Growing up we’re taught that debt should be avoided at all costs, but in the property world this isn’t strictly true. The single most important secret known and used by all the great property investors is that using other people’s money can make us rich. Or, to put it another way, using other people’s money greatly increases the return on any of our own cash that is put into a property deal.
It goes without saying that YES, of course there are certain types of debt that should be avoided at all costs. However, the truth of the matter is that most businesses cannot grow without the proper use of investment debt.
Unless you are one of the few investors that has started out with a hefty saving pot, to build a sizeable and profitable property investment portfolio you will have to take on some short-term debt. Fortunately, this is probably easier than you think.
Gearing (or to use the American term, ’leverage’) is defined as using borrowed money to increase the returns on your own money invested, either through rent or capital growth, and is the reason why investing in property is more profitable when you use someone else’s money.
The best way to explain this is to give an example and compare the gross yield against the return on our own capital invested.
Let’s assume we are cash rich and buy a property for £100,000 and rent it out for £600 per month. Ignoring fees and other costs to keep the example simple, the return on investment can be calculated as follows:
Gross yield = rent/purchase price x 100
Gross yield = £ 7,200 (which is 12 x £600) / 100,000 x 100
Gross yield = 7.2%.
Having put in all the cash ourselves, in this instance the gross yield is the same as the return on our own money invested or cash-on-cash return. As such, the return on our own cash is also 7.2%.
However, let’s instead assume that we borrow the maximum amount possible. A buy to let lender would lend us 75% of the loan to value or LTV, so by using the £100,000 as a deposit, we can borrow £300,000 and can purchase 4 small properties for £100,000 each (or one large property for £400,000).
In this instance, and once again ignoring costs, if we buy the 4 smaller properties and we also assume that our lender will grant us an interest only loan at say 4%, our return on investment will be significantly more.
The rent we will receive will be £28,800 (4 x £7,200) each year. However, we will need to pay the mortgages. This will be 75% of £400,000 which is £300,000.
Rent received £28,800
Less mortgage interest £300,000 x 4/100 £12,000
Net profit £ 16,800
The return on our own money invested = 16,800/100,000 x 100
ROI = 16.8%.
As such, by gearing up and buying multiple properties, we are able to increase the return on our investment from 7.2% to 16.8% from rent alone. Return from rent however, is only one way of generating a return. But what about long term capital appreciation?
Assuming that the value of the properties increase at around 5% in line with long-term trends in the UK, (8% is the average for the past 50 years, however for those who are pessimistic about potential for future growth rates, I’ll compromise and adopt an average of 5%), let’s see how these two scenarios affect capital appreciation.
If we purchase one £100,000 property for cash and it increases in value by 5%, then the return on our money due to capital appreciation will be as follows:
Purchase price £100,000
Value after one year £105,000
Increase in value £ 5,000
As we put £100,000 of our own money in, the return from our own money invested would be: 5,000 / 100,000 X 100 = 5%.
However, if we were to follow the second scenario and use the £100,000 as the deposit and borrow to fund the purchase of 4 properties with mortgages of 75% LTV, here’s what would happen:
Purchase price £400,000
Value after one year £420,000
Increase in value £20,000
As we put £100,000 of our own money in, the return on our own money invested will be: 20,000 / 100,000 x 100 = 20%. In this case, the return on our own money invested – which will have derived from capital appreciation – will jump from 5% to 20%.
When we total the returns from rent and capital appreciation we can see that our “non-geared return” on our own money is 12.2%, but our “geared return” is 36.8%. In other words, it’s 3 times higher.
To give a final scenario, imagine we were able to buy 4 x £100,000 properties using 100% finance, what would be our return on our own money invested then? Strictly speaking, without having invested a penny, there can be no return to calculate. But if we put none of our own money in but get some money out, then the return to us is infinite.
You may now be wondering how you can achieve 100% finance.
There are many ways of achieving 100% finance but the simplest would be to borrow the deposit (the £100,000 in our example) as a mortgage, or re-mortgage against your own residence, for example. Following on from this and having established a portfolio of buy to lets, you could then go one step further and refinance these properties; draw out the equity, and use that to fund deposits on subsequent purchases.
This is just one strategy that professional property investors use to achieve great success. Ultimately, they are not afraid of taking on “good debt” and they use the power of gearing to grow their portfolios and wealth.
Peter Jones B.Sc FRICS
By the way, I’ve rewritten and updated my best selling eBook, The Successful Property Investor’s Strategy Workshop, which is an account of how I put together my multi-property portfolio, starting from scratch and with no money of my own, and how you can do the same. For more details please go to ThePropertyTeacher.co.uk