by Rob Dix
Margin is hardest to find when the market is buoyant or supply is constrained, because an increase in competition or a lack of other options will mean that investors are willing to accept a smaller reward for doing the work. Later in the book we’ll look at where to go looking for this kind of opportunity, but for now just believe that it is possible. For example, take this property, which clearly needed a fair bit of work and sold for £55,000: (propgk.uk/liverpool-refurb). Around the same time, nearby properties in good condition were selling for £85,000 or more: (propgk.uk/liverpool-prices).
“Equity out of thin air” is the key to putting less cash into subsequent deals. Let’s see how…
We’ll start off by buying the property for £55,000, but we won’t use a mortgage to do so. A mortgage wouldn’t be appropriate here, because:
As you’ll see, we only want this original loan for a matter of months, at which point we’ll refinance. Mortgages are intended to be held for multiple years – so even if you use a mortgage product that doesn’t have a specific penalty for paying it back early, lenders don’t like it and might not lend to you again.
A mortgage company might not lend anyway if they don’t consider the property to be “habitable” – such as there being no functioning kitchen or bathroom, or the property just generally needing so much work that they don’t think anyone could live there right now.
So a mortgage won’t work, but we don’t want to put in that much cash either. Instead, we’ll use bridging finance – a form of short-term funding (usually up to a year), which is specifically intended for this kind of situation. Whereas mortgages are typically for up to 75% of the property’s value, bridging normally goes up no further than 70%. It’s more expensive than a mortgage – the interest rate is usually in the range of 0.75%–1.5% per month, plus fees of around 2% of the total loan amount – but it’s quick and easy to arrange.
(The terms of bridging loans – the rates payable, and when and how fees are paid – vary extensively between different lenders. To provide a “worst case” for this example, I’m assuming that you need to pay all the interest and fees out of your own pocket at the outset. In reality, the terms will be more favourable to you than that.)
Let’s look at the purchase:
Deposit: £16,500 (30% of £55,000 purchase price, with a £38,500 bridging loan for the rest)
Stamp duty: £1,650
Finance costs: £3,850 (based on a borrowing rate of 1% per month for eight months, plus a 2% fee)
Refurb cost: £10,000
Purchase costs (solicitor, survey, broker fees etc.): £1,500
That leaves us putting in £33,500. It’s more than the straightforward buy-to-let purchase from Strategy 1 involved, but don’t worry – we’ll be getting a lot of it back soon. (And as I’ve said, in reality the finance can be structured to put in less cash upfront.)
Now, with the work done, we want to get off our expensive bridging loan and onto a traditional mortgage product. And importantly, when we do so, we want to borrow 75% of the new value of the property – the £80,000 we believe it’s now worth, rather than the £55,000 we paid for it.
Under most circumstances you can’t apply to re-finance until you’ve owned the property for six months (which is why I reckoned for eight months of bridging payments), so we put a tenant in the property while we wait for that day to arrive. When it does, we borrow 75% of £80,000 – which leaves our cash position like this:
New borrowing (75% of £80,000 valuation): £60,000
Repay bridging loan: £38,500
Left in the bank: £21,500
We originally invested £33,500 and got £21,500 back after refinancing – meaning that we now have just £12,000 tied up in that property. If we want to move on to another identical purchase, we already have £21,500 in the bank – so we just need to save up that extra £12,000 in order to do the exact same thing again.
Before moving on to discuss the implications of this, let’s see what our month-to-month finances look like now we’re refinanced. Again, the rental income is £577.
Mortgage payment (interest-only loan of £60,000 at 5% interest rate): £250
Buildings insurance: £20
Management fee at 10%: £57.70
Repairs allowance at 10%: £57.70
Like last time, I’m going to build in an allowance for the property being empty for two weeks out of every year. After doing so, that leaves us with a monthly pre-tax profit of £184.37 – equal to an annual profit of £2,212.47.
In profit terms, that’s identical to Strategy 1 – where we just bought the property for its market value. When you look at our ROI though, things are very different. On the straight purchase for its market value, it was 8.8%. After buying cheap, refurbishing and refinancing, it’s a little under 18.5%. That makes sense: we’re making the same return on a smaller investment left in after refinancing.
Lessons
So, where does this leave us?
Well, it leaves us needing to find another £12,000 to invest again. That means that if we manage to save “just” £1,000 per month, we can buy one property every year. (And just like before, by saving up the rental income it will soon accumulate and allow us to buy at a faster rate.)
As a result, by putting in more effort in terms of finding the opportunity and doing the refurbishment, we’re able to put ourselves in exactly the same position as in Strategy 1 while halving the cash requirement. (Noting, of course, that the initial cash requirement is higher because we can’t borrow quite as much and need to find the funds to pay for the refurbishment.) If we’d managed to secure a bigger discount, it would have been possible to do even better – it’s theoretically possible to get all your cash back out of a deal upon refinancing, but it’s not easy.
Here, we see what’s going to be a common theme in this book: when you’ve got less cash to invest, you’ll have to put in more effort and accept more risk to get the same result – and vice versa.
We haven’t addressed the risk in this strategy yet, so let’s do that now. Whereas with a straight “purchase and wait” strategy you can’t go far wrong, successfully executing a “buy-refurbish-refinance” strategy involves:
Finding the opportunity in the first place
Accurately judging the refurbishment cost, so you know how much you can afford to pay for the property and still get the margin you need
Successfully negotiating the purchase at that price
Conducting the refurbishment on time and on budget
Convincing the mortgage lender’s valuer that the property is, mere months later, worth significantly more than you paid for it
Later in the book we’ll see how to do all of these things. But at every one of these points there’s not only more effort to be made, but also an element of risk to accept – because even the most experienced investor gets things wrong occasionally.
There’s also risk associated with short-term market changes: for example, if the market drops 20% while you’re in the process of adding 20% in value, you’re not going to be able to get the revaluation you were hoping for. Over the course of a long-term investment these dips can be ridden out (if you structure your portfolio to survive a recession, which we’ll discuss in Part 3), but it’ll affect your plans more drastically if it happens at the wrong time while you’re trying to lock in a gain.
Before wrapping up, let’s just cover a couple of points to help generalise this strategy to situations other than the one I’ve presented here.
Firstly, if you’re able to fund the initial purchase and refurbishment with your own cash instead of using a bridging loan, all the better – because you save on some hefty fees. (Although there’s an “opportunity cost” to consider if you could have been doing something else useful with that money.)
Another advantage of cash is that you’re not forced to refinance as quickly as possible to get yourself off the expensive bridging finance rates. If the market did take a temporary tumble at the wrong time – or for s
ome other reason it turned out to take longer before you could refinance – you could just wait it out without worrying about your interest rate.
Secondly, don’t be put off by the fact that I’ve used a relatively cheap property as an example in this strategy. It works every bit as well on more expensive properties – and can work anywhere in the country, not just the north. I’ve only stuck to the example of a cheap property because it allows you to buy one per year with an amount of savings that won’t seem outrageous to most people. If you’re able to invest more, or you’re willing to wait a couple of years or more between purchases, everything I’ve said applies to pricier properties too.
Chapter 3
Lock away a lump sum and watch it grow
Aim: Invest a lump sum of cash, and turn it into a much larger amount of cash (or a mortgage-free income) in 10–20 years.
In a nutshell: Buy properties with an eye on capital growth, then sit back and wait.
Upfront capital required: High
Effort involved: Low
Ongoing investment required: Low
Payoff: Long term
So far, we’ve looked at two strategies that only take into account one source of property profits – rental income – without really mentioning the possibility of capital growth. Let’s put that right.
Firstly, back to basics. With any property you buy, you have two potential sources of “return” on that investment:
Profit left over after receiving the rent and paying out your expenses
Growth in the property’s value over time
When some people calculate their “ROI”, they combine their rental profits with a projected percentage uplift in capital growth every year. Personally, I don’t see the sense in this: for a start it doesn’t reflect reality (there’s no way property will go up by exactly the same steady percentage every year), and also that increase in value doesn’t do you any good until you either sell or refinance to access the extra equity.
I don’t want to give you the idea that capital growth isn’t important: in many cases, the returns you get from capital growth will dwarf the rental income you receive. But capital growth isn’t certain, whereas rental profits are. As an investor, you’ll therefore be looking at properties that target some mixture of the two – and you can be strategic in your acquisitions to target properties that are more heavily weighted towards one or the other. In the first two strategies we focused 100% on income, and treated any capital growth as a bonus. In this strategy, we’ll go completely the other way.
Example
In this example we’ll pretend that we’ve got £250,000 burning a hole in our bank account, ready to be invested in property. This strategy is just as applicable when you’re investing smaller amounts of money, with the caveat that low-value properties (to pluck a very rough number out of the air, I’d say under £70,000) tend not to offer the greatest growth potential. This is an idea we’ll return to later.
£250,000 might sound like a lot of money to have saved up – and it is – but you’d be surprised by how many people I hear from who have that kind of sum to invest. Alternatively, some of that cool quarter mil’ might be in the form of equity that you can take out of your own home. That’s fine (as long as you have the income to support the extra borrowing), but bear in mind that you’ll have higher personal mortgage payments to meet each month and/or be extending the amount of time until your home is paid off.
By definition, a strategy that prioritises capital growth is going to be a medium-to-long-term strategy – so for the purposes of this example we’re interested in where a £250,000 investment can get us in 20 years’ time.
As we’ve seen, mortgages are typically available for up to 75% of the property’s value. With our £250,000, we could theoretically then buy £1 million of property – although because there will be transaction fees to account for (like legal fees, stamp duty and so on), it will actually end up being slightly less than this.
While that money could buy one mansion with its own home cinema and climate-controlled wine room, it would turn out to be a terrible (if fun) investment. Instead, it would be more wise to split that investment between six properties worth around £150,000 each.
Let’s look at this flat in Southampton, which recently sold for £142,000: propgk.uk/southampton-buy.
With a purchase price of £142,000, we can buy six based on the following figures:
Deposit: £35,500 (25% of £142,000 purchase price)
Stamp duty: £4,600
Purchase fees (solicitor, broker, survey, etc.): £1,500
For a total investment of £41,600 per flat – £249,600 for six.
Each should rent for approximately £850 per month. (Here’s one that rented for £850: propgk.uk/southampton-rent.)
Now let’s see how the monthly figures break down. From the £850 monthly rent, we’ll deduct the following:
Mortgage payment (£106,500 borrowed interest only at 5% ): £443.75
Service charge and ground rent: £100 (estimated)
Buildings insurance: £0 (usually covered within the service charge)
Management at 10%: £85
Repairs allowance at 5%: £42.50 (a lower allowance for flats, as the service charge covers some elements that we would be paying for with a house)
After allowing for the flat being empty for one month per year (still cautious, but longer than we’ve used before because tenancies in flats like this tend to change over more frequently), we end up making a monthly profit of £165.
With six of these, that gives us a grand total of £990 per month before tax. Life-changing? Absolutely not, but that’s not what we’re interested in for the purposes of this strategy.
Instead, join me in my time machine as we travel 20 years into the future – where we’re all presumably riding around in driverless cars, you can download the contents of this book directly on to a chip in your brain, and U2 is still putting out disappointing albums. We’ve handed all our properties over to a letting agent, and barely given them a second thought. When we finally remember to check up on them, where have we ended up?
At this point I’ll make a statement that might sound like a huge assumption, but I think is actually a very safe bet: property prices will have at least doubled after 20 years.
Historically, property prices in the UK have doubled on average every nine years (the longest doubling period has been 14 years). Now, we need to be very careful about two things: extrapolating forward from historical data, and applying a UK average to a specific situation. We’ll come back to both these points – but for now we can be somewhat confident that by extending the timeframe to 20 years, doubling will have occurred.
So, in 20 years our six properties – worth a combined £850,000 when we bought them – will be worth £1.7 million. Yet, brilliantly, the total borrowing will be exactly the same as it was before: £639,000. This is the magic of leverage once again: while property prices and rents go up over the long term (even if only in line with inflation), the amount borrowed stays the same. (The interest rate on that borrowing can change of course, which is why you need to have room in your figures to incur higher borrowing costs without being in a loss-making situation. Expect to see lots more about this in Part 3.)
At this point, we have at least three options.
The first option is to sell them all. After paying off the mortgages, we’ll have just over £1m in the bank. We don’t know what the capital gains tax (CGT) regime of the future will be, but if we assume it’s the same as it is now and we don’t take even the most basic measures to mitigate it, we’ll be left with £700,000 after tax.
So we originally put in £250,000, and got out £700,000. That money, invested in a stock market portfolio where it grows by 4% per year, will generate an income of around £28,000 per year for life. However, £28,000 in 2036 won’t have anything like the same buying power as it does now – which is why I favour another option.
The second option is to sell two properti
es to raise a total of £568,000, which is used to pay off the majority of the mortgages on the other four – leaving an outstanding mortgage balance of £71,000. On top of the remaining mortgage balance, the worst-case CGT bill (assuming the same tax regime as today) would be £80,000. Remember those rents we’d forgotten about but which have been accumulating for 20 years? Those will pay off those liabilities instantly.
After selling we’re left with four properties, each of which is making a monthly profit of £575 now we no longer have mortgage interest to pay. That gives us a monthly income of £2,300 – or £27,600 per year. And there’s still the potential for further capital appreciation in the future.
The big advantage to this second option is that rents will have gone up with inflation over 20 years too. That means your monthly income won’t actually be £2,300 – it will be the 2036 equivalent of £2,300 in today’s money. You’ve taken your initial £250,000, put in absolutely no effort, and given yourself an inflation-proof income of £27,600 per year.
The third option is to do something that at first seems a bit bonkers when you first hear it: not only not pay off the mortgages, but actually increase your mortgage balance each year and use the extra borrowing to pay yourself a (tax-free) income. My business partner Rob Bence has been known to refer to this as “the ultimate property strategy” – and while it’s certainly not right for everyone (and isn’t something I follow myself), it’s worth knowing about in case it’s the right option for you.
Because it takes a bit of getting your head around, it’s best explained visually – so I roped him in to record a video course that gives you the lowdown. It’s yours for free as part of the extras for this book, so go get it at propertygeek.net/extra.
