Are HMO's a Recipe for Profit?

Property investors may well have read reports that in the first quarter of 2018, houses in multiple occupation (HMOs) typically delivered the best rental returns of all UK property classes - producing average yields of 7.1%.

We have often made the point that average national figures don't mean a great deal, mainly because so much depends on local market conditions. Nevertheless, some HMOs are clearly delivering good results in parts of the country, so we thought we'd take this opportunity to examine the subject. We approached our in-house specialist, property investment consultant Michael Johns, and asked him for his views.

Q. 7.1% is a respectable return. Are HMOs as good as they seem?

[Laughs.] Well, we're starting with a deceptively difficult question. I suppose I'd have to say that yes, some HMOs are delivering good profits. But this is a very chequered market, and returns vary considerably in different areas. There are all sorts of reasons for that, so to make the kind of returns that the headlines are suggesting, investors will have to do a lot of careful homework.  On the plus side, HMOs are purpose-designed to maximise rental income. Take a conventional house and convert it to put as many bedrooms in as you can, and - so long as the demand is there - you're almost bound to achieve better returns than you would from the original home. But a lot depends on how you buy it in the first place - whether as a traditional home or as a ready-converted HMO. Another big consideration will be the need for ongoing management.

Q. Let's take the first of those issues: the initial purchase. How does that affect profitability?

This is a big issue. There are essentially two ways to invest in an HMO. One is to buy an existing HMO, and the other is to buy a house that you plan to convert. Of the two, the second option is almost always the more profitable. When you buy an ordinary house, you'll be buying at about the standard market valuation and you'll be able to get a mortgage on it, so you should subsequently be able to take advantage of leverage as capital values rise. On the other hand, if you buy an HMO from its existing landlord, he or she will be valuing it as a live investment - very much like a business - so it will tend to be priced a lot higher because of the yields it delivers. 

To put some numbers to that as an example, you might pay £200,000 for a conventional home, on top of which you'll pay a few thousand in conversion costs. But if that same property has already been converted and run as an HMO, you might be looking at closer to £280,000. To add to that, you'll probably also find that banks aren't willing to lend against that sort of higher valuation, so you'd then be looking at a cash purchase, which means you've no chance of getting any leverage advantage. Finally that same restriction also means that if and when you want to sell the property, you too will only be able to sell to cash buyers, so your market will be more limited.

For those reasons, if you're looking at investing in an HMO, my personal view is that you would be better to go for a traditional property and convert it yourself.

Q. You mentioned the need for ongoing management...

Yes, and that's another big consideration. In my experience, HMOs take an awful lot of managing. Often, you'll be looking at older properties that have been in private rather than business ownership. Consequently, they won't always have been professionally maintained. Besides facing the initial conversion costs, investors might have to deal with safety improvements, energy efficiency upgrades and more general repairs than, say, a new build investment opportunity. And even if the property was previously run as an HMO by someone else, these things might not have been adequately looked after. It's probably fair to say that this is an under-regulated part of the industry so it's important to check for yourself that your new property meets all the relevant safety and energy regulations. After that comes the need to keep the place well maintained and marketable. Here, a lot depends on the kind of tenants you get. A lot of HMOs are about providing much-needed accommodation at the most affordable end of the market, so typical tenants might include students and young workers who are trying to move up the career ladder. These aren't always the most conscientious, careful or long-term tenants, so be prepared for regular repair and maintenance bills.

Of course, that's not to say that you have to manage such things yourself. Many investors choose to appoint a rental management agent. That's fine, but some management companies charge a premium because they know how much work is likely to be involved, and some refuse to take on that sort of work at all. If you're looking for a hands-off HMO investment, it will pay to do proper research in order to find a suitable agency - one that can deliver a professional service at a sensible price.

Q. You're making HMOs sound like quite an onerous investment...

No, not necessarily. It's just that it can take a lot of genuinely hard work to find the right property in the right area, on the right terms, and available with the right support.  Look at it this way: there's a definite shortage of affordable accommodation for students, young people and for lower income workers who are trying to move up. HMOs meet that need in a way that doesn't require a lot of new building on greenbelt land. At the same time, a well chosen property can also deliver healthy profits for the landlord. So HMOs certainly shouldn't be dismissed out of hand; it's just that I know a lot of investors who have said "I bought an HMO and I didn't realise how much work it would be; now I wish I'd gone for something else." It can be a bit of a minefield and people need to approach this market with their eyes wide open.

Q. So are there other pitfalls people should be aware of?

Regulation.  I think the UK Government is taking an increasingly anti-HMO stance, and local councils are gradually introducing more and more restrictions. In Liverpool, for example, HMO landlords now need to have a licence, which they have to renew (and pay for) every year. In Nottingham, landlords need a separate licence for every HMO they own. There's a lot more paperwork coming in, and slowly mounting costs, so it's possible that central and local government will gradually try to legislate the market out of existence.

There are several reasons why the public sector is feeling wary of HMOs. Partly it's about government not wanting to see too many family homes being converted into private rentals. Partly it's about local planning concerns - for example, not wanting to see a house full of noisy students moving into an otherwise quiet family neighbourhood. HMOs also have higher levels of occupancy, so they can add to local parking and traffic problems, which can also be a headache for councils. These can be emotive issues for residents and they can quickly turn political.

One other legislative issue is the possibility that local authorities will soon insist on minimum room sizes, in an effort to eliminate the kind of stories you read about people renting out 'a cupboard under the stairs'. You can see the motivation, but it opens up a can of worms: people in smaller units might be forced out and have to look for lodgings elsewhere; lodgings that they might not be able to afford. That risks more problems with homelessness and other social problems, and more pressure on an already under-supplied housing market.

Q. So, all in all, are HMOs worth the hard work?

There's no right answer to that. Choose a good one and yes, it could easily be worth it. But you need to buy on the right terms and in the right area. It needs to be in decent condition, and you need to be confident that you can meet all your legal responsibilities without eroding your margins too much. You need to be confident that you understand - and can pay for - the likely maintenance demands, and you need to decide whether you can afford the added costs of a management agency if you plan to make it a hands-off investment.

That all takes time and effort but if you make the right choices, then an HMO can deliver good profits.

Q. It sounds like there's a 'but' coming...

Of course.  We've already looked at some of the pitfalls and people really need to be conscious of them. They also need to consider the alternatives. The headlines back in May identified HMOs as the number one investment for yields but that's looking at a broad national average. In reality, I think there are better options available in many parts of the UK.

Q. Like what?

7.1% is a pretty good yield but there are off-plan developments offering higher returns and these are sometimes assured for five or more years - so they'll deliver better returns with the added benefit of investment security.  And serviced apartments are really coming to the fore this year. They're still a relatively new option for many investors - which might be one reason why they haven't previously featured in national statistics - but they tend to produce much better yields than other property classes. You might be looking at returns of around 8% to 10%, and importantly, they take investors into a more reputable, higher value market. As a result, management agencies will be more ready to offer affordable support, ongoing maintenance costs are likely to be lower, and landlords are less likely to get calls from angry neighbours complaining about noise in the middle of the night.

Q. So, any final thoughts?

It's all about being realistic; doing the research and being aware of what you're committing to. Without question, some HMOs will produce very worthwhile returns, but I know a lot of investors who have regretted buying HMOs that were promoted on the basis of unrealistic figures. People have told me they were led to expect returns of 12% but when all the costs had been paid, the real figure turned out to be much more like 5% or 6%. That isn't terrible, of course, but that's probably going to have been the result of an awful lot of work. There are easier, hands-off investment opportunities that promise better yields, more security and less vulnerability to future changes in legislation. 

If you have questions about property investment options, please call Michael or one of our other advisers on 01244 343 355.

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