Why do people Buy to Let?

A lot has been said about Buy to Let over the last twenty years. It isn’t rocket science and it isn’t the 21st Century’s equivalent of alchemy. But some might be persuaded that it is.

However, buying property as an investment has proved to be a successful and lucrative investment decision for some and here we will address some of the benefits and pitfalls those new to the market should consider.

Firstly, when you own property and rent it to someone, your intention is to generate a return on that income. With savings rates at less than inflation, cash sitting in a building society is being eroded by inflation year on year. Bonds are not much better and for those with a six figure sum to invest, property starts to look like a very attractive option.

To someone with £100,000 spread over say three savings accounts an annual gross rental return of say 6% per annum looks good. And on the face of it, it is good. But here is the first cautionary note. The word is gross. Unlike savings income from your bank or building society, there are costs incurred when you own property. For example, the property needs to be properly insured for risk, you need to find a tenant and once found you need to collect the rent and manage the property. When the central heating boiler stops working you are likely to be saddled with the cost - and the hassle.

Then there is bad debt. We have all heard the stories of bad tenants that move in and stop paying rent. It can take months to get them out and during that time your mortgage still needs to be paid, your insurance has to be covered and your legal bills will be mounting up.

In fact, even if you have a good tenant relationship, property is still more like a small business than investing in bonds or unit trusts. In comparison to having cash spread across several UK registered banks the risks are considerably higher and the effort involved can be considerable.  

All of this said, you might be starting to wonder why anyone enters the buy to let market! Well there are potential benefits, and here they are;

Relatively High Initial Returns

If you are in the enviable position of having a couple of hundred thousand pounds in cash sitting in the bank with nothing to do, investing in the right property can be very sensible. First of all, you are likely to obtain a gross initial rental return on your money of about 5%. Of course, in some areas returns are less and in others, the returns are more and your initial return is as likely to be set by investor demand as any other asset class.

Buying a dilapidated terraced property in an ailing town in the North of England will be easier (and cheaper) than buying a mansion house in Belgravia. And the initial rental return you might be prepared to accept would reflect the likely hassle and risk involved.

The savvy investor will also be looking at the opportunities that exist for growth in the property’s capital value.

Additional Returns From Capital Growth

The initial rental return is only part of the sophisticated investor’s thought process. Buying for a rental return is one thing, but buying the right property in the right area is likely to bring another medium term benefit - a growth in capital value.

This has several benefits. First of all, any growth in capital value is, all things being equal, going to reduce your Loan to Value Ratio. Over time this will effectively strengthen your position with your lender and perhaps even enable you to remortgage, thus releasing more cash which you might then use as a deposit to buy another property. Capital growth is usually not taxed until it is realised, so this is an effective way of gearing up your initial investment.

The Effect of Gearing

Gearing is a term given to the ratio between your debt and your equity. For example, when you borrow £120,000 to add to your £80,000 deposit and buy a £200,000 property, you have effectively geared your £80,000 cash to buy a £200,000 asset.

If that house goes up by 30% over 10 years, then you now have a property worth £260,000. Even if your rent has only been covering your interest-only mortgage repayments, you will still have made a £60,000 ‘profit’ and, because you geared-up your initial deposit of £80,000 you can see that your return on your own £80,000 capital employed was £60,000.

That is a 75% return on your cash over 10 years, a 7.5% simple mean annual return, excluding any surplus rent, repayments of loan capital or rental growth. Borrowing against an asset allows you to ‘gear up’ cash and reap significant benefits.

Of course, the downside to this is that gearing works both ways. If values drop by say 15% and you have borrowed £80,000 on a £200,000 property, your loan to value has dropped from 60% to 70.6%. This might take you outside your agreement with your lender and require you to find more cash to reduce your outstanding loan. Gearing is a double-edged sword.

Flexibility & Control

Owning an asset means you have more control than simply holding a piece of paper that promises you a return. Of course, whilst this ownership has its advantages, it’s worth remembering that you need to manage that asset and deal with the ‘hassle’ that ownership brings with it. Of course, you can employ specialists to deal with the day-to-day problems, but that costs money, reduces returns and, when problems occur, you are still the only person motivated to resolve them!

Tax Planning & Inheritance

As things currently stand, owning real estate is beneficial when planning for inheritance tax. The pensions and annuity business is being changed as I write this, bringing more flexibility and allowing certain assets to be left to surviving beneficiaries, but owning property is still a rock solid, if sometimes time consuming, investment alternative worth considering.

For advice on how much you may be able to invest in your Buy-to-Let investment, contact us on 01628 507477 for an initial chat without obligation. We also arrange remortgages and loan restructuring for existing property holdings.

Related Blog Post: What is a Buy to Let Mortgage?