Standard BTL properties will lose money if interest rates rise while Houses in Multiple Occupation remain profitable

Analysis carried out by Platinum Property Partners (PPP) reveals that the Houses in Multiple Occupation (HMOs) are the most stable and profitable form of buy-to-let (BTL) investment, protecting landlords against higher costs caused by an interest rate rise.

HMOs - rented to young professionals and key workers - are intrinsically geared towards maximising rental income by letting each room on an individual basis. Recent research for PPP (Investor returns compared: a guide to recent buy-to-let and HMO returns) has shown that compared to capital gains, rental income for all types of BTL is by far the most dependable and stable source of return on investment.

HMO landlords are therefore best positioned to absorb the higher mortgage costs caused by an interest rate rise, an event which the Bank of England has indicated will take place in early 2016.

Table 1: How standard BTL and HMO investments cope with a 3% interest rate rise*

Standard BTL property HMO property
2014 Current 3% rise Current 3% rise
Average purchase price £183,391 £183,391 £245,486 £245,486
Average mortgage £138,594 £138,594 £170,310 £170,310
Average mortgage rate £4.00% 7.00% 5.17% 8.17%
Monthly gross rental income £754 £754 £3,298 £3,298
Monthly mortgage interest payments £462 £809 £733 £1,159
Monthly gross profits £292 -£55 £2,565 £2,139

Table 1 shows that the profits of a standard BTL investment can be wiped out by a 3% rise in interest rates (assuming mortgage rates increase by the same amount) as gross rental income is not sufficient to cope with higher mortgage interest repayments. In this example, a 3% interest rate rise has led to a £347 increase in monthly payments - making the annual mortgage bill over £4,000 more expensive and resulting in a £660 annual loss.

The HMO property already has higher monthly mortgage interest payments due to limited product availability, the complexity of the model and the amount of tenancy agreements on any one property. Should rates rise by 3%, these mortgage repayments would rise by £426. However, because the HMO property generates a much higher gross rental income of £3,298, these extra costs are easily absorbed, with enough money left over to still earn a profit (£2,139 per month, down from £2,565).

This is still the case despite the commonality that HMO landlords pay for all household bills, which typically amounts to £533* a month, leaving £1,606 profit.

Average HMO rental income is up to four times higher than standard BTL

A key characteristic of HMOs is the maximisation of income from a given size of property by creating extra rooms and renting them to multiple tenants. Based on PPP data (see table 1), the average monthly rental income for an HMO property in 2014 was £3,298.

In comparison, the average monthly rent in the wider BTL market in 2014 was £754. This data suggests HMOs can generate rental income that is up to four times higher than the rents achieved in a standard BTL property.

Rental income is most dependable source of return on investment

Previous analysis carried out by PPP shows that rental income is a far more stable and dependable source of return than capital gains, dispelling the myth that the success of any BTL investment is mostly about rising house prices.

From 2010 to 2012, investors operating in both the standard BTL and professional HMO market were sustaining capital losses. It was only in 2013 and 2014 that capital gains began to recover*.

In contrast, rental income consistently increased throughout the same period for both asset classes, albeit at a much higher rate for HMOs.

Table 2: Cumulative net income and capital gains from standard BTL and HMOs (2010-14)

Standard buy-to-let HMOs
Year Cumulative rental income Cumulative capital gains Cumulative rental income Cumulative capital gains
2010 9.5% 0.0% 15.2% 0.0%
2011 19.6% -9.4% 30.4% -5.4%
2012 30.0% -2.2% 45.5% -3.3%
2013 40.8% 16.5% 60.7% -8.1%
2014 51.7% 30.8% 75.9% 31.9%

These figures show that while capital gains are a volatile form of return - falling into the negative if property prices are in a downturn - rental income is much more stable and therefore reliable.

Landlords looking to futureproof their property must plan ahead

The best way that landlords can ensure their investment can cope with an interest rate rise - and any other unexpected costs - is by planning ahead and having a good understanding of the financial performance of their portfolio.

Research carried out by PPP in 2014 showed that a severe lack of research and poor planning is preventing many BTL investors from maximising their income. A quarter of BTL investors sought no advice and carried out no research before making their property purchases and a staggering 93% had no five year plan for their investment.

Separate research by PPP shows that landlords are also prone to miscalculating their returns. Almost one in eight (12%) landlords do not take any costs into consideration when calculating the financial performance of their BTL portfolio. In addition, one in four landlords pay mortgage interest but do not take this into account.

Just one in five (21%) investors use the most effective measurement methods when calculating their returns (Return on Investment and Return on Equity) and more worrying still, a quarter (23%) of UK landlords do not measure the return on their BTL investments at all.

Steve Bolton, Founder and Chairman of Platinum Property Partners (PPP) comments: "In recent years, there has been an influx of investors to the BTL market, with bricks and mortar proving to generate returns that outperform all other asset classes. However, not all BTL is equal, and our data shows that HMOs generate much higher rental income than standard BTL properties. HMOs will therefore be an attractive option for investors looking for a lower risk strategy that achieves a strong level of income.

"With many changes on the horizon for landlords, including the proposed restrictions to mortgage tax relief and looming interest rate rises, it's never been more crucial to have a decent cushion of rental income to absorb any rising costs.

"However, many landlords are failing to correctly calculate their returns, and our earlier research shows that a worrying number entered the BTL market with very little forward planning. Without a clear picture of what they earn from their BTL investment, a landlord is more vulnerable to market changes. Landlords must have a clear strategy and plan ahead to be able to accurately assess how futureproof their investments are."

* HMO averages based on PPP data for 2014. Standard BTL purchase price in 2014 from Halifax House Price Index. Standard mortgage from CML BTL market summary (gross advances / number of mortgages). Standard BTL mortgage rate assuming a rate of 3.5% plus base rate. All mortgage interest payments based on interest-only mortgage and 25 year term.

* Based on average utilities paid by PPP landlords in 2014.

* Independent analysis carried out for PPP: Investor returns compared: a guide to buy-to-let and HMO returns (June 2015).