“Leveraging”, the practice of an investor purchasing more of an asset using borrowed funds, is flourishing once more. With a more buoyant economy and greater confidence amongst investors, leveraging is a tool that is once again rising in popularity since the credit crunch. Borrowers and lenders hold varied views on this topic and it is important to address both, analysing the pros and cons of this technique.
Beginning with the advantages, leveraging improves the return on capital and makes your money work harder as the borrower earns more from the equity. It helps the investor grow a larger portfolio more quickly, resulting in greater cash flow. It is a simple principle that is used throughout all businesses, not just by property investors. A classic example being that of Manchester United where the club’s owners, the Glazers, used heavy leverage to buy the club and secured an excellent return for their equity. They used cash flow from the football club to service that debt, paying down what they owed to increase their equity value.
A crucial aspect for investors planning to leverage is being able to understand their ability to withstand shocks, such as an interest rate rise. Investors need to service their debt irrespective of whether property prices are going up or down. For example, if you are paying 7% debt on a portfolio while borrowing at 75% LTV, you would need an income of 6.6% gross yield from your property merely to pay the debt and break even. That is gross yield assuming 20% of running costs, such as insurance and wear and tear. All that remains after wear and tear and costs is going towards servicing debt, resulting in no free cash flow. Landlords tend to focus on the yield they can get from portfolios but should look at debt affordability in terms of yield needed to service the interest.
Property investors also need to be wary of short-term house price fluctuations – house prices can go down as well as up, but the debt level won’t go down. Long-term trends are positive for property but the debt does have to be serviced. More highly leveraged landlords are therefore more at risk from having to sell in a falling market as they cannot maintain the debt. Another disadvantage is that higher leveraged landlords don’t have as much freedom as those that are less highly leveraged. The former have a stakeholder (the lender) so if, for example, they wish to carry out some development work on their property, they will have to gain the approval of the lender. This obviously limits the landlord’s independence and flexibility. Higher leveraged landlords will also be paying more for their money as leveraging means higher LTV which equals higher debt costs.
Most professional landlords would aim to keep their overall portfolio sensibly geared at 60/65%, although within the portfolio there will be certain properties where higher gearing is appropriate. The regulatory environment is fundamentally different post-credit crunch and few lenders allow constant re-mortgaging. A good level of leveraging will get borrowers the best returns: around 60-65% is a medium space in which to operate as there isn’t too high a level of risk. This provides the debt in order to grow the portfolio as well as the headroom to withstand shocks, striking a sensible balance.
To conclude, it becomes apparent that deciding whether leveraging is the right strategy depends almost completely on the borrower. Investors need to understand and be clear about their appetite for risk before using leverage as a growth strategy. The overwhelming view appears to be that there is a place for leveraging but it is imperative that it suits the client and that they are suitably experienced to manage the risk. As a broker with close relationships across the lender spectrum, RLA Mortgages would always recommend a sensible and sustainable approach to leveraging for property professionals, investors and landlords. We closely analyse all available options from the high street lenders right through to buy-to-let specialists such as Shawbrook Bank, and can navigate the complexities of the market in order to secure the most appropriate product for your circumstances. With regulatory pressures increasing and some uncertainty across the property markets due to political forces at play within the capital, it is more important than ever to ensure clients get the right product, the right lending partner, and the right outcome.
Please note lenders have different minimum criteria requirements and not all landlords and property types will qualify for this specific product. For further information contact RLA Mortgages.
This is a financial promotion and in no way should it be viewed as a personal recommendation or advice. Before a recommendation/advice can be given you should seek independant mortgage or financial advice.
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