14:27 PM, 3rd December 2010, About 13 years ago 8
This rule of thumb is very simple. 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. If you don’t have the right level of liquidity reserve, don’t panic. There are ways to correct the situation, either by restructuring, or if that isn’t possible, by looking for ways to reduce your costs and increase your cashflow.
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 have an opportunity to increase your returns. However, this has to be balanced against a cash reserve to get you through difficult periods that you will encounter from time to time due to:
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 £20,000 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 80%.
In this example let’s assume the investor could raise a mortgage of £80,000, repay the £20,000 mortgage and have £60,000 left over.
The investor could then buy another £100,000 property with the benefit of an £80,000 mortgage by investing £20,000 of the £60,000 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:
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. I appreciate that interest rate margins are higher now than they were a few years ago and that costs of refinancing are high. However, this must be balanced against the risks of no or low levels of liquidity.
To learn more about my property investment strategy please read the following posts in this order: