Interest rate arbitrage explained

This week, I’m sharing two increasingly popular strategies that I use personally, but before I go any further, I should make it clear that the following reflects my own personal views and experiences. It is intended for general information purposes only and should not be regarded as financial or investment advice.

I also fully appreciate that the elements of one of the strategies discussed below may feel counterintuitive. This is because most property investors have spent years, sometimes decades, conditioning themselves to believe that lower gearing automatically equals lower risk.

I should also make it clear from the outset that I am naturally a cautious investor. While I managed to get comfortable with property and debt, I have never been comfortable with stock markets, cryptocurrencies, speculative trading, or investment classes such as gold and silver, where values can fluctuate dramatically. What I personally prefer these days are investments paying fixed quarterly coupon returns for fixed terms, where I can clearly understand the anticipated income profile, security position, and expected exit timeline before investing any money.

These types of investments do exist, including opportunities capable of producing the kinds of returns used in the illustration below, but many landlords have never heard much about them because they are not marketed to the general public in the same way as bank deposit accounts, ISAs, or mainstream investment products.

Under UK financial rules, many alternative fixed-income investments can generally only be promoted to High Net Worth Individuals and Sophisticated Investors. Broadly speaking, that means people with net assets of at least £250,000 excluding the value of their main home and pension fund. As a result, many of these opportunities operate quietly and are often only discovered via referrals from other experienced investors.

I will explain a couple of examples of the principle using the following simplified illustration.

A landlord with £3 million of equity generating £60,000 net annual income is effectively achieving a 2% return on equity before future capital growth is taken into account. That is the position many landlords now find themselves in: large property portfolios, low gearing, strong net worth, but relatively modest cashflow.

They continue to hold properties because they don’t know what to do for the best. Should they sell? If they do, what about CGT and the loss of future capital appreciation? Where would they reinvest the proceeds?

Some have considered retirement abroad or relocating to lower-tax jurisdictions such as Dubai, but remain undecided or feel tied to the UK due to family, lifestyle, or business considerations. There are often many other factors too, because no two people’s circumstances are ever exactly the same.

This is where an interest rate arbitrage strategy can become relevant. The principle is straightforward: borrow money at one rate of interest, invest it elsewhere at a higher rate of return, and retain the difference as additional cashflow. Banks and mortgage lenders operate this model as common practice.

A typical landlord example might involve refinancing part of a portfolio using a fixed-rate buy-to-let mortgage at 6%, then allocating part of the released capital into fixed-income investments paying higher coupon returns. The difference between the two rates can potentially create additional income generated from existing equity.

If £1,000,000 were borrowed at 6%, the annual interest cost would be £60,000. If the same £1,000,000 were allocated into investments paying fixed coupon returns of 10%, the gross annual income would be £100,000. The difference is therefore £40,000 per annum.

There are tax considerations, but let’s park that for now and focus entirely on the principles.

That £40,000 represents potential additional gross annual cashflow generated without increasing rents, buying more property, dealing with additional tenants, or taking on refurbishment projects. It is simply a different use of capital.

This strategy can be used both in the medium and long term. Some landlords simply want to buy themselves time before making decisions about selling properties. Others want to test alternative investments first, whilst still retaining most of their portfolio.

For many landlords, the issue is not a lack of wealth. The issue is that too much equity remains tied up inside property, producing relatively modest income returns compared to the amount of capital trapped within the portfolio. That often becomes more noticeable as portfolios mature, LTVs reduce, compliance costs rise, and retirement planning starts moving higher up the agenda.

The irony is that many landlords spend years trying to reduce gearing in pursuit of “safety”, whilst simultaneously trapping huge amounts of equity inside low-yielding assets producing relatively modest cashflow. In some cases, a carefully structured refinancing strategy can actually improve lifestyle flexibility, liquidity, and financial resilience rather than weaken it.

That does not mean that an interest-rate arbitrage strategy is suitable for everybody. It simply means there may be more options available than many landlords realise.

For landlords who have already released substantial cash sums, possibly from selling properties, there may well be other investment options that have not appeared on their radar yet.

Property118 consultants are familiar with the broader concepts discussed above and, where appropriate, may be able to help members identify suitable regulated professionals for further advice and guidance.

Most importantly, the objective of our consultancy meetings is not to pressure anybody into making investment decisions. The objective is to help landlords achieve clarity.

Sometimes that results in deciding to reduce exposure to property. Sometimes it results in refinancing and restructuring. Sometimes it results in taking no action at all, other than gaining reassurance that they are already on the right path.

The common factor is that landlords stop operating on autopilot.

If you have reached the stage where your portfolio has created substantial wealth but not necessarily the lifestyle, liquidity, or freedom you expected, perhaps it is time to start looking at the bigger picture.

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