Buy to let strategy – the 20% liquidity reserve rule of thumb

by Mark Alexander

14:27 PM, 3rd December 2010
About 9 years ago

Buy to let strategy – the 20% liquidity reserve rule of thumb

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Buy to let strategy – the 20% liquidity reserve rule of thumb

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:

  • Negative cashflow which may be caused during periods of high interest rates
  • Unexpected maintenance bills
  • Rental voids
  • Problem tenants
  • This is not an exhaustive list.

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:

  • 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.  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:

  1. The Roots of my Property Investment Strategy
  2. What you shouldn’t do with your buy to let mortgage
  3. How I maximise the returns on my liquidity fund (cash in the bank)
  4. Sell or hold after completing a refurbishment?
  5. (You are Here) | Buy to let strategy – in this article Mark Alexander explains the 20% liquidity reserve rule of thumb
  6. What’s more important, cashflow or liquidity? Mark Alexander reports
  7. Is your property portfolio ownership structure optimised to enable you to pay the minimum amount of CGT, income tax and IHT?
  8. The history of No Money Down and Instant Remortgages since 1992
  9. How I minimise rental voids
  10. How I choose my tenants
  11. How I minimise property management issues
  12. Are YOUR tenants YOUR best ambassadors
  13. Due Diligence
  14. My 1000th post on my favourite property forum
  15. Property management advice
  16. Property investment advice


Comments

11:54 AM, 7th December 2010
About 9 years ago

Here's a little story for you to demonstrate how I look at this. I was driving down the motorway recently, the roads were very quiet so I was travelling at around 70 MPH in the inside lane. A few cars wipped past me every so often breaking the speed limit, but that's their choice. In the distance was one car, all alone in the middle lane. It was travelling at 40 - 50 MPH. The driver thought he was safe in the middle lane doing 20 - 30 MPH under the speed limit.
This reminds me a bit of some property investors. They've been conditioned to believe that 20% - 30% below the LTV limit is somehow safer. They also believe that their middle of the road strategy is somehow safer because they have space either side of them. The reality is that they are simply making slower progress and their strategy is in fact dangerous.
I'm not completely against low gearing if that's also matched with high liquidity of course. I'd liken that to doing 40 - 50 MPH in the inside lane. It will frustrate a few people but there's nothing wrong with what they're doing. They must realise though that it's going to take longer for them to arrive at their destination.

12:36 PM, 8th December 2010
About 9 years ago

So, I have a medium sized portfolio of £2m current value (lowered from highest value attained before the banks did their worst) and Mark thinks I should have £400k sitting in the bank earning nothing? In fact that £400k is LOSING me money due to inflation. Yes, that's a safe, but stupid, option. Nothing more than a badly devised advert for his 'services' - dupes only apply.

19:12 PM, 9th December 2010
About 9 years ago

Dear Mike

Thank you for sharing your point of view and taking time to respond. We are all individuals and there are many different opinions on strategies that can be followed with not one size fitting all.

I wish you the best of luck in building and managing your portfolio.

Mark Alexander

4:25 AM, 28th December 2010
About 9 years ago

I did a little thought experiment in which an investor had a 100K house with an 85K mortgage. A year later, its value increased by 10% but he was happy with it to remain in bricks and mortar. The year after that, it increased by another 10% and again left it as it is. A 3rd year went past and it increased by a further 10% now valuing it at 133K. Six months later the market crashed by 20% leaving his house with a value of 106.48K and decided he had missed the boat and left it in.

Using the same scenario, another investor actually remortgaged his house every year and banked the difference. So, in the first year he released 8.5K which he banked and his mortgage increased to 93.5K. In the second year, he released 9.35K which he banked. and his mortgage increased to 102.85K. In the third year, he released 10.28K which he banked. and his mortgage increased to 113.135K. Before the market crash, his bank balance was 28.13K. After the crash, his bank balance was unchanged but the value of his house was down to 106.48K but with a mortgage of 113.135K. This gave him a negative equity of only 6.665K which is more than covered by the 28.13K bank balance.

If investor B had been foolish to reinvest the money, he would've been bankrupt if he couldn't keep up the higher payments due to the higher mortgage amount. So, if you want to get to your destination quickly, make sure you get there in one piece! Otherwise, you lose it all and many people have fallen foul of this - they thought they had got it under control when the very things they were depending on weren't there when they needed them.

The moral of the story is that you can only depend on cash or liquid assets NOT equity which can FALL as well as rise. So, when your assets do appreciate significantly, DO release the equity while you still can remortgage those assets. Don't worry, the value of your asset remains the same; it's just your debt that rises. Furthermore, the cash in the bank + the debt will always be greater than the value of the asset because, if the value of the asset falls, then the cash + debt remain the same. If the value rises, it just means that your equity has risen and you should release it as soon as is practicable

But I do agree that 20% is too high a figure. Let's work out a sensible figure: For a 100K property with a 75K mortgage, the interest-only payments @6% will be 4500 annually. You also need insurance and maintenance cost say 1000 giving a total 5500. Other unforseen calamities will raise it to a maximum of 10K which is 10%. This is belt and braces as the additional 4500 is a little too much but it's better to be safe than sorry. I look at it as a sinking fund to maintain cashflow; so that if it falls below 10K, you need to top it up and if it goes up beyond the 10K, you can invest the excess.

However, the investment will increase the limit of the sinking fund. For example, if you buy another asset worth 100K then your sinking fund should be 20K but your income should be around twice as large as before; so you'll have little problem topping it up.

10:04 AM, 28th December 2010
About 9 years ago

Dear Kasim

Thank you for sharing your thoughts.

This article should also be read in conjunction with http://www.property118.com/index.php/maximise-returns-on-liquidity/ and http://www.property118.com/index.php/the-roots-of-my-property-investment-strategy/
Regards

Mark Alexander

4:23 AM, 7th August 2012
About 7 years ago

so kasim, your strategy is to keep a 10% reserve based on the value of the property itself? Is this correct?

10:44 AM, 7th August 2012
About 7 years ago

Fantastic post

Mark Alexander

11:37 AM, 7th August 2012
About 7 years ago

thanks for commenting


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