Buy to Let – Could gearing accelerate your returns?

Buy to Let – Could gearing accelerate your returns?

Buy to Let GearingThere are lots of Buy to Let investors who would like to become full time landlords. The Q3 Landlords Panel Report from BDRC shows that 29% want letting to be their main source of income in the future. However, the report also shows that, in order to get to this point, many of them will need to add to their portfolio.

10 properties appears to be roughly the point when letting becomes a viable full time career. When a portfolio reaches 5 – 10 properties, the number of profitable, full time landlords more than doubles from 14% to 37% and for those with 11-19 properties, it jumps again, to 55%.

More than half of the UK’s landlords are not yet at the point of using buy to let as a viable full time job, but it could be possible in the right circumstances and with the right advice. It all depends on how much risk they are willing to take on.

Moving up a gear

Gearing is an investment term that refers to taking on debt in order to increase the potential of investment capital, and it could hold the key to a full time lettings business for some.

At a time when interest rates are low and rents remain healthy, gearing can significantly increase the returns available to Buy to Let investors, whilst enabling them to spread their capital over a greater number of properties.

As with any investment though, increased returns come in exchange for increased risk. Alerting landlords to the possibilities available to them, and suggesting the most effective strategies for balancing risks is where Buy to Let mortgage broking can come into its own.

Here are some key pointers to consider when it comes to considering whether gearing is the right approach for you.

Maximising the potential rental yield

Splitting an investment over multiple properties through Buy to Let mortgages has the potential to increase rental yield if done correctly. Since mortgage interest payments are tax deductible, it also increases the net rental income that a landlord receives.

Let’s start by taking the example of a landlord buying a property for £200,000 and charging rent of £1,000 a month:

If the landlord bought the property outright, the rental yield would be 6% (£12,000 / £200,000 x 100).

However, if the landlord geared up his or her investment, buying the same property using a mortgage of £150,000 at an interest rate of 4%, the rental yield would actually double – to 12%. The mortgage interest payments amount to £6,000 per year, reducing the rental income to £6,000, but the size of the required investment is reduced more significantly. The calculation becomes: £6,000 / £50,000 x 100.

We must also bear in mind that the £6,000 in mortgage interest is tax-deductible. Therefore, a higher rate (40%) income tax payer could save an additional £2,400 per year, further increasing their return on investment.

However, care must be taken as using gearing to expand a Buy to Let portfolio leaves landlords more vulnerable to both interest rate rises and void periods. It may be possible to use longer term fixed rate mortgages as one means of managing this risk. Building potential void periods into rental projections should also form an important part of financial planning and mitigating investment risk.

Capital appreciation on your buy to let investment

In addition to rental income, landlords can hope to generate capital appreciation from their properties when house prices increase and the total is multiplied by the number of properties in the portfolio. The risk, of course, is that house values can also go down, and in some circumstances, renting a property out may exacerbate depreciation.

The ability to maintain Buy to Let investments over a long period is an important consideration when it comes to balancing the risk of house price declines – and planning exit strategies well in advance is essential for realising full value from capital appreciation.

Spreading the risk

Several of the risks involved in gearing a Buy to Let investment can be offset by the act of expanding a portfolio itself. Larger portfolios provide greater flexibility, with the ability to sell underperforming properties and learn from the characteristics of better performing ones when it comes to replacing them. Stronger performing properties can also help to address shortfalls in any that don’t do as well.

Post courtesy of The Mortgage Works.