You’ve probably seen the various claims made by so called Property Gurus on their ‘Get Rich Quick’ websites that borrowing money against property will make you a multi-millionaire overnight.
Well, as much as I like to de-bunk this sort of hokum as much as the next person, there is more than a grain of truth in this. In fact I would go as far as to say that property investment works much better if you do raise a mortgage against each property you buy to let. There’s no magic, no alchemy, no having to sell your soul to the devil, just mathematics combined with expected capital growth over time (though some would say maths is an instrument of the devil).
For those who know how the formula works, I apologise if I’m teaching egg sucking techniques but here’s how it works. Using the assumptions that you buy a house for £150,000 and you borrow £75,000 against it, you’ll have a sensible Loan To Value (LTV) of 50%. Buy the right house in the right place and you should be able to achieve £625pcm in rent. That’ll give you £7,500 gross for the year and equates to a gross cash yield of 5% per annum. An interest only mortgage taken out for, say, 15 years will currently attract an interest rate of 4.5% per annum providing for a monthly mortgage payment of £281.25 which leaves £343.75 from the £625pcm rent. So what does that do to your gross cash yield? First you’ve got to bear in mind you’ve only used £75,000 of your own money towards the purchase price of the house, the other 50% is someone else’s. 12 times £343.75 equals, £4,125 per annum and this divided by your £75,000 gives you a revised yield of 5½% per annum.
By using someone else’s money you have enhanced your annual return, in this example not by a lot, I’ll grant you. So, the obvious question is what if I could increase the LTV? Wouldn’t this increase my returns by even more? The answer is a resounding, Yes. But since I was taught to be cautious, I wouldn’t advocate going above a LTV or 50-60% because you have to take into account the distinct possibilities of the following nasties happening to you over time and you need to have a comfortable buffer to be able to deal with them:-
- Void periods (a pestilence all landlord’s best avoid)
- Unexpected expenses in addition to your normal running costs
- Interest rate rises
- Decreases in rent
That’s all very interesting but why should I go to all the fuss and bother of getting a mortgage when my return is only going to be enhanced by a measly half percent per annum? Well…… presumably, you have invested in a buy to let property for the long term and therefore you desire to grow your capital over time. If so, then this is where sticking a mortgage on a property really gets the mathematical juices flowing. But before I show you the sums, I would just say, for those property investors who simply want to generate the best possible cash return from their property and are not motivated by potential capital growth, there is absolutely no point in mortgaging it.
Right, let’s assume you have a 15 year investment horizon to match your 15 year mortgage of £75,000 on your House purchased for £150,000. Let’s also assume house prices grow by a modest 5% per annum – remember, I was taught to be cautious and for my benefit, I need to keep the maths simple. Because of the compounding effect of the annual growth rate, remarkably at 5% per annum, your house goes up in value to just under £312,000 (Don’t believe me? Put the figures into an online Future Value calculator). Add to that the rent you’ve been paid over the years which is another £61,875 (after paying the mortgage interest) which takes your total return up to £373,875. That’s within a whisker of giving you a 500% return over the life of the mortgage or put another way 33% per annum. Sell the house pay off the mortgage and you’ve got a net profit of a tad under £300,000.
How does that compare with the returns on the property without mortgaging it? Well it still grows from £150,000 to £312,000. Add all of the rent accumulated - £112,500 (its all yours, no mortgage payments to make) which takes the total return up to £424,500 BUT this equates to only 18.8% per annum. This is because it’s cost you twice as much; £150k versus £75k to end up with a substantially lower return.
There are lots of other aspects to consider when buying a property investment but the purpose of this exercise was to explain how borrowing makes your investment work much harder for you. I hope I’ve succeeded but if you have any questions, please give me a call at Martin & Co in Norwich on 01603 766860.
I will leave you with one unanswered question. If you had £150,000 to spend on a house in the first instance, why not take two mortgages and buy two houses? Do the maths………
Martin & Co Norwich