Your deposit is your investment capital
Residential property investment is a unique asset:
- Unlike stocks, shares, and bonds, it is a tangible asset: it’s real. You can see it, touch it, feel it.
- Unlike precious metals, you can get an income from it.
- Unlike fine wines, vintage cars, and postage stamps, opening or damage can be repaired to maintain (and even enhance) value.
When you buy in the best places to invest in property UK and finance it with a buy-to-let mortgage, you get to take advantage of the benefits of leveraging in property investment. Your investment capital works harder for you because you make money on other people’s money. This can massively boost your return on investment. Savvy professional investors can make 15%, 20%, and more on the capital they invest via capital gain and rental income.
To access this potential, you will need a sizeable deposit. This is for two reasons:
- Lender’s attitude to risk
- Regulation of buy-to-let mortgages
In this article, you’ll learn more about these two reasons for needing a large deposit to invest in residential property. You’ll also discover why this hasn’t changed the attractiveness of residential property as an investment asset.
Lender’s attitude to risk
Banks, building societies, and specialist mortgage lenders were all hit by the Global Financial Crisis. The ensuing ‘Great Recession’ hurt whole communities. Millions lost their jobs. Many, many homes were repossessed. Mortgage lenders took back properties that were in deep negative equity. They lost millions – even billions.
With the benefit of hindsight, it is now possible to see that some lenders had been reckless in their lending policies. They had required minimal or no deposits. I even heard from a financial advisor (who worked for a major high street bank at the time) how the bank was agreeing 125% mortgages with wages self-certified. Madness.
This experience has left many lenders more reticent to lend. To protect their balance sheets and revenues, these lenders now require a bigger cushion against potential house price falls.
Residential property investment, despite that it is a real asset with an increasing tenant demand, is viewed as being a higher risk by lenders. They are scared that tenants will cause expensive damage to a property, or that the property will suffer long void periods, or that it won’t make the rental income forecast. All these reasons could cause you to default on your mortgage.
If the lender sees fit to repossess your property, and its value has fallen (e.g. during a pullback in the property market), the lender could lose money when it sells it. Hence, the need to ask for a larger deposit. However, it is not only a lender’s internal attitude to risk that determines the size of deposit you will need to put down to invest in property.
Regulation of buy-to-let mortgages
The Prudential Regulation Authority (PRA) introduced new criteria for lending to property investors in September 2016. These regulations set out a minimum interest coverage ratio (ICR), based upon possible future interest rates. Lenders must now assess the affordability of your property investment by considering:
- Rental income
- Interest rates of a minimum of 5.5% or 2% above their level when the mortgage is made
For many lenders, the new PRA regulations have meant that the standard ICR rose from 125% to 140%.
How has this affected the deposit you need?
Let’s assume that you are investing in a residential property valued at £200,000. You want to borrow £150,000 to invest, and the interest rate on this mortgage is 3.5%. Your mortgage interest payments would be £5,250 per year or £438 per month. Previously, the lender would have assessed as follows:
- 125% x £438 = £548 per month
Provided your rental income was forecast at £548 per month or higher, the lender could offer you a mortgage to invest. With the new rules, the goalposts have moved. The calculation made by the lender now becomes:
- Mortgage interest assessed at 5.5% = £150,000 x 5.5% = £8,250 per year = £688 per month
- 140% x £688 = £963 per month
If the rental yield on your investment property is only forecast at, say, 5%, the £833 per month rental income will not be enough to pass the PRA affordability test – even though the actual mortgage rate you pay (3.5%) leaves a sizeable profit.
The effect of a larger deposit
Putting down a larger deposit decreases the mortgage interest you will pay. This means the rental income needed to meet regulatory requirements is decreased.
Let’s take the above example, and instead of a 25% deposit, you put down a 40% deposit. Now:
- The mortgage amount is £120,000
- Interest assessed on this mortgage is £6,600 per year or £550 per month
- Rental income required is £770 per month (140% x £550)
If the rental yield is 5%, your rental income of £833 per month will produce an assessed profit (before other costs) of £283 per month.
As you can see, the larger deposit means that the lender can offer you a buy-to-let mortgage. Of course, if your actual mortgage rate is only 3.5%, your actual profit after mortgage interest payments and before other costs is £483 per month. Put another way, that’s a gross return on investment of 7.25%. And that’s before any capital growth is considered. With house prices in the regional cities rising at 5.5% annually, the property in our example would produce a total gross return (after mortgage costs) of around 12.75%.
Summing up, you may need a larger deposit to invest in residential property today than you did in 2015, but the return on this investment capital is still hugely attractive. To find out how you could maximise the return on your underperforming investment capital, cash in the bank, or home equity, contact Gladfish today on +44 207 923 6100.
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