For anyone looking to profit from property investment, the old rules about avoiding debt may as well be thrown out. So long as it’s the right kind of debt, explains Alex Marshall. You just need to take your opportunities and remember the property investor’s golden rule…
Maybe it’s a hangover from the war years, but I tend to find that our parents’ generation think ‘credit’ has to be avoided at all costs. That you should only ever buy something if you have saved the money for it. The trouble with inheriting this attitude is that you are potentially missing out on a very simple and powerful way to grow wealth for yourself and your future generations.
In his excellent book Rich Dad Poor Dad, entrepreneur Robert Kiyosaki introduces the idea of good debt and bad debt. In a nutshell, bad debt is money you borrow to spend on a depreciating asset like a new car or a new yacht. Not only are you paying the interest on the debt, but the asset itself is losing money every month too. Good debt, however, is money that you borrow to buy an asset that is likely to appreciate, like a property or a business. Yes you pay the interest each month, but the value of the debt in relation to the asset goes down eventually (called loan to value or LTV) as the asset appreciates.
Why property is good debt
Property has a characteristic that no other asset class has. You can borrow money to buy it. If you think you can do that with other asset classes, try ringing up your ISA provider (like Hargreaves Lansdown) and explain that you have £25,000 in an account with them and you would like them to lend you £75,000 to buy more shares, gold or bitcoin. They will do one of three things: politely disavow you of your beliefs, start quietly sniggering down the phone, or simply hang up as they think they have a crank caller on the phone.
Property has a characteristic that no other asset class has. You can borrow money to buy it.
The fact that you can easily borrow 75% of your property value explains why the whole buy to let (BTL) investment boom went so gang busters for so long. However with the introduction of ‘landlord unfriendly’ government legislation in the UK, such as a 3% purchase tax surcharge on second properties, and changes to the tax deductibility of mortgage interest, some say the party is over.
Others say that because the casual landlords (i.e. owners of one or two properties who also have a day job) are exiting the market, there is money to be made. Albeit not in quite such the easy way it was before. Previously, with the market rising, everyone was making money, but now you need to do a little more number crunching (due diligence) before making a purchase. But this could still be well worth doing, given the ease of borrowing money to invest.
Borrowing money to invest in property is called leveraging yourself. Friends or colleagues will quite rightly say that leverage is a beautiful thing in a rising market and a deadly thing in a falling market. Indeed, that is close to the truth, but not quite the whole truth. More accurate is the old adage buy property and then wait (as opposed to the more fear-based approach, wait and then buy property). This points to the fact that if you hold property long enough then it will appreciate in value. For example, in the 30 year period from 1986 to 2017 house prices increased by an average 6.18% per year.
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Leverage in property only becomes deadly if you are forced to sell during a period of falling prices. But even minimal research will tell you what you can rent your property out for. You will also know what a five-year fixed Buy-To-Let loan will cost you (currently around 3%).
In other words it does not matter if for a period of time your property has gone down in value as long as the rent you are receiving easily covers all your costs. You will need to budget for finance at 3%, repairs and maintenance, potential voids (your property being empty) of four weeks a year, and tax. Cover these and you are not losing money so you will not be forced to sell and then realise a loss. You can then weather the storm knowing that the rent is covering everything until prices go up again.
Raising finance without selling
A golden opportunity for people here in the UK to build their wealth in a very simple way is when they move house. Most people think (and I used to think this too) that in order to buy a new house they have to sell their old one, especially if they are downsizing. They then fall in love with a new house, and endure much anxiety as they try to sell their old house. So much anxiety in fact that during the process which may take months and months (if not years), they are likely to lower their asking price again and again until it sells (agents love it when you do this. After all they still make nearly the same amount of money but the likelihood of them closing the deal is increased).
However there is a great alternative which means you don’t have to endure the anxiety of selling. In today’s Brexit climate that may not be a good thing anyway. So what is the alternative?
Instead of selling your old house, you keep it and rent it out instead. You can then typically borrow 75% of its value
Instead of selling your old house, you keep it and rent it out instead. You can then typically borrow 75% of its value very easily at a fixed rate for five years on what is known as a LTB mortgage (Let to Buy). All you will need is a good independent broker, and then get a tenant to pay rent. Some rudimentary number crunching will show you how to pay all your costs and even give you an extra monthly income too.
This has the added benefit of ring fencing the asset. After all if you sold your old house and had a pile of money just sitting in the bank, then it is mighty tempting to start eating your way through all that lovely capital! Whereas, having that money tied up in the house and providing you an income gives you an asset that will appreciate over the long term, and one that you can’t easily fritter away on new speedboats.
Let’s say your old house was worth £500,000. If you sold it and bought another house for £375,000, your total assets would still be £500,000. However if you kept your old house, borrowed 75% or £375,000 to buy that new house of yours, your assets would be £875,000. Now imagine fast forwarding five years and house prices have gone up a conservative 15%. In scenario 1 your £500,000 is now worth £575,000, but in scenario 2 your £875,000 is now worth £1,006,250.
In other words by using ‘good’ debt you have grown your wealth substantially. And as long as you are never in a position where you are forced to sell, you can ride out any house price declines and do as many rich and savvy investors do, and NEVER sell property!