Which Property Investment Strategy Should You Do First?

Today, I was struck by one of those surprising questions that life occasionally throws at you. For years, you quietly take things for granted. Then suddenly, you find yourself in a familiar situation, being hit by an obvious question that’s not occurred to you before and to which there is no obvious answer. This time, it happened as I was sitting in a rather smart Harrogate hotel. My lunch guest had opted for a pot of tea to go with a rather beguiling Yorkshire curd tart that had been winking at him from the cake trolley. As the waiter put our drinks on the table, I couldn’t help noticing that my guest’s tea had arrived in one of those small stainless-steel teapots that are ubiquitous in hotels and cafés across the country. Instantly, I knew what would happen next.

Sure enough, as my friend poured himself a drink using the teapot’s ridiculously undersized handle, only about three-quarters of it actually went into the cup. The rest dribbled onto the tablecloth, leaving an unattractive brown stain that would doubtlessly cause much tutting from the waiting staff. To make matters worse, having foolishly forgotten to wear any asbestos gloves, he also had to put the teapot down rather abruptly to avoid sustaining third-degree burns.

Now, you might think that the surprising question is, ‘Who on earth designed a teapot with a tiny handle that scalded the pourer and a spout so badly shaped that no matter how quickly or slowly you pour, you can’t help but make a mess?’. Surely, in teapot terms, it must flaunt some fairly rudimentary design rules. However, the more surprising question is, ‘Which organisation’s buying department decided to purchase this useless teapot in such vast quantities that it became virtually ubiquitous throughout the entire hospitality industry?’ I suspect it’s the same people who invented those conveyor toasting machines that are omnipresent in hotels across the world, and which somehow manage to churn out hot bread after one rotation and charcoal for those foolish enough to risk a second lap. Not that it bothers me in any way.

Interestingly, the property world is not immune from its own surprising questions. And here’s one that should probably come up a lot more often than it does, namely, “Should I start with buy-to-lets and move on to do a development project later? Or should I do a development project first, and then do buy-to-lets afterwards?“. It’s a surprising question only because more investors don’t think to ask it; they often head off down the buy-to-let route without giving development a second thought, either now or sometimes ever. So, if that’s the question, what’s the answer? Let me try and shed some light.

For many people, the problem with property investment is money or, rather, the lack of it. Buy-to-let investing generally involves the investor needing a deposit, usually 25% of the purchase price, to get the ball rolling. It’s why many people get into property investing in mid-life or later after they’ve built up enough capital from their day job or business to afford their first rental property deposit. Now, there are many variables in both buy-to-lets and in development, so when looking at specific examples, we need to bear in mind that there are many other ways of skinning the cat that could produce different figures. But let’s make a start and see how we get on.

The first thing to say is that I need to keep things simple. If I use precise numbers and factor in tax, inflation, tenant finding fees, and the like, or compare corporate versus personal ownership, things will get confusing very quickly. So, excuse the broad-brush approach, but hopefully, it will serve better to demonstrate the principle, even if the numbers won’t be to the penny.

Imagine you had £75k to invest and wanted to acquire a buy-to-let property. You could put down a 25% deposit on a £260k house (which is broadly the average cost of a UK buy-to-let property, according to Zoopla), and this would cost you £65k, leaving you £10k to pay your buying costs and stamp duty. So far, so good.

Let’s also assume that you receive a rent of £1,200 per month from your new tenant. From this, you’d need to deduct your mortgage repayments of, say, £700, plus another £200 per month in maintenance and insurance costs. This leaves you a monthly profit of £300 or £3,600 annually, before tax.

A few things might strike you about this number, the first being that it’s not very large. If you opt for a fully managed letting service or have some expensive bills one year, your profit could easily be wiped out altogether. The second thing that might strike you is that you’ll need quite a few buy-to-lets if you’re going to move your income needle meaningfully. Ten buy-to-lets is a decent portfolio, but based on these numbers, they will only net you £36,000 each year overall, before tax. Of course, I’m only looking at vanilla single lets. Opt for a different strategy, such as HMOs, and while your upfront costs, tenant management overheads and voids will increase, your ROI will be higher overall. As I said, there are many variables, and it’s worth investing in your property education to discover the best model for you.

But of course, we’ve only looked at one part of the buy-to-let model, so now let’s look at the second, which will make a significant difference: capital growth. Property prices have historically increased over time, and while there are no guarantees that they’ll continue to do so, there’s no reason to suggest that they won’t. The trickier question is, ‘How quickly will they rise?’ An old rule of thumb suggests that property prices double every ten years; however, it depends on which decade you look at. Since I have to pick a number, I’m going to suggest that a 15-year period would currently be more realistic/prudent. This means that after ten years, your buy-to-let property will now be worth around £420k, having increased in value by £160k. This makes things look a bit rosier and should cheer you up a bit if you were in the doldrums following the previous paragraph.

So, what does this mean in terms of being able to buy your second buy-to-let? The good news is that the equity growth you’ll enjoy over the next ten years will eventually allow you to remortgage your first buy-to-let to create the deposit for your second investment property. So now, you’re into your eleventh year, and you’ve just got your second buy-to-let. This is all well and good, but waiting a decade before you can buy your second unit doesn’t feel like you’re taking the property investment world by storm. Even if you kept remortgaging every time your properties increased significantly in value, it’s going to take quite a while to get up to ten properties. And even that will only return a rental profit of around £36k per annum in today’s money, before tax. This organic way of growing a portfolio is relatively slow, and many landlords look to leverage other capital sources to speed things up. They might remortgage their home, borrow against a business, or use other savings or windfalls to try and grow their portfolio more quickly. But if those options don’t appeal or aren’t available, then they’re stuck playing the waiting game.

Let’s now turn our attention to property development to see how the numbers compare. You could do all sorts of developments, but I’m going to use a straightforward type, which is to convert a small commercial building, e.g. a shop, office, or light industrial unit into flats using permitted development. And again, I’m going to use round numbers to make things as straightforward as possible. Let’s assume you bought a shop for £400k and that it will cost £325k to convert the uppers into flats (including all labour, materials and fee costs) plus another £75k in finance costs. Your overall costs are, therefore, £800k, and let’s assume you’ll sell the finished units for £1m, which means you’ll make a £200k profit.

Now, at this point, many people look at the numbers and see that development requires a lot more cash than buy-to-lets, so they drop property development from their thinking straight away. After all, they simply don’t have that type of cash to invest. But they’re missing a big trick because, while there’s more money involved in development, it’s where the cash comes from that’s important. Let’s see how things play out.

The world of property development is supported by a vibrant community of specialist commercial lenders, peer-to-peer lenders, family funds, and banks. In our example, you’ll need £400k to buy the shop, and one of these commercial lenders will lend you up to 70% of this amount, which means you now need to find the remaining £120k deposit. But commercial lenders don’t require you to pay the entire deposit yourself. They’re happy for you to borrow the deposit money from other people – a.k.a. private investors. These private investors could be friends or family, networking or business contacts, etc., and you’ll be able to pay them a very healthy rate of interest for their trouble. It’s worth stating that the lender will almost certainly want you to pay some of the deposit yourself – they usually want developers to have some skin in the game – but this might be as little as 10% of the deposit, which in this case would be just £12k.

So far, we’ve bought a shop for £400k and only put in £12k of our own money. But what about the additional £400k of development and finance costs we now need to turn the shop into flats? Well, the same lender who lent you the money to buy the shop will also lend you 100% of the £400k you need to develop it. This is a major revelation for many people because the scale of the financial leverage involved is quite astounding. To be clear, in our example, we’re simply turning a shop into flats, and we’ll be borrowing £788k of the £800k we need. We’ll be putting in just £12k of our own money and making a £200k profit at the back end, and that’s after we’ve paid ourselves back our initial £12k investment and also repaid our private investors. How long will such a project take? 18-24 months is reasonable, but let’s say two years to be safer. I’m struggling to think of another investment strategy that can reliably turn a £12k investment into £200k in two years. Is it easy? No. Is it possible for first-time developers to achieve this? Absolutely. And are there many empty shops and commercial buildings currently ripe for development? Of course, there are loads up and down the country.

I’ll reiterate that there are all sorts of other factors, including inflationary ones, that could affect the values I’ve quoted in both scenarios. But, even allowing for this, you can hopefully appreciate that the difference between the buy-to-let and development models is fairly stark.

So, where exactly does this leave us when we return to our original question, namely, which should you do first, buy-to-let or development? It depends on your situation. For those lacking a buy-to-let deposit, small-scale development could be viewed as something of a no-brainer. The lower personal investment requirement, coupled with the ability to generate a large amount of cash relatively quickly, will likely be highly attractive and allow you to create deposits you need for your first buy-to-lets. In profitability terms, it also beats doing rent-to-rents or deal sourcing, which are both common property strategies for those who lack the funds for a deposit.

Even if you have the deposit to buy your first buy-to-let, I’d still recommend investigating the development option simply because combining development with buy-to-let is such a powerful strategy. And if you’re an existing landlord who’s unsure where your next deposit is coming from, it’s potentially a game-changer.

In my example, I picked a very modest development, and a profit target of £100k to £500k is readily achievable from these small-scale projects. What surprises many people about development is the financial leverage. Our example of turning £12k into £200k in two years is on an entirely different level from buy-to-let investing (or most other investing). Yet small-scale development is a great fit for landlords, many of whom already develop their buy-to-let properties when they refurbish them or convert them into HMOs. Being a landlord developer can give you the best of both worlds and means you don’t need to have all your eggs in one property basket.