Exploring the benefits of using gearing in property investment
In my last investment blogs, I introduced the concept of capitalisation rates as a way to compare the return on a property investment and how you can use the capitalisation rate as a guide to inform your bid price in property negotiations. You can read those articles here:
- What return should I expect from my investment property?
- How can I use the capitalisation rate to invest in property for income?
In this post, I’m going to look at how using the leverage offered by a buy-to-let mortgage powers your return.
First, let’s recap the property investment example we’ve been using
You may remember that we used the example of an apartment that cost £180,000 and had the following financials associated with it:
That’s an annual return of 4.17% on your invested money (£180,000). That’s without accounting for any (if any) capital growth, of course. Oh, and it assumes you stumped up the whole £180,000 purchase price. But what if you didn’t have that amount sitting in a bank account earning next-to-zero percent interest?
A buy-to-let mortgage powers your return
Professional property investors understand that leveraging (sometimes called ‘gearing’) is a very powerful tool in property investing. It’s one of the seven reasons why investing in property beats all others that David Lines wrote about in July.
In plain English, leveraging is when you use someone else’s money to make a profit for yourself. In the case of property investment, that someone else is a bank or other buy-to-let mortgage lender. The money that you use is the buy-to-let mortgage.
Let’s say that you had £54,000 available to invest. That just happens to be the 30% deposit we’d recommend on a property investment of £180,000. To complete the purchase, you’ll need to borrow £126,000. Let’s say that you pay 3.8% in mortgage interest. That’s £4,788 per year.
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Your net income now reduces to £2,722. But your personal capitalisation rate increases to more than 5%. Just to put this into some perspective:
- The dividend yield on the FTSE 100 is 3.72% (July 2016, FTSE Russell).
- The coupon (interest) on a UK 2-year Gilt is 1.25%.
- The best interest rate for £54,000 on a cash account is 1.8% (according to MoneySavingExpert Martin Lewis) with Shawbrook Bank, and you do have to lock your deposit away for a minimum of two years.
- If you wanted retirement income, at age 65, according to Hargreaves Lansdown the best standard annuity rate is 3.6%. Of course, once you’ve bought an annuity, the money is gone forever. Property is always there. Oh, and your annuity income will never increase.
Income that blows away the competition
In our example (a conservative one, I have to say) the annual income on your investment is a little more than 5%. That is:
- 35% higher income than dividends pay on the FTSE 100
- 300% higher than the government will pay you to borrow your money
- 178% more than the highest interest rate you could receive on cash savings
- 39% more than you’d receive on the best annuity
- Unlike cash accounts and gilts, your capital could grow
- Unlike annuities, you’ll have a real asset to leave to loved ones after your death
- Your income should naturally grow with inflation
- If your property value increases, you can pay off the mortgage and pocket the profit (less a few capital gains tax)
Why haven’t I mentioned tax?
By now you might be asking yourself why you haven’t invested in property already. You might also be pondering the 14 investment property facts your financial advisor won’t tell you. You may also want to ask about tax, and why I haven’t mentioned it.
The fact is that you will have some tax to pay on your rental income. How much depends on your individual tax position. So, rather than me try to second-guess your tax position, why not use our buy-to-let tax changes UK tax calculator to get an accurate assessment? It’s free to download, and you’ll be able to get an accurate assessment of the tax liability on your investment in moments.
The other reason is that all the investment returns quoted above are before tax, so to make an accurate comparison a before-tax figure is always the one to use.
For more information contact the team at Gladfish on +44 (0)207 923 6100.
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