Hi, Peter Jones, author, property investor and ex-chartered surveyor.
In a previous video, I showed you five reasons why I think the buy to let is a fantastic investment. And in this video, I want to give you an extra bonus reason which I think is so important I want to do this one on its own in its own video, and that is it allows you to use gearing.
What’s gearing? Well, nowadays we call it leverage. Leverage is the American term but the UK term is gearing. And gearing when is when you can increase the amount that you spend or you can increase the return on your own money by using other people’s money by using borrowed money. The usual way we do that in buy to let is to use a buy to let mortgage.
So what does that mean? Well, it means, first of all, you don’t have to save up the whole price of a property. So for example if properties in your investment area are £100 thousand or £150 thousand you don’t have to spend the whole of your life saving every spare penny to hopefully be able to buy a property in 50 years time when you’ve saved up any spare change that you have because you can use gearing. You can use a relatively small amount of money to be able to borrow a larger amount of money and buy a more expensive property.
In our world, for example, if you’re going to buy a £100 thousand property, a typical buy to let mortgage is 75% LTV which means you only have to put in £25 thousand so if you have to do any savings at all you only need to save a quarter of the price of the property. But it’s even better than that because when you look at the figures you’ll see that by using borrowed money you actually greatly increase the returns on the money that you put in.
To illustrate this point I’m actually going to use some figures and I can jump onto the computor.
So, let’s assume you buy a nice little buy to let in your investment area, and I’ve got a picture up there of some terraced houses.
It doesn’t have to be terraced houses, don’t worry about the type of property, I just want to show you the principle. And similarly don’t get too hung up on the maths, I’m using a very simple example but again it’s just the principle that I want to show you.
Now let’s assume that you buy the terraced house all for cash. Somehow or other you have managed to save, and you’ve saved up £100 thousand, and you’ve bought the property. And this particular type of property lets out in your investment area at £650 a month which is £7,800 per annum, or per year. The return on your own investment, the return on you £100 thousand is going to be £7,800 divided by £100 thousand x 100, that’s the mathematical formula for working it out which gives us a return of 7.8%. All very easy. You’re going to make 7.8% on your money if you buy the property fully for cash.
So let’s have a look at buying the same property but this time we’re going to use a mortgage so the purchase price is a £100 thousand but this time we’re getting a buy to let mortgage with a 75% loan to value which means we can borrow £75 thousand but we have to put in the difference. We colloquially call it the deposit and we have to put in £25 thousand. The rent is the same, £650 a month or £7,800 per annum, but this time we’re going to have mortgage payments and let’s assume that our mortgage is costing us 3.5% per annum for a year which is a fairly typical rate at the time of recording this video, and that’s equivalent of £218.75 per month or if we look at it as an annual figure, if we add up all the £218 per month over the course of the year, it means that we pay out £2,625 a year.
If we deduct the mortgage payments from the rent we’ll get what we could call a “Net” Rent. Now I’ve put “Net” in inverted commas there because it’s not net in the sense of net of tax or net of all costs it’s really just net of mortgage. And for our purposes that’s really all I want because I just want to illustrate the point as I say. Our net rent is going to be £5,175 per annum.
So, what’s the return on our money investor going to be? Well, the formula this time is £5,175, the net rent after deducting the mortgage, divided by the amount of money which we put in. Now, this time we didn’t put in £100 thousand, we only put in the deposit, as we call it, of £25 thousand times the usual 100 gives us a net return on our own money invested of 20.7%. Interesting.
But of course, the return from the rent is only one of the returns we can expect from our property.
At the time of recording this video, despite all the calamity in the world, the UK property market has just been through something of a bit of a boom so at times we do see increases in capital value. And let’s assume that in our first year of owning the property the value of the property goes up by 5%.
What is the return to us then?
Well, if the property increases by 5% over one year our non-geared return is very easy to work out, because we know that 5% of the value £100 thousand is £5 thousand so the return is going to be 5%. So our non-geared return in terms of the capital growth in terms of the increase in value is 5%.
But what about for our geared return?
Well remember we’ve only put £25 thousand in but we’re still going to benefit from the extra £5 thousand in additional value because after the 5% increase in values the property is going to be worth £105 thousand that extra £5 thousand is ours. So we can work out our return on the capital increase using our geared formula which is £5 thousand divided by £25 thousand x 100 which means the geared return which we get from borrowing money to buy the property is going to be 20%. 15% more than if we just bought the property for cash.
So let’s add all of this together and see how the two different scenarios compare. If we buy the property for cash with no gearing, with no leverage, with no borrowing then we’ve seen the return on the rent is going to be 7.8%. The return on the capital value the return on the increase in value over the first year is going to be 5% giving us a total return of 12.8%.
Okay that’s much, much better than we’re going to get in the bank but just look at the difference when we borrow the money to buy the property, because the return on the rent is 20.7%, the return from the increase in value or the capital value is 20% giving us a total of 40.7% substantially more than if we just bought the property for cash.
And this is why even if you can buy a property for cash I always say that you shouldn’t. It’d be much better for example if you had the £100 thousand to spilt it into 4 deposits and buy 4 properties each worth £100 thousand to get the extra return on your money.
So I hope you can see from the example just how powerful using gearing is and I think this is something which a lot of people don’t understand. The converse of this is, and this isn’t the time to discuss this in this video, is when somebody says to me I want to pay off my mortgage. Well why would you want to pay off your mortgage when you can actually take the payments which you’d use to pay off a mortgage and then roll them into another property and benefit from the gearing.
I hope you found this video useful and informative, and if you did then please come over to my website www.thepropertyteacher.co.uk where you’ll find loads more great property-related resources including free special reports to download and my best-selling series of e-books which includes The Successful Property Renovators Workshop, 63 Common Defects In Investment Property And How To Spot Them, and if you’re just starting out in property or you want to grow your portfolio you may be particularly interested in The Successful Property Investors Strategy Workshop in which I’ll take you through exactly how I started and built my property portfolio starting literally with none of my own money, and how I built a portfolio of £2 million worth of property in just four years, that was starting from scratch.
I’ll take you through everything that I did right so that you can copy me and do the same, and I’ll also show you everything that I did wrong so that you can avoid the mistakes that I made and so that you can progress in property and be far more successful, far more quickly than I ever was.
And this is based upon my own real-life experience, and it took me about four years to actually work out how to do property investing properly, but in the 200 pages in The Successful Property Investors Strategy Workshop, I’m going to show you all that four years knowledge condensed down so you can use it immediately.
And until next time,
Here’s to successful property investing.
(ex) Chartered Surveyor, author and property investor
PS. By the way, I’ve rewritten and updated my best-selling e-book, The Successful Property Investor’s Strategy Workshop, which is an account of how I put together my multi-property portfolio, starting from scratch and with no money of my own, and how you can do the same.
For more details please go to: