For many people even the word “debt” makes them shudder and agitated. The vast majority of us are brought up to live within our means by our parents. In reality the average person today will have a credit card, maybe a personal loan not to mention a mortgage to acquire that dream home. So while the word debt does cause many people to take a step backwards it is part of everyday life and while it should be respected it should not be avoided.
Investing in property
The most traditional type of property investment is only made possible by taking out a mortgage with your bank or finance company. This is property investment in its purest form and for those looking at building a property portfolio it is no different. If we take a traditional mortgage as an example, people will only take out a mortgage which is deemed “affordable” based upon their personal financial situation. Why should this be any different for somebody looking to invest in property as a long-term career?
Limit your downside, increase your upside
There is scope to make a significant return in property development by requiring land with planning permission, developing a property and selling the asset. In reality how many investors would get anywhere near this dream scenario without taking on debt and taking on some risk? No investment in the world is risk-free and the lower the risk the lower the potential returns. So, how would you use debt to create a lucrative property development?
Let’s say you acquire land with planning permission at a cost of £50,000 (your initial outlay) with the potential to build a property which could be valued at £300,000 plus. If for example it would cost £150,000 to build this property (financed with borrowed funds) that would equate to a cost before financing charges of £200,000. The idea would be to acquire the land, build the property by drawing down funds stage by stage and then as soon as it is finished, sell it for the highest price. In theory there is a potential gain of £100,000 before taking into account interest on borrowed funds used to build the property.
Giving yourself some headroom
In this scenario the total cost of the property is £200,000 (before financing costs) therefore you have some financial headroom between the market value at the time and the cost of building. In many ways this reduces your downside because in a worst-case scenario you sell it for £200,000 and walk away with no loss and no gain, or you could take £250,000 for a quick sale and still bank a profit. While there is obviously more to developing a property than picking a random piece of land, building a property and selling it, the idea in principle is very straightforward.
In practice you would need to ensure your contractors were reliable, offering stage payments and potential penalties if they miss targets, you could even offer a bonus built into the contract to encourage them to finish early. At the end of the day the quicker you can build the property, sell it and repay all outstanding loans the less financial charges you will incur and the greater the potential profit.
This is just one example where debt can be used in a sensible manner, building a development where there is something of a safety net if things did not go as planned. The sooner you join the property development process the greater the risk but also the greater the potential reward. Balancing up when you could feasibly join the chain and what kind of liability you would be willing to take on will ultimately dictate what kind of developments you get involved in.
It would be wrong to suggest it is easy to make money in the property market but if you are careful, plan your finances and give yourself some headroom in the event of unforeseen circumstances, there is potential to use debt to your advantage.
You may also find this article of interest:- How to become a property investor without a mortgage