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Using Finance to Increase your Returns
After recently attending local property networking events it still amazes me that investors think it’s a good idea to buy properties for cash. Firstly, the financial returns are less when a property is purchased for cash. Secondly, it means a large amount of cash is tied up for six months as no remortgaging can take place until a period of six months has elapsed. This means if a bargain property opportunity comes along within that six month period you will miss out, unless you have more cash to hand. So start as you mean to go on i.e. gear the property on purchase with a mortgage, ideally 75% to 80% loan to value mortgage.
Without Gearing
Mr & Mrs Smith don’t believe in finance. They use their £100,000 accumulated savings to purchase one investment property for cash. They let the property for £600 per month, i.e. £7,200 per annum. Due to inflation, the rent increases and eventually, after 5 years of fluctuations in the property market, the house increases in value by say 40%.
Outcome – MR & MRS Smith property investment now = £140,000
Note: This example of without gearing could be said as the same as if it were a stock market investment.
Mr & Mrs Jones use their £100,000 accumulated savings as deposits to buy £500,000 (five) of properties, just like the one Mr and Mrs Smith purchased. On this basis they also receive five times as much rental income, i.e. £3,000 per month or £36,000 per annum. The other £400,000 is borrowed (80% Loan to Value) and they pay interest on this amount of 5.0%. This works out to be £20,000 per annum. Therefore, net of interest they receive £16,000 per annum.
They are already better off than Mr & Mrs Smith, but what happens in years to come? Well it is probably safe to say that Mr and Mrs Joneses rental income will rise with inflation as per Mr & Mrs Smith. However, Mr & Mrs Joneses mortgage costs remain the same. Therefore, the gap between both couples rental income will continue to widen as time goes by!
We then need to look at the year 5 positions, when the properties have increased in value by say 40%. Mr & Mrs Smith have made a capital gain of £40,000 and have £140,000 worth of investment property. On the other hand, Mr and Mrs Jones have made a capital gain of £200,000, five times as much as Mr & Mrs Smith’s cash property investment (or stock market investment).
Outcome – Mr & Mrs Joneses property investment now = £700,000
The same principle is true whether you buy investment properties of £50,000 or £200,000. The larger the property value, for instance 10 times more, the greater the potential capital gain (£500,000 per property), but the greater the potential loss if property values goes down.
Note: As the property value goes up the rental yield generally comes down, which can lead to negative cash flow, and a definite negative cash flow if interest rates go up significantly.
As explained above many investors purchase investment properties for cash to create both an instant income and a property portfolio. Alternatively the funding process known as “Gearing” can be implemented.
As stipulated the mortgage amount is paid by the rental income; the difference represents the investor’s profit. There is no limit to the size of the portfolio that can be produced by implementing this system!
Let’s now look at what happens when Mr & Mrs Jones refinance their five properties after 5 years by the use of further advance/ re-mortgaging. Remember after 5 years their portfolio is now worth £700,000 in this example. At 80% Loan to Value this will raise £160,000 as an ‘Equity Release’ i.e. £560,000 less original borrowings of £400,000.
Mr & Mrs Jones then use the £160,000 as deposits to buy £800,000 (eight) of £100,000 properties. On this basis they now receive thirteen times (5 + 8) as much rental income, i.e. £600 x 13 = £7,800 per month or £93,600 per annum. Their total borrowings now total £640,000 + £400,000 = £1,040,000 (80% Loan to Value) and they pay interest on this amount of 5.0%. This works out to be £52,000 per annum. Therefore, net of interest they receive £41,600 per annum.
Outcome – Mr & Mrs Jones property investment now = £800,000 + £700,000 = £1,500,000
To some investors this all now starts to look very worrying, all those 000’s at first glance can look a daunting prospect. However, you shouldn’t be afraid of debt, just be mindful of it. After all, nations and countries are built on debt; America has over 15 Trillion dollars of debt.
Debt only becomes worrying and a problem if there is no mechanism to service the debt. Fortunately property provides a good and dependable income stream that can adequately service the debt providing the properties are not over geared (over financed), and exhibit a reasonable ‘Gross Yield’ of 7% or above.
Moving another 5 years ahead; due to inflation, the rent increases and eventually, after 5 years of fluctuations in the property market, the house increases in value by say another 40%. Note: This is fair to assume as since the 1950’s property prices have doubled on average every 7 to 10 years.
Outcome – Mr & Mrs Smith investment now increases from £140,000 by £56,000 to £196,000.
For Mr & Mrs Smith this represents a £96,000 increase on their original investment of £100,000, which is great but as you will now find out it’s not even half as great as the Joneses.
Outcome – Mr & Mrs Joneses investment increases from £1,500,000 by £600,000 to £2,100,000.
For Mr & Mrs Jones this represents a £960,000 (£2,100,000 less borrowings of £1,040,000 and £100,000 investment) or 10 times/ 1,000% gains on the original investment of £100,000. This means the Joneses are now property millionaires. Not only that let’s now look at the rental income situation for both parties now that 10 years has elapsed.
Note: It’s reasonable to assume that with inflation the rental income would increase by 50%, just as a loaf of Bread costing £1 will be £1.50 in 10 years’ time.
Rental Income Outcome – Mr & Mrs Smith £600 + 50% = £900 per month/ £10,800 per annum
Rental Income Outcome – Mr & Mrs Jones £7,800 + 50% = £11,700 per month/ £140,400 per annum less mortgage/ borrowing interest of £52,000 = £88,400 per annum
From this simple illustration you can see the Joneses are now living on easy street and the Smiths will still have to count the pennies in their later years. Furthermore when one property is empty (Rental Void Periods) the Smiths lose 100% their rental income, whereas the Joneses only lose 8% of their rental income; safety in numbers.
Caveat Emptor Statement – “Note for ease of illustration property maintenance and management costs have been excluded; this is just meant to be an illustration of what ‘Gearing’ can do providing you gain further knowledge on property management and investment skills.”
“So do try to Keep Up with the Joneses”
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9:05 AM, 11th May 2012, About 12 years ago
I wasn't advocating 80% Loan to Value at all; I have never used above 75% LTV for over 5 years now.
The article is purely and simply to illustrate the differences between buying for cash and buying with mortgage (gearing) and nothing more.
It was never intended to be a strategy proposal by itself, its merely a principle for people to adopt with other skills if their desire is to build a larger portfolio over the long term with any given starting fund.
The reason I choose 80% LTV instead of the norm 75% for the calculations is because they are rounded up nicely and simply. Cash flow also depends on what type of property you buy whether new or old.
Mark Alexander - Founder of Property118
9:13 AM, 11th May 2012, About 12 years ago
Yes I understood that, we discussed it offline, others will not have had the benefit of that discussion though so that's why I lead the thread into a direction where further "safety strategies" could be debated and considered. This is an excellent piece, it has good SEO and will no doubt appear in searches. Therefore, newbie investors will find it in search and that may well be their first experience of Property118 and the Property Maverick. It makes a lot of sense, therefore, to expand the debate into a discussion about liquidity and yields.
Jonathan Clarke
12:12 PM, 11th May 2012, About 12 years ago
Hi Mark
Yes spot on - £1000 in rent which is £950 LHA directly payable to me + £50 top up pcm. The tenant is moving in day 1 and has 6 kids so gets lots of child benefits to afford the £50 top up. We have discussed liquidity in the past and I`ve always thought your 20% is on the high side and i used to feel comfortable on about 2% in an era of prices rising and i was building my portfolio. I understand they are or were risks attached to such a low level for me but nothing ventured nothing gained.
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. I now run at about 5% and by end of 2012 will be at about 7% to prepare for interest rate rises. But with other investments due to mature and unencumbered property which i could sell 25% BMV if needs be my safety net could within a short time frame increase to around 10% which is well within my comfort zone. It is about getting the balance right of course as you say and some are more risk adverse than others. I would not personally buy at 7% yield but there are those I know who are happy with that. They are maybe mid 30`s have two good steady incomes for the next 20 years and view property as a long term pension type investment for mainly capital growth and maybe only £100 positive cashflow pcm. Nothing wrong with that strategy either.
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The main thing for me as Maverick says and you endorse is have no fear whatsoever of good debt. Respect debt yes but control it to your advantage and gear your investments accordingly. The biggest hurdle I find with new investors I advise is that many cling on to the mind set that you should pay off mortgage debt when I advise you should do the opposite and acquire mortgage debt. Parents and the traditionlist educators are of course well meaning when they say pay off your mortgage as they naturally think and believe that they have your best interests at heart. BUT they have a lot to answer for sometimes as many unfortunately dont really understand mortgage debt. They hold others back with their own fears and negative approaches to good debt. You can be sensible controlled skilled and maverick all at the same time. ( I`m a Top Gun fan). Aim to be the best of the best
Be a rebel with a cause 🙂
0:36 AM, 12th May 2012, About 12 years ago
Hi Mark,
Is there a blog from you anywhere which gives your analysis of how you arrived at the 20% of debt held as cash? I'm sure we'd all be interested to see your thinking. Thanks Tim Fawcett
Mark Alexander - Founder of Property118
9:52 AM, 12th May 2012, About 12 years ago
There is indeed Tim, I documented the roots of my property investment strategy a long time ago, it's a 16 part series. This is a link specifically to the section about the 20% liquidity rules but please feel free to read the entire series or simply pick out what you want. At the foot of each blog is a link to other parts of the series. See >>>
http://www.property118.com/index.php/btl-strategy/896/
Jonathan Clarke
11:44 AM, 12th May 2012, About 12 years ago
Hi Mark
Does your 20% liquidity strategy take into account individuals lifestyle aspirations. I was just thinking if for example 2 investors came to you with identical portfolios but one had a 200K pa already expensive lifestyle as per your example in part 6 of your series and one investor was quite happy with their existing modest say 24K pa lifestyle would your advice be the same as to them both aiming to have 20% liquidity? Is that 20% rule fairly fixed in your eyes? Personally I would be thinking that as lifestyle expenses can be quite a major variable in individuals a lesser % of liquidity say 10% is required or advisable perhaps for the more modest spender.
Mark Alexander - Founder of Property118
12:05 PM, 12th May 2012, About 12 years ago
Jonathan, a question that makes another person think is an excellent question, yours has made me think deeply, thank you.
I devised that strategy based upon a the reality that most people spend what they earn. The investors I observed back in the early 1990's to formulate the strategy considered their property investments to be long term. They had reinvested all profits into the continued growth of their portfolio's, they were not living off the proceeds as they had alternative income sources, some from employment, others from other businesses.
The property investors that failed did so due to lack of liquidity when interest rates doubled to 15%. Very few could support the negative cashflow from surplus earnings elsewhere, particularly those who grew large portfolios. It is very natural for us to match our incomes to our lifestyles. It concerns me that people are doing that now we are in such a low interest rate environment, I'm guilty of it myself.
The investors with 20% liquidity reserves scraped through the early to mid 90's high interest rate period, however, if interest rates hadn't fallen back when they did, they too would have failed. The negative cashflow reduced their liquidity reserves to virtually zero.
My conclusion is that gearing is a calculated risk. However, the lack of gearing also puts the chances of improving returns at risk.
We all make our choices and whatever anybody decide is right for them must accept the consequences and risks, whether that is mediocrity, optimal success based on available resources or complete failure.
15:45 PM, 12th May 2012, About 12 years ago
I like Mark's response. One of the problems that has caused the recent crisis is that people extended their mortgages and spent the money on non-investment goods like holidays, new cars that depreciate and luxury goods. It's tempting to do the same with high net rental incomes received on buy to let portfolios too. From a business point of view the 20% rule combined with a discipline of not spending the net rental income but instead investing it could be best. Of course there might be some landlords out there that live off their properties entirely and don't hold down other jobs - in their situation it is a matter of adjusting the amount of income that is drawn out of the property business according to economic circumstances - not an easy balancing act I would imagine. Particularly when we are all not too sure when and by how much interest rates and buy to let mortgage rates are going to rise. This takes us back to the original question. An interesting dilemma!
9:19 AM, 13th May 2012, About 12 years ago
I agree 20% cash reserves on debt value is a good idea as a general rule of thumb especially if an investor is a low income earner and has a small portfolio's of 1 to 10 properties. Note the cash flow risks are higher if you have say two properties and lets say one isn't paying and you have to evict that tenant and the other property became empty; you would have 0% rental income to service the mortgage debt. Whereas if you had 20 properties and 2 properties are not producing income the rental void/ loss is just 10%.
In my instance 20% cash reserves on debt would mean £1 Million sitting in the bank earning 1% interest/ doing nothing. Personally I have always sort to make equity make more equity, money makes money so today I like to box clever and box clean today. Also positive property income/ cash flow is great and important because it must be there for the good and bad times. Today I reinvest much of the income back into some of the properties otherwise "Income is easily spent" so I focus on the equity gain and equity protection. I like to make sure going forward there is at least a 3% interest rate cushion (see my property analysis blog), if further cushion is needed in times of hardship then self management, self property repair, selling some properties, increasing rents, using cash in the bank, cutting back on lifestyle can be exercised and selling the fancy car etc can be exercised (forward diaster management considerations).
Today I only buy if my deposit money/ cash in (25%) is doubled on day one of purchase without lifting a paint brush. If I am putting £25,000 in I want the actual equity in the property to be £50,000 at real market value; this is achieved on 8 out of 10 purchases. So in today's market £1 Million could make me £1 Million within a year, without lifting a paint brush and without leaving my house. However builders are now getting wise to having to sell off stagnant stock at cost and are now moving more towrads building to order only. I have done my years of renovating old houses and no longer want such hassles.
Yes new builds only offer 7% to 8% yields on houses and 9% to 10% on apartments, but with zero maintenance for at least 3 years its an effective better net yield than 80 year old terraced properties on 12% gross yields that are bigger blood suckers than Count Dracula. Compare these to the new build yields in 2005 to 2007 that were 5% and 6% resepctively one can see the value.
In terms of liquidity for rainy days I prefer is to have a minimum of 6 months cash to cover all mortgage payments as if there was zero rental income coming in; so that's a cash reserve of £100,000 give or take £25,000 at all times. This flucutates up and down with property purchases, property sales and remortgages over the year. However this lower rainy day liquidty is gained from a diversification of property types, property areas and tenant types, but I don't get involved in higher yield HMO's because don't I wouldn't want one situated next to me so I can't evoke the same to another.
Over the years I have never flown close to the wind, I stopped buying in 2006/ 7 and sold some properties as rental yields just didn't make sense at the then 5% yield, and I have never once used the no money down deal process. My process and methodolgy has always been about buying well (value investing). As far as I am concerned markets going up are just a bonus and shouldn't be solely banked upon; buy profit for today and if the cherry on the cake comes (further capital appreciation), well then that's even better and happy days!
Mark Alexander - Founder of Property118
16:16 PM, 14th May 2012, About 12 years ago
Hi Kelvin
Please help me to understand the mathematics.
If you buy a property valued at say £120,000 at a 25% discount then that suggests you are paying £90,000. My question is whether your 7% gross yield is based on the £120,000 value or the £90,000 purchase price. If the 7% yield is based on the full value of £120,000 then the actual yield based on purchase price is in fact 9.33%. That's great for a new build deal.
However, if the 7% yield is based on the £90,000 purchase price that means the yield based on the full value of £120,000 is only 5.25% (pre-credit crunch yields) which would make it impossible to remortgage to 75% of value whilst retaining positive cashflow unless rental values increase significantly. In this latter scenario I can't see how this stacks up as a long term hold investment. If you are renting these properties short term and then flipping them on to first time buyers at full market value I can see that it could work, providing of course that first time buyers will pay full market value for a property which doesn't have the fresh feel of a brand new home.
Please explain.
Regards
Mark