Leverage in Property Investing & Why It’s Important
You may be starting out on your property investment journey and are wondering whether you should use leverage in your investment(s).
This short guides aims to present the importance of leverage in a succesful property investment portfolio.
Why Leverage is Important in Property Investing
- What is leverage in property investing?
- Benefits of leverage
- Is leverage good or bad?
- Overleveraging and maximum leverage
- Why leverage is important for a succesful portfolio
What is Leverage in Property Investing?
In the majority of investment vehicles, you spend a certain amount of money, let’s say £1000, and own £1000 worth of an investment, i.e. 100% of your investment was paid for by you.
There is an advantage to investing within financial and property markets, with the latter being least risky, which is refered to as leverage, gearing, mortgage or debt financing.
With leverage, you are using other peoples money (banks or other financial institution) to purchase a larger investment property. To illustrate what we mean, check out the image below.
With zero leverage, the buyer will own 100% of their house and thus have no mortgage to pay back, compared to buying with leverage where the buyer will only own 20-25% of the property in the majority of cases (75-80% LTV mortgage).
Benefits of Leverage in Property Investing
As mentioned above, leverage when investing in the market can allow you to purchase a larger property which will of course have a much higher value.
But the benefits don’t stop at simply owning a property of higher value. In 5-10 years when the value of property has increased a substantial amount, you’ll have the ability to sell at a profit or refinance.
In both cases, you will have a larger return on investment (ROI) with a larger property.
Let’s look at two simplified examples to explain further:
Example 1 - Selling
Person A: Purchases £100,000 property with no leverage.
Person B: Purchases £800,000 property with leverage and £100,000 of their own money.
5 years down the line, property prices have increased 10%. Both person A and B decide they would like to sell.
Person A will generate a profit of 10% of £100,000, which is £10,000. Person B generates a profit of £80,000 (10% of £800,000).
This example doesn’t take into consideration mortgage repayments of person B, or capital gains tax of both A and B, however, person B will still generate a substantially higher profit compared to A after 5 years.
Example 2 - Rental Income
Again, both A and B purchase a £100,000 and £800,000 property respectively.
During the 5 years between buying and selling, both parties decide to let their property. To simplify the example, both properties generate 8% of their value per annum in rental income.
You can quickly see that property B will be earning a significantly higher rental income than property A.
In both examples, although person B has leveraged, they do not owe any of the rental or capital gains profit to the lender – This is one of the most beneficial aspects of leveraging a property investment.
Is Leverage in Property Good or Bad?
So far, it may seem that there can’t be any downsides to leveraging a property investment.
However, this is only provided that the market continues to grow and strengthen.
If you have obtained a variable rate mortgage and the market experiences a significant dip, you could find yourself in negative equity. I.e. monthly mortgage repayments are higher than your monthly rental income and your property is worth less than your mortgage amount.
However, worse than this – if you have a property which is not in very high demand and a recession hits, you could find the property tennant-less for a prolonged period of time, which will make a significant dent in your portfolio.
So while leveraging can provide considerable advantages to monthly rental income and capital gains in the long run, you should be very careful.
The type of mortgage used and whether the property will be in high demand are two important considerations to make to minimize periods of negative cashflow and negative equity.
If you are more comfortable with not borrowing any money against your property, there is one main advantage of no leverage:
You will not have any monthly mortgage repayments and thus not have to worry about fluctuating property prices affecting mortgage interest rates.
Many people prefer to have no leverage in their primary residence, as there would be far less stress if made redundant – the looming worry of having no job to keep up with mortgage repayments does not exist, meaning if you have no income for a prolonged period of time, you will not loose your own house.
Over-Leveraging Property and Maximum Leverage
Prior to the 2008 recession, many lenders were offering mortgages of 100% LTV, with some even offering over 100% LTV!
However, with current stricter mortgage stress tests and personal income checks, these no longer exist in the UK, therefore over-leveraging is no longer a major concern.
Maximum mortgages currently available in the UK are around 75-80% LTV, with some institutions lending higher amounts to first time buyers.
However, just because you may be able to obtain a 80% LTV mortgage does not mean you should take it, especially if you have not researched the area. With a higher mortgage comes higher monthly repayments – the most important aspect to consider is whether you can keep up with repayments during lengthy void-periods.
Further to this, markets may take a downturn and if you are locked in with a variable rate mortgage, your rate is very likely to increase and you can quickly find yourself repaying more than you are earning from the investment.
Why Leverage in Property Investing is Important For a Successful Portfolio
Putting it simply, leveraging allows you to amplify your profits. A 75% mortgage on a property will equal around 4 times your original equity.
As shown in the examples above, leveraging a property investment allows you to access a higher priced property using other peoples (banks/lenders) money.
To become a sucesful portfolio investor, you cannot simply purchase all of your properties with no leverage. Well, you can, however the return on investment seen will be miniscule compared to using leverage.
Take two investors, A and B, both with a starting capital of £100,000. Investor A uses no leverage, B uses 75% LTV mortgages.
Investor A purchases £100,000 worth of investment properties. B has used their £100,000 as deposits on various properties, with the 75% LTV mortgage, their portfolio is worth £400,000.
During a 10 year period, both A and B generate 8% PA in rental income: Investor A has generated £80,000, B has generated £320,000.
During the same 10 year period, property prices have risen 10%: Investor A has available equity to refinance of £10,000, while investor B is able to refinance for £40,000
Investor A now takes their £80,000 profits and £10,000 equity to purchase another £90,000 worth of property. Investor B uses their profits of £320,000 and £40,000 equity to then purchase a further £360,000 worth of leveraged investment properties.
Investor A’s portfolio is now worth £190,000, while investor B has a portfolio worth £1,840,000.
Again, this example is simplified and does not account for market fluctuations, mortgage repayments, void periods, capital gains tax, income tax and solicitor fees. However, you can see that investor B’s portfolio is growing at a much faster rate than investor A’s.
Growth of property portfolios over a 20 year period. Both A and B start with £100,000.
Neither A or B refinance, however available equity is taken into consideration assuming growth of 2% each year along with 8% PA rental income Capital gains tax, mortgage repayments and other payments not accounted for.
Points to Take Away
Not all debt is equal. There are good debts and bad debts. Debt to finance a property investment is good debt – it will make you more money, not lose you money like a personal credit card loan*
There is a saying – “Cashflow is king“. Ideally, you should aim for your portfolio to pay you the maximum amount each month rather than focus on possible capital gains.
Looking to read more about property investing? Check out our 13 property investing fundamentals.
*Property market prices can decrease, which can cost you money if your investment is incorrectly leveraged. Seek expert advice when leveraging, gearing or mortgaging an investment or personal property
Want to share this article?