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It's no secret that leveraged property investment has been very lucrative in recent decades, but people have been made bankrupt as well, especially in 2008. I'm trying to get to grips with how people with larger portfolios sleep at night with lots of mortgage debt to their name.

Let's say I have one Buy-To-Let worth £200k with £150k debt against it and it's held in an SPV with a 20% personal guarantee (PG). The most I can lose personally is 20% of debt, so £30k. This isn't too scary, unless I've spent all my money it probably won't bankrupt me and it's not an insurmountable amount of money to rebuild.

Anyone hoping to grow big though is going to one day end up with much more debt than this, perhaps they will end up with 20 of the same property, worth a total of £4M with £3M debt and the same 20% PG. Now they are personally liable for up to £600k! That's a much scarier amount.

I can think of a few ways investors might justify these risks and I'd be interested to get your thoughts.

A) prices will never fall more than 25% and so negative equity will never occur, and if the property needs remortaging at this price (which won't be possible without putting new money in because of the new value) then it can be easily sold to cover the debt.

B ) before prices get anywhere near dropping by 25%, the government will step in to support the housing market

C) The investor has sufficient other assets to cover any insolvency in their property portfolio 

I get the impression that a lot of people are either not thinking about this risk or thinking of A and B. In my eyes at the moment, only C is really that safe. If the properties are held personally or with a larger PG, then much more is at risk. 

As an investor grows their portfolio, they might be under the impression that they are unstoppable, but if they keep up a mortgage LTV of 75% across their portfolio, they are no more safe against bankruptcy than someone with a single property, and in fact have more to lose.

Please let me know what you think, do you have a way to mitigate against these risks? Am I missing something? Thanks

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Not to worry you, but the PG would be 100% of the loan - if the house was somehow worth nothing, you'd still be liable for the full mortgage.

With that out of the way, how realistic are your examples? 2008 certainly shows that if you buy at the peak, you could find yourself in negative equity for quite a while - we've got a property that's still worth less than it originally sold for in 2007! Are we still on the same situation as 2007? Not currently for a number of reasons. Prices haven't reached those sorts of levels, yet, but mainly that credit is still nowhere near the same levels. Back then, you could have got a 90%+ mortgage easily and you'll still hear stories of same day mortgages for an increased value etc. We aren't anywhere near those levels of madness yet.

So is there a risk with a 75% mortgage? Probably. If you bought a £200k house and it almost immediately dropped by 30%, you're in negative equity. But is that a problem? The bank could in theory enforce any clauses about maximum 75% LTV, but that would mean they'd need to know the price had dropped that far and then what - they insist you pay them £10k to reduce the LTV, you refuse, they take the property back which is now worth less than the mortgage, have to sell it, have all the associated costs and then try and get any shortfall from you?! As long as you're making the mortgage payments, are they really going to think that's a good idea? 

And that last bit is the key. Negative equity is only an issue if you want to either sell or remortgage to improve the rates. As long as the property has a tenant who at least covers the mortgage and other costs, there's no need to do that and you can just ride it out.

The advantage of more properties is the reduced risks relating to voids. If you've got one property and no tenant, you're covering the mortgage, insurance, potentially service charge etc. If you've got ten properties and one is void, it's not a big issue. You can also have some unencumbered properties in a larger portfolio, so if needs must you can quickly sell to pay off a debt elsewhere.

Remember as well you don't need to use leverage or at least to levels that make you uncomfortable. You could buy a property for cash and then there's no risk, other than potentially losing some of the capital or you could save a bigger deposit and get a 65% LTV mortgage etc. 

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7 hours ago, Dino V said:

Not to worry you, but the PG would be 100% of the loan

Thanks for pointing that out. I have spoken to brokers who have told me 20-30% but not sure of the exact terms. If 100%, the concern is the same, just greater.

Back to the consideration of negative equity, thanks also for the rest of your reply. I like your emphasis on negative equity only being a problem if one needs to sell or remortgage. I suppose that by staggering mortgage terms you will never be remortgaging everything all at once either. Even so, the prospect of a prolonged downturn would still be alarming (it happened in Japan, and in parts of the UK, it could happen again). I guess this is why it's important to stress test at high interest rates, in case you end up stuck on a variable rate not being able to remortgage.

I also take your point about having unencumbered properties which I suppose falls into the category C) of the suggestions I gave in my original post. My reservation here, and also with having lower LTV across the portfolio, is that at reduces the yield of the portfolio as a whole. If an investor is buying property with a 7% ROI but backing each one up with an unencumbered property with ROI of 3%, then the overall return is 5%. My point being that the returns that make property so great only come with a large amount of leverage due to yields being so low in today's environment, so someone going down the road of property as their main investment vehicle would want those leveraged returns, otherwise why not just invest in stocks. (I'm also sceptical about future capital growth, as you can probably tell! But I acknowledge that can greatly boost total returns).

It seems like overall the point you're making is that negative equity is extremely unlikely to be a problem an investor actually has to deal with, but that there's not much one can do to actually protect themself against the remote possibility other than reducing leverage. Would you agree?

Anyone else have a view on this subject? Thanks.

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Overpay for any property and you risk negative equity. The closer to the top of the market you buy, the greater the risk. My last purchase was December 2020, so I could now take a fairly hefty correction just to get back to what we paid let alone into negative equity. That doesn't mean we wouldn't buy again now, but I'm not seeing the deals at the moment so need a bit of a slowdown to make it feel worthwhile. 

The yield depends where you're buying and how you calculate it. Working on gross yield, as simplest assuming no mortgage, I'd be looking for at least 6%, plus any capital growth. For areas with more dubious growth prospects, I'd want 8%. That makes it worthwhile doing, especially with leverage. Might need rents to rise a bit in most areas to get back to that.

Are the prospects better than a simple index fund? Maybe, maybe not. I don't choose, I invest in both as I feel that gives a more diversified portfolio. I'm also more interested in the rent than the capital growth as a future retirement income. Rent is therefore a bit smoother than stocks, so allows me to feel comfortable getting the income I'll want in times like now when the market is going through a correction. But that's where having a strategy aligned to your goals is important.

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Over the long term, property prices will always go up. That's pretty much a guaranteed fact because of inflation. Everything costs more as time goes by, including property, and that will continue to be the case as long as governments continue to print money. There will be dips/crashes along the way, but as long as you are always cashflow positive then you won't be forced to sell, so you can ride out the dip and wait for the market to go up again.

In 2008, the UK market dropped an average of just over 15% from peak to trough, so if you leverage at a sensible 75% LTV then it's unlikely you'll end up in negative equity. Of course some areas fell by much more, but even then, negative equity is only an issue if you are forced to sell. What caused issues back in 2008 was people over-leveraging with negative cashflow in real terms because they were speculating on growth. That's unsustainable and that's when they became forced sellers. When you think about it, that's basically what a crash is.....forced selling at scale. Nobody is going to sell a property for less than they paid unless they are forced to, so if you never put yourself in a position of being forced to sell then you'll be fine.

The key considerations when making any investment are:

1. Don't over-leverage (75% LTV is a sensible amount). 2. Always ensure positive cashflow (I mean real cashflow, after expenses, not just a headline yield that sounds good!). 3. Make sure you are investing for the long term, so you don't need to sell short term if market conditions change.

If you do all those things, you have nothing to worry about.

The final thing I would advise is don't invest in undesirable areas just to chase yields. Make sure there are basic fundamentals: jobs, transport links, and amenities. Areas that have high demand will be the ones that drop least and recover first when there's a crash because people will always need jobs and somewhere to live, so those will always be the safest investments, even if they don't have the very highest yields.

Chris (www.fintentional.co.uk)

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Thanks to you both for your further thoughts. The point about being forced to sell as the main risk to avoid is a good one and was not how I was looking at it previously, so thanks for bringing that to my attention.

I too value income above capital growth (you can see my scepticism on long-term future capital growth in this topic: Macro-economics and the risks to property investors - Interest rates - House prices ).

An 8% gross yield is usually about when I think the net returns starts to look particularly appealing, if you assume low capital growth. It also, in light of your points about good income meaning you can cover your costs even if interest rates rise, provides a good buffer to rising costs. You make a good point though, Chris, about avoiding areas without fundamental strengths, and that makes 8% nigh on impossible at the moment, at least for a basic residential BTL strategy.

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It's not as simple as just incomes and interest rates that affect affordability. I think the point that you haven't considered is the effects of inflation and quantitative easing. Since the start of 2020, average house prices have risen around 20% in the UK, but at the same time the money supply has risen by a similar amount due to QE through the pandemic. In simplistic terms, if the country as a collective now has 20% more money than we had two years ago, we can afford to pay 20% more for things (particularly big-ticket items like property). As I mentioned in my original post above, as long as governments continue to print money, prices will continue to go up. Another way of looking at this is not necessarily that property prices are going up, but that the real value of the currency has gone down so it doesn't afford as much, and that's effectively what inflation is.

One of the reasons why this continues to happen is that it benefits governments and policy-makers. The UK government debt is currently at its highest level since war time, however with interest rates low, the cost of servicing that debt is also relatively low. Increasing interest rates would therefore have a negative impact on the government and the cost of servicing their debt payments. At the same time, inflation benefits the government as it devalues currency (or devalues debt over time). While the BoE and government may pay lip service to combating inflation and increasing rates, I feel they are unlikely to do this aggressively because it wouldn't be in their best interest. As and when interest rates do rise, they can only do so slowly, otherwise it would be detrimental to economic growth, and no government wants that because it means they are unlikely to be re-elected in that scenario.

If you consider these effects of inflation and QE, the question then changes from whether or not you think property will continue to grow in value, but whether or not you think GBP (money) will continue to drop in value. When you frame the question this way, do you come to a different conclusion? Even in a scenario where all other variables remain constant so there is "zero growth", property would still be an asset that goes up in value with inflation, funded by debt (mortgage) that reduces in value with inflation, and produces an income (rent) that rises with inflation. So you are effectively winning in three directions.

When you look at where the historical returns of property investment have come from, it's the capital growth (with the help of leverage) that makes BTL such an appealing investment. Rental returns are a tiny fraction of the overall wealth generated. Without leverage, property wouldn't make sense as an asset class compared to stock market investing, which would have returned higher and for less work. Although leverage will benefit your rental returns too, the biggest benefit by far is on the growth returns, so I would argue that if you are not anticipating growth, you probably shouldn't be investing in property.

Ultimately, any investment strategy will depend on your goals. Of course it might feel safer to buy in cash and invest for rental returns, but if your goal is to generate a meaningful income, maybe to replace your salary as is common for many people, this is going to be very cash intensive. If you assumed a 5% net return, and wanted to replace an income of £50k, you would need to save up £1 million which is just unrealistic. Investing purely for cashflow at the expense of growth (unless you have lots of cash to invest, or a job/business generating lots of cash) is almost an acceptance that you will not achieve your financial goals. Therefore I would argue that it's safer to have a plan based upon assuming realistic levels of growth that make your goal achievable over the long term. It all depends on your situation, but for most people, it's far safer to invest for growth now and give themselves the opportunity of future success than invest purely for cashflow and accept that this is the best income they can achieve (without finding more cash to invest). Worst case scenario there's no growth and you're no worse off, but the upside is far higher, and history is in your favour.

Thanks for providing an interesting discussion topic, and I hope you found my input interesting too.

Chris (www.fintentional.co.uk)

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  • 3 weeks later...

Hi Chris,

Great post and some great insight, i like reading your posts, im at the stage of almost quitting my Job, me and my wife have built up a portfolio of 14 properties split evenly between us in our own names, our own house is mortgage free worth probably about 375 k and without going into figures the overall LTV on our portfolio is around 57%

im happy enough with the cashflow but it has the potential to be a lot more but my wife is a lot more Risk averse than me which i can understand too.

the biggest fear i have at the minute about quitting my job even though withe property income we are more than Financial Independent is and this sounds stupid what if Property income where to dissapear or some new technology or advances or government changes do away with buy to let income and no longer make it feasible, what would your answer be on that one

im trying to reassure myself with the old adage when people say " it's as safe as Houses"

Cheers

Barry

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Hi Barry,

I'm glad you enjoy reading my posts, thanks for the feedback, that's great to hear.

One of the great things that makes property such a sound investment is that housing is a basic fundamental human need. People will always need somewhere to live and that is never going to change. There is no possible technology or government changes that could stop people requiring homes to live in.

It's possible that where people want to live could change, but as long as you have bought in good areas with all the usual fundamentals that people want and need to be close to, you'll be fine. They could decide to increase taxes, but usually when a tax is increased you get less of whatever it is being taxed, so if increased taxes lead to less landlords, that's less choice for tenants which forces rents upwards.

Firstly consider that "retirement" can mean different things to different people. You don't have to stop work altogether. You could test the water by taking a mini-retirement or sabbatical if your employer is agreeable. You may stop doing the job you're doing now, but without the burden of needing to earn money, many people find alternative work that they enjoy and provides purpose or find meaningful, but also provides some income as a happy side effect. I personally retired from formal employment last year once I became financially free from my property portfolio, but I continue to work on a consultancy basis because I'm passionate about how property can benefit people's lives. Now I help people to build portfolios, achieve their goals, and start living the life they want. It provides me with an identity, a feeling of purpose, and of course makes an income. The key is to work out how you want to spend your time.

So much about taking the leap from employment into retirement is psychological. I know many people who reach their income goal only to increase it or put another self-made barrier in the way. Everyone has their own risk tolerance and that's fair enough, in fact, it's vital that you consider and mitigate all risks before making any big change. What I would advise is to consider how you would spend your time if you did quit your job? If you have something enjoyable or meaningful that you would like to be doing instead, then assuming you have enough income, it's really more of a risk to not quit your job as the longer you put off the things in life you enjoy, the less chance you have of ever getting to do them at all.

I hope that helps Barry!

Chris (www.fintentional.co.uk)

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Hi Chris and Barry,

Thanks for the interesting thoughts here and sorry I did not reply to your previous message sooner, Chris. My response may come across as contrarian, but I am just trying broaden the discussion.

I think I will always be sceptical about growth prospects while at the same time proceeding to invest with an expectation of some growth happening. By normal asset valuations methods (eg. using yield or net present value of future income), it is hard to imagine asset prices getting much higher in real terms without economic growth (see Antti Ilmanen's work for a good account of why). The only lever left to pull is loosening lending rules, but we know that is unlikely to end well. To counter this, I think the aging population is going to put pension pressure on asset prices, perhaps meaning yields settle at a lower level in the future.

As for quantitative easing, it's hard to argue that this doesn't have an inflationary effect on asset prices since a lot of it goes straight into the bond market. I see this as a different mechanism to general inflation though, which in the immediate term takes more money from people's pockets so they have less to spend on mortgage repayments. In the long term one might expect it to balance out and people's wages rise to match. You ask a good question, Chris, whether I would come to a different conclusion if asking whether GBP will drop in value. I think my answer here is "yes, eventually". What I don't know is whether the effects of inflation will filter through fast enough to counter any plunges in real asset values that might take place along the way. If I have an investment horizon of 40 years, it would be easy to say that over that time frame, inflation, wages, interest rates etc will all balance out, but it would be prudent to have a plan that will not bankrupt me at any point in those 40 years during a period which might for a while be unbalanced. That's why I'm focussed on mitigating this risk.

Beginning to take place now is a shift in policy making power from the baby-boomer generation to the millennial generation. The millennials look at the boomers and see that they have all the wealth, built over decades, largely by luck of the draw of falling interest rates and decent economic  growth. At some point we will likely see new policy makers orchestrate a means to redistribute that wealth between generations. I don't know how that can be achieved smoothly but can imagine it might involve engineering a decline in real house prices. Do you have any thoughts on how this might play out?

I am relatively early in my investment career, hence I am trying to identify these long term macro trends. Barry, I don't speak as someone in your fantastic position of having achieved financial independence, but my two cents would be that you should not put what you've already got at risk. It is standard practice for pension investments to de-risk as the investor approaches retirement and so I would apply this thought to a property portfolio as well. If you have enough income already, go and enjoy it. Don't put yourself in a position where you'll worry about it. I agree with Chris that housing is an essential need and so I personally don't worry about rental income vanishing (as long as the portfolio is somewhat diversified). What you might have guessed from reading my posts though is that I don't view the prosperity of the leveraged investor as an essential need and so we have to find a way to stay alive (avoid bankruptcy). The next few decades is quite likely to be different to the last few for investors of all kinds, and so I think a bit of caution on the leverage is prudent. How much LTV is 'safe'? I don't know, I started this discussion to try and help with that question. 

Lastly, I love Chris' point about the high risk option being not quitting your job, if you're already in a good position to do so. It's not a natural way to think, but I think there's a lot of sense in it when you weigh up life as a whole.

 

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Hi Tuk,

One thing I think we all agree on is that enjoying life is the most important thing. Money and investments are just a vehicle to help us afford the things we need and desire. If Barry (or anyone else reading) has enough income from their investments to "retire" and enjoy doing the things they want to do, then I really believe that is exactly what they should do. The only guarantee in life is death (sorry for sounding morbid!) so it's vitally important that we all enjoy the time we have, and the risk of dying before you've had chance to enjoy the things you want to do in life is the biggest risk of all.

I also think we are agreed that you should always invest in a safe and sensible way that minimises and mitigates risk of bankruptcy. Your initial question was to establish what amount of leverage is "safe". Given that property values always have (and always will) go up over the long-term for all the reasons we have discussed, it is important to ensure that you are never in the position of being a forced seller in the short term. This is the key factor to mitigating risk. Even if prices go down on paper in the short term, they will always recover and go up again in the long term and you will continue to receive an income in the meantime, so if you can establish some short term security and have long term goals you'll be fine. I believe that 75% LTV is a safe amount to leverage and would be recommending 5-year mortgage fixes, as rates are likely to be higher in 2 years than they are now, and 5 years gives you plenty of security and certainty of costs. When you come to refinance in 5 years, you are likely to have much more equity from the growth over that time so you'll be needing a lower LTV (which will be cheaper). It's also likely that rental income will be higher in 5 years, given that rents consistently go up roughly in line with inflation. Also remember that interest rates are slowly increasing now because inflation (and therefore property price growth) is high. However, if there were to be a market crash, rates would be cut again (just like they were back in 2008).

Normal asset valuation metrics (yields etc) are not the only consideration when valuing property. It works for valuing businesses in the stock market because they are bought purely for investment purposes and making money. However, property is not only an investment or asset class, it is people's homes, so it's more nuanced. Shortage of supply and competition from buyers who want and need somewhere to live will also have upward pressure on prices. This is an important distinction because when a crash eventually comes, it's the higher yielding properties that only have demand as an investment that will fall hardest, whereas the properties with high owner-occupier demand will hold their value best and recover first. We saw this in 2008, as even in a crash, people still need somewhere to live and want to live in the nicest home they can. It's therefore vital to recognise that not all properties are made equal and to invest in properties with real life fundamentals, not just a strong yield on paper.

Nobody knows what political changes could happen to influence the market in future, so this is something that you just have to react to as and when and if it comes. If you worry about hypothetical challenges then this can lead to inaction, and taking no action at all is a far bigger risk in my opinion. In fact, inaction is a guarantee that your situation won't improve, and when factoring inflation, that by default means that you are accepting your situation getting worse.

Unless you are already at the point of financial freedom, we all need to invest in something, not only to try to grow our wealth, but even just to maintain it and keep up with inflation. If you don't invest at all and just hold cash, you will be losing money in real terms. Whatever you believe the current causes of inflation and cost of living to be, it's clearly the case that the price of everything is rising sharply right now. Therefore the only way to protect our finances from this is to invest in assets that benefit from inflation. I don't believe property investment to be a get rich quick scheme, but I am strongly of the opinion that it is the best (and safest) option for wealth building over the long term.

Ultimately, I think your approach of continuing to invest with an expectation of growth happening but also with some caution and focus on risk mitigation is a sensible one. Nobody knows for certain what the future holds but I find it interesting to hear all perspectives and ultimately hope that this conversation benefits lots of aspiring property investors!

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