Balancing high gearing risks with high liquidityMake Text Bigger
High gearing effectively means borrowing as much as possible. That’s all very well if property values are increasing but what if you get your timing wrong?
In this article I will explain the pro’s and cons of high gearing and how to minimise risk.
The benefits of high gearing.
Just suppose you have £100,000 invested into property. That could represent owning one property worth £100,000 with no mortgage or four £100,000 properties, each with a £75,000 mortgage. If the property market was to rise in value by 10% you would have made £10,000 on the first strategy and £40,000 on the second strategy. Furthermore, if the cost of ownership is less than the rental yield then cashflow would also be higher as a result of the high gearing strategy.
Risks associated with high gearing
If interest rates were to rise before you had time to react your positive cashflow could very quickly turn negative. If this were to coincide with falling property values your losses would be compounded in the event of having to sell up
Balancing the risk
I have a very simple rule of thumb for balancing high gearing risks with high liquidity. If you have £100,000 of buy to let mortgages you should have £20,000 in the bank.
This article was written to show you a safe strategy that you may never have considered before. The strategy was based on a study of how various landlords fared in the late 1980’s and early 1990’s property crash when interest rates hit 15% and property values plummeted by 30%+.
If you don’t have the right level of liquidity reserve, don’t panic. There are ways to correct the situation, either by restructuring (remortgaging or selling some properties to release liquidity), or if that isn’t possible, by looking for ways to reduce your costs and increase your cashflow to build a liquidity reserve.
More often than not, investors have insufficient liquidity in reserve. However, many could have far greater levels of liquidity as well as being in a position to improve their returns.
The rational for using the 20% rule of thumb is that by having the maximum possible mortgage you maximise the opportunity to increase your returns. However, this has to be balanced against a cash reserve to get you through difficult periods which you will encounter from time to time due to:
- Negative cashflow which may be caused during periods of high interest rates
- Unexpected maintenance bills
- Rental voids
- Problem tenants
You also need to make sure that you are buying the right properties, in the right locations, at the right price and at the right yields but that’s another topic altogether.
Let’s look at two examples:
Investor owns £100,000 of property with a £10,000 mortgage but has no cash.
This investor has far too much equity exposed to the property market.
The investor should remortgage to the maximum LTV(Loan to Value), say 75%.
In this example let’s assume the investor could raise a mortgage of £75,000, repay the £10,000 mortgage and have £65,000 left over.
The investor could then buy another £100,000 property with the benefit of an £75,000 mortgage by investing £25,000 of the £65,000 he has spare.
This would leave him with two properties at a combined value of £200,000 and £40,000 in the bank.
The benefits are that when property increases in value, say 5%, the investor has made £5,000 on two properties, not just one, thus doubling the return on equity in property as well as correcting the liquidity problem. If the investor encounters problems, having cash in the bank transforms the problem into an inconvenience as opposed to a potential financial disaster. The cash is accessible immediately and the investor is in control. It’s also important to remember that it is possible to shop around for a return on the cash investment to minimise the real cost of the borrowed money.
Some investors would argue that no matter how small the differential is, it’s not worth paying because they will borrow the money if or when they need it. The problem with this is:
- What if the property has fallen in value?
- What if lenders are not prepared to lend the money?
- What if the state of the property means that it can’t be remortgaged until it is put right?
- What if the money is needed quickly?
Another typical example is an investor with 60% gearing and very little cash. I would advocate looking at the costs of refinancing to retain a 20% liquidity reserve for the reasons given above.
It is important to note that this strategy is not available or right in all circumstances, but a summary of why it is extremely popular for Buy to Let investors.
If you would like to view the most popular Buy to let mortgages available in the market today, see how much you can borrow and what it would cost please feel free to CLICK HERE to use our Buy to Let mortgage sourcing calculator.
My buy to let property investment strategy is documented and constantly updated in the Advice section of this website. To get back to the main menu >>>