The ability to leverage our money in the form of mortgages, to increase our buying power is one of the main reasons why property is preferred by many over other asset classes. Not only does this allow us to drastically increase the returns on our invested capital, but the specific nature of the leverage (mortgages) allows for the mitigation of risk.
Over the past 25 years, the average return from leveraged property (at 75% Loan to Value) has been around 16.1% per annum. This figure speaks for itself when compared to the average return of other asset classes such as cash-bought property (9.7% approx. per annum), FTSE all shared index (6.8% approx.), and cash in bank (4% per annum).
To be able to use mortgages to our advantage as investors, the true nature of mortgages must be understood, including how they differ from other kinds of debt. This provides us with a better understanding of the potential benefits, as well as the risks involved, and thus how to mitigate the latter.
The nature of a buy to let mortgage means that we can borrow a comparatively high loan to values (up to 75%) over the long term (usually around 30 years) at low-interest rates (currently 2-4%). Most importantly, the bank is unable to ask you to repay this loan, regardless of if your investment falls in value, as long as you are servicing the debt (paying your interest payments monthly). Simply put, there is no other asset class where investors can obtain debt like this with these conditions.
By using leverage, it means that if we achieve average capital growth on our property/asset value, we will get extremely high levels of returns on our 25% cash deposit invested.
Of course, with leverage comes some risk. The two main risks are, firstly, not being able to service your mortgage, and secondly, the rise of interest rates. Providing that you’ve bought in a desirable location with solid fundamentals, your property will be rented, and servicing the debt should not be an issue. This means that even if the value of your property drops 8%, as it did in 2008, you’ll have the option to wait for the market to recover whilst still bringing in a healthy rental income. Furthermore, there’s no danger of the bank re-calling the loan. Remember, if the rental yield is better than the interest rate on your loan, leverage also enhances your rental returns!
It is also important to note that if you are making use of leverage, it is advisable to have a certain amount of cash set aside for the ‘worst-case scenario’. If our property ends up being empty, our cash reserves will be able to cover the interest payments on the mortgage for a given amount of time. The amount of cash you have in reserve will depend on your risk profile and how confident you are in being able to find a tenant in certain situations.
In regards to potential interest rate rises, it is important to stress test your portfolio at higher interest rates so that you have a sufficient buffer to account for such rises. Several factors should prevent the base rate from reaching the heights of the 80s. This will be covered in more depth in a different article.
It is also possible for us investors to use fixed-term mortgages to help avoid any sudden changes to the interest rate. We can use these fixed terms to them plan our next steps and prepare for any of the changes that are happening around us in the wider economy.
It is also important to keep in mind that interest rates typically rise to combat and control inflation, however property prices and rents will typically outperform inflation! I will cover this in more detail in the next edition of this blog which will be focused on ‘Inflation’.
Margin loans are an example of another type of investment debt. We could use margin loans to leverage into a specific stocks and shares investment, however this is usually more expensive with higher levels of risk. Rates are usually +6% which means that returns of above 6% would be needed just to break even. As mentioned before, the average return from the FTSE all-share index over the past 25 years has been 6.8%. Furthermore, if the value of your investment falls below a specific level, the bank can ask for you to sell, or require you to inject further funds into your investment,(known as margin calls). This may force you to sell at a bad time and lose money!
Please get in touch if you have any questions or would like to discuss this topic in more detail! Keep an eye out for my next blog where we will be looking at inflation and the effect it has on our investments.