only.
Let me explain the concept further, if a property is valued at 10% yield and produces an income of £10,000 per annum then it will be valued at £100k assuming there is no deduction for expenses. At 8% yield the same income would produce a value of £125,000, 7% yield would be valued at £142,857, 6% £166,700 and 5% £200,000. Looking at it from another way, 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 required an income of £10k and interest rates are at 5% you need to deposit £200k (£200k x 5% = £10k) into the bank’s savings account, at 6% £166,670, 7% £142,857 and at 8% £125,000. Now, hopefully you have the concept of valuing on income lets move on to the detail. See later more on how to calculate the yield
Early this year when I had one of my properties valued the valuer was considering whether to use a 7% or 8% yield. Purpose built student property is now being valued at 5.50% – 6% yield. In the end the valuer decided on 8%, the rational being that my tenants were not as permanent as students, and so required higher management! Having let to students I am not so sure, maybe students have changed a lot since I let to them, but I doubt it. It comes down to what the valuer assesses HMO properties are currently fetching when they are being sold and student housing is the big thing now with lots of demand from investors for purpose built units.
When there is a lively market i.e. plenty of buying valuers can get information about what is being paid for property in that sector, known as comparables and can be more certain as to the going rate for that kind of property. There is little uniformity in the property market. Yields range from 3.5% for prime London office space to over 12% for secondary i.e. out of town, shops and offices. Remember over three times the yield then less than a third of the value!
The problem is that no market is perfect and valuing property which is much less flexible than say shares is not an exact science. Lenders want certainty and that is the role of a valuer. A variation of up to 20% is generally accepted as being reasonable in the property market. That is a big difference and we could all get rich on that. Just ask three estate agents to value your own residence and see what figures they come up with.
Valuing an HMO on income is usually only used if it produces a higher value than the bricks and mortar value. No one is normally going to want a lower value for their property. Many valuers are uncomfortable about valuing residential property on income and try and reconcile the two values by reducing the income value to being closer to the bricks and mortar value. It is, therefore, essential to choose a valuer who is comfortable with valuing HMO’s. A valuer will also want to feel comfortable with you that you are professional, competent and above all going to remain solvent for at least another three or four years. The last thing the valuer needs is for your properties to be repossessed and they have to justify their valuation. After 3 or 4 years in a rising market there is less likelihood of any come back on the valuer.
The yield is not everything, the valuer’s view on expenses can have a major influence as well. Expenses are things like repairs, utilities, insurance etc but not the mortgage interest. Valuers tend to be confused on the treatment of bad debts and voids, the more cautious will include them and so increase the deduction. Some will also deduct a further 3% for selling or purchase costs. Many valuers will, when valuing a HMO, take a standard 25% reduction for expenses, others are more cautions and I have had over 40% deducted from the income to cover expenses.
Loan to Value
Lenders in the commercial field normally only lend up to 70% of the yield valuation though I have known lenders to go as far as 80% LTV. The other complication is that some lenders put a second cap on the amount they will lend by limiting the loans to the vacant possession value. The vacant possession value is similar to the bricks and mortar value.
Gone are the exotic variations (confusing!) of rates available in the ‘buy to let’ market. Commercial loans cost more, usually about 1.5% over base or libor, though if you consider that normally standard variable rates are usually 1.6% over base or libor, may not be so bad. The other major limitation is that most of the lenders insist on a short repayment period for example 10 years, very few will give a twenty year interest only loan. A ten year repayment mortgage causes enormous cash flow problems compared to an interest only mortgage, it costs about twice as much a month. I do not know how other borrowers cope, I usually end up remortgaging to reborrow the capital I have repaid. I have also discovered that some lenders are open to a ‘capital holiday’ i.e. will give one to four years interest only but you need to ask.
Just as valuer’s vary on how they treat expenses so they vary on their assessment of yields or whether to even value on yields. The choice of valuer is fundamental to this whole process. If you choose one which is over cautions, they may often refer to themselves as, ‘Very professional’, if they do, do not touch them, they will wreck any prospect of obtaining finance by their qualified reports. Lenders are very easily put off lending even by one negative remark. You need a valuer who is prepared to take a commercial view. My book ‘How to Become a Multimillionaire HMO Landlord’ talks in more detail about how to choose a valuer.
How to calculate yield
Take the yield and divide it into 100 to produce the yield multiplier e.g. 7% yield = 14.29, 8% yield = 12.5. Take the gross rental income per annum and deduct expenses, usually 25% is the norm to give the net income. Multiply the net income by the yield multiplier and that gives you the market value of the HMO.
A HMO producing £32,200 per annum. If valued at 7% yield and deducting 25% for expenses (the same 25% deduction is achieved by multiplying the gross rent by 75% and for a 40% deduction multiplying by 60%).
£32,200 x 75% x 14.29 = £345k market value.
With a 40% deduction for expenses
£32,200 x 60% x 14.29 = £276k market value.
Same HMO as example 1, valued at 8% yield deducting 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 = £241k market value
HMO Daddy’s Quick Method
Assuming a 25% deduction for expenses, a short cut for an 8% yield is to multiply the gross rent by 9.375 for 40% deduction for expenses multiply by 7.5 and for 7% yield with 25% deduction for expenses multiply by 10.72 or 8.57 for 40% deduction for expenses.
You get the same result.