It may initially seem counterintuitive. Why would one want to take on the additional complication, risk and expense of a mortgage, if one can buy a property outright in cash? Monthly interest repayments can hack a considerable chunk out of a property's monthly cash flow, limiting an investor's ability to save and reinvest those funds.
The answer is relatively simple - and is the same reason that many of the world's most highly regarded institutional investors and private equity funds use debt to finance acquisitions. Used correctly, it can supercharge returns on investment, and turn a solidly performing asset into a goldmine.
How professional investors use leverage to supercharge their returns
Mechanism 1 - Increasing cash flow and ROI
In our article '5 key property investment calculations', we demonstrated how using leverage can materially enhance an investor's ROI. Let's revisit that example briefly:
ROI = Annual Rental Profit / Cash Invested
No leverage (cash only deal):
Property Price = £100,000
Acquisition Costs (Stamp Duty, legal fees, surveys, etc) = £5,000
Cash Invested = £105,000
Annual Rental Income = £9,000
Annual Costs (e.g. letting agency fees, etc.) = £2,000
ROI = ((Annual Rental Income – Annual Costs) / Cash Invested) x 100
ROI = ((£9,000 - £2,000) / £105,000) x 100
ROI = (£7,000/£105,000) x 100
ROI = 0.667 x 100
ROI = 6.67%
Now let's apply leverage to the investment, and observe the impact on the cash flow and returns.
With leverage (interest-only mortgage, assuming a 4% interest rate):
Property Price = £100,000
Acquisition Costs (Stamp Duty, legal fees, surveys + mortgage fees) = £7,000
Total Mortgage = £75,000
Cash Invested = £32,000
Annual Rental Income = £9,000.
Annual Rental Costs (e.g. letting agent fees, etc.) = £2,000
Annual Mortgage Costs = £3,000
Total Annual Costs = £5,000
ROI = ((£9,000 – £5,000) / Cash Invested) x 100
ROI = (£4,000 / £32,000) x 100
ROI = 0.125 x 100
ROI = 12.5%
Though the annual return is lower where leverage is used, due to the need to repay mortgage interest (£4,000 versus £7,000 in the cash-only deal), the ROI is much higher in the second example, as £4,000 represents a higher percentage return on the cash invested in the deal.
Extrapolating the impact
Extrapolating outwards, what would happen if our investor, rather than investing his entire budget into one property, were to acquire three £100,000 properties with his original cash budget, using leverage? Let's assume he finances each purchase using 75% debt and 25% cash, a typical loan-to-value ratio for buy-to-let investments:
Property price = £100,000 x 3
Deposit amount = £25,000 x 3 = £75,000
Acquisition costs = £7,000 x 3 = £21,000
Total cash invested = £96,000
Annual Rental Income = £27,000 (3 x £9,000)
Annual Costs (including Mortgage Costs) = £15,000 (3 x £5,000)
Annual Return = £12,000
ROI = (Annual Rental Income – Annual Costs) / Cash Invested x 100
ROI = ((£27,000 - £15,000) / £96,000) x 100
ROI = (£12,000 / £96,000) x 100 = 12.5%
We can see that our investor has now increased his ROI from 6.67% to 12.5%. But his annual return - i.e. his net cash flow - is now also substantially higher - £12,000 per annum rather than £7,000. He has also invested £9,000 less overall.
Mechanism 2 - returns on capital growth
In a rising property market, leverage can also have the effect of greatly increasing returns on investment from a capital growth perspective. For example:
Investor A:
Property price day 1 = £100,000
Acquisition costs = £5,000
Property sale price after 10 years = £150,000
ROI = (£50,000 / £105,000) x 100 = 47.61%
In this scenario, Investor A buys in cash outright. Including acquisition costs, his total cash invested is £105,000. 10 years later he sells the property for £150k. This represents a pre-tax ROI of just under 50% - a good return. Now note the impact on that return if a second investor were to make the same purchase, but utilising leverage in the form of a 75% interest-only mortgage.
Investor B:
Property price day 1 = £100,000
Mortgage amount = £75,000
Deposit = £25,000
Acquisition costs = £7,000
Cash invested = £25,000 + £7,000 = £32,000 Property sale price after 10 years = £150,000
Principle amount owed to the bank = £75,000
Cash return to investor = £75,000
Net profit = £75,000 - £32,000 = £43,000
ROI = (£43,000 / £32,000) x 100 = 134%
In this scenario, the property has also increased in value by £50,000. On a sale of the property, Investor B repays the bank its £75,000 loan, leaving £75,000 left over. Of that, £32,000 was the original investment, so this represents a £43,000 gross pre-tax profit - a 134% return.
Of course, the principal amount of the loan is not ‘free’ – the bank will charge interest on this amount, which needs to be repaid each month. If the interest on the £75,000 loan is 5%, Investor B will have paid £312.50 per month for a period of 10 years, a total of £37,500, which would reduce the gross profit, UNLESS the property is rented out for that period for more than £312.50 per month, in which case Investor B’s gross pre-tax profit is maintained at a minimum of £43,000.
An alternative way to look at this would be to ask whether our Investor should use his £100,000 budget to acquire one property outright, or to buy four properties, each worth £100,000, using a £75,000 mortgage and £25,000 in cash. If property prices were to increase 10% over five years, in scenario A, his portfolio would be worth £110,000, and he would have made a £10,000 return (on paper) - a 10% return from capital growth. In the scenario B, his portfolio would be worth £440,000, and he would have made a £40,000 return (on paper) over the same period - a 40% return from capital growth.
Note: For simplicity we have not taken into account factors such as time value of money. Inflation, among other things, would have an impact on returns too, however the general principle stands.
The potential risks - exacerbating losses in a falling market
Is is often the case, risk and reward are closely correlated when it comes to leverage. While the benefits of leverage where property prices are stable, and particularly where property prices are growing, can be significant, if property prices fall, the leverage can work the other way to increase an investor's losses. By way of example:
Investor C:
Property price day 1 = £100,000
Mortgage amount = £75,000
Acquisition costs = £7,000
Cash invested = £25,000 + £7,000 = £32,000
Property sale price after 10 years = £50,000
Principle amount owed to the bank = £75,000
Cash return to investor = £50,000 - £75,000 = -£25,000
Net profit = -£25,000 + -£32,000 = -£57,000
ROI = (£-57,000 / £32,000) x 100 = -178%
In this scenario, the property has fallen in value by £50,000. If the Investor were to sell the property, Investor B would have to repay the bank its £75,000 loan. His £32,000 original investment amount would be wiped out entirely, and he would still owe the bank an additional £25,000. This represents a -178% (negative one hundred and seventy eight percent) return. Had the investor bought the property entirely with cash, his loss would have been limited to -53% (being £-57,000/£107,000) x 100.
As in the example above, unless the property is rented out during the repayment period for an amount equal to the mortgage interest, Investor B’s gross pre-tax loss would be in excess of £57,000 and worse than -178%. On the other hand, if the investor were able to rent out the property for more than the interest payments on the mortgage, this would mitigate his losses.
How investors mitigate their risk
While historical performance is not a guarantee of the future trend in terms of house prices, due to the supply and demand tensions within the UK housing market and general inflation, it is unlikely that an investment acquired at market or below-market value in a suitable area will be subject to a fall in value of the type outlined in the example above.
In addition, the negative impact of leverage is likely to only be an issue if Investor B is forced to sell the property and thereby ‘crystallise’ these outsized losses at a time where the house is of a lower value than when he acquired it. If he were able to hold onto the property until the market recovered, the loss would never be realised.
The key to ensuring that a portfolio is strong enough to ride out any such falls is therefore to ensure each investment is always cash-flow positive, and to stress-test that cash flow position against potential factors outside of the investor's control (such as increases in interest rates or falls in market rents).
In practice, banks will do a good deal of the work for investors in ensuring there is an adequate buffer between the rental income and the mortgage repayments -banks are now required to ensure they 'stress test' their lending via "interest coverage ratios", and most lenders insist that rental income must be at least 125% of the mortgage interest, assessed at a higher interest rate than contemporary levels.
Summary
Leverage can be a very powerful tool in an investor's arsenal. Using the same principles and mechanism employed by leading institutional investors and private equity funds, individual investors can, on a smaller scale, use debt to vastly enhance returns. Debt is never without risk, and should always be utilised with care. However there are means by which investors can mititgate those risks, including avoiding paying above market value for properties, ensuring that any investment property has a strong cash flow position and interest coverage ratio and that it can withstand stress-testing of an increase in costs which is outside of the investor's control (for example, interest rates, fall in market rents, etc.).
About Oxstone
Oxstone is a market-leading UK property sourcing company and purchaser's agency. We leverage the latest AI-enabled property sourcing and investment analysis software and our strong network of connections across the UK to source, analyse and secure excellent residential and investment properties for our clients, including off-market properties that are not available to the general public.
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