Even though the majority of us are brought up to believe that debt should be avoided at all costs, this is not necessarily the case when looking at real estate investments. Many property investors successfully gear up their property portfolios using debt vehicles within a predetermined investment portfolio structure. While this particular area of investment will not be suitable for everybody, many successful property investors are able to use debt to maximise their returns. So, why do property investors gear up their investments?
What is gearing?
The term gearing is simply another word for debt/leverage and basically means using funds available to utilise debt vehicles such as mortgages/property loans. In its most basic form let us assume that you have £200,000 to invest in a property. If you acquire a property for £200,000 then there is no debt to take into consideration. Let us assume that the value of the property in question increased by £20,000 you have a 10% return on your investment. Any return is gratefully accepted but are there other ways to use your core funding of £200,000?
Let us assume that rather than by one property outright you look to utilise various debt vehicles such as mortgages to maximise your exposure. If we work on a 75% loan to value for each mortgage then it is possible to put down a £50,000 deposit on four different properties (valued at £200,000) and use gearing to cover the additional £150,000 per property. If, as in the example above, property prices were to increase by 10% then rather than a straight £20,000 profit you would have a £20,000 profit on each of the four properties, totalling £80,000.
There is obviously a cost to using debt to acquire property and the prevailing interest rate will depend upon the market at the time. However, if for example you were to secure a rental income equivalent to the interest rate on a mortgage you took out then this would effectively leave you cash flow neutral. In a perfect world you would benefit from a rise in property prices across four different properties as opposed to one property if you did not utilise debt finance. There are obvious risks when looking at gearing up your portfolio such as a reduction in rental income, an increase in mortgage rates and a fall in the value of your properties.
Giving yourself headroom
If a 75% loan to value ratio is the maximum allowed for a mortgage arrangement then it is safe to assume that if you reduce your investment, thereby reducing your debt requirement, to say 60% loan to value then you could in theory negotiate a better rate. As you are borrowing less against a property this gives the lender more security against a fall in property prices.
It will obviously depend upon an individual’s circumstances as to whether this style of investment is applicable.
While these two examples are extremes, there are opportunities to utilise debt instruments to maximise your exposure and your potential profit. However, this potential reward does come at a price because a significant fall in property values and/or rental income may impact your ability to finance your debts. This then opens you up to a whole array of potential risks.
In reality you need to take a balanced approach to property investment and gearing, ensuring that you have a backup plan in the event that additional funds are required at relatively short notice.