The Dangers of Low Rental Yields on Buy to Let

For many years buy to let investments were seen as a far safer alternative than putting money in shares and were also seen as more profitable than putting money in the bank. That may have been true for a large part of the this decade, but it proved dangerously optimistic for many buy to let investors in 2007 and 2008 when property markets crashed. An asset class that many people hoped would provide for their retirements proved to be just as risky as shares.

Yet people could have protected themselves better by being more intelligent about the sorts of properties they bought and the prices they paid. The main mistake that many residential property investors made was to ignore the price they were paying for a property in the belief that house prices always go up. For them it didn’t matter how expensive the property was since they thought it would be even more expensive a year or two later.

In fact, property markets have a strong tendency towards mean reversion, which means they move about around an average. Sometimes property markets are undervalued and at other times they are overvalued. The best way of profiting from property investing is to understand which is which and the easiest way of doing that is looking at rental yields. In 2007 average buy to let rental yields had fallen so low that investors weren’t making enough to cover the costs of borrowing needed to fund property purchases. In effect they were losing money every year in the hope that rising capital values would bail them out. That was a clear sign of a bubble. Spotting the near top of the cycle is however easier than spotting the bottom. Rental yields have improved greatly over the past year but are still relatively low by historic standards, which should still be a warning sign to investors now.