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Boosting your property profits with debt

INVESTMENT GUIDE: Getting the right finance will make a huge difference to the performance of your property investments
May 23, 2008

A property is one of the most expensive purchases you'll ever make, so the prospect of doing it several times over as an investment can be a daunting one. But it's worth taking the time to get the financing right, because the way you approach the funding of your investment will make a big difference to how successful it is.

As with many areas of the financial services industry, the mortgage market is filled with jargon and can be off-putting. Avoiding the whole thing altogether by investing on a small scale and buying your properties for cash is a tempting option. There are plenty of attractions – you'll have no big debt pile to worry about and no monthly mortgage payments to meet. So if the property is empty for a while, there's no major worry. You'll also avoid paying mortgage arrangement fees. And by not taking out a loan, you'll ensure that all the rent comes directly to you, so if you're looking for a regular income stream it can be an attractive way to do things. If you've borrowed money to buy the property, the interest payments will usually take up all of your rental income and possibly more.

Why borrowing makes sense

But if you're looking to invest in property as a route to capital growth, refusing to take out debt (or in the jargon, refusing to leverage your property) might be a big mistake. "It's the leverage you get on the property that makes it an attractive investment," says Lee Grandin, managing director of mortgage broker Landlord Mortgages. "The landlord makes money by borrowing money."

Consider this example from the Association of Residential Letting Agents (ARLA). Imagine that you're interested in buying a property that costs £326,098 with a view to renting it out. The property comes with a rental stream of £16,548, or 5.07 per cent of the purchase price. Imagine that you intend to keep it for five years, and that in that time the property market grows by 8.7 per cent each year and the rent grows by 2 per cent a year.

If you buy the property outright with cash, then the total return after five years (counting both rental income and capital growth) works out at an average of 11.1 per cent a year. However, if you take out a mortgage for 75 per cent of the value, and provide the rest of the money yourself, then the return rises to 21.68 per cent a year – more than double the return that would be made on a debt-free investment.

That's because, by borrowing, you're making your money work a lot harder. In the first of the examples above, you need £326,000 to benefit from all the gain on a £326,000 house. In the second, you only need £88,000 to benefit from the same scale of gain, so the percentage profit is much higher. While its true that by borrowing you'll reduce (or even eliminate) your rental income, the potential gain from rising prices is much higher.

There are other advantages to borrowing, too. First, you can build up a bigger portfolio. By putting less into each property, the money you have available can stretch to more properties. That provides some security if there are problems with one of them, such as a period when the property is empty.

You'll also end up paying less in tax because interest payments can be offset against your tax bill. For higher-rate taxpayers, the difference can be significant. In the ARLA example above, the investor who borrowed nothing earns £93,914 in rental income over five years. A higher-rate taxpayer would have to pay £37,566 of that to the chancellor in tax. The investor who borrowed money would see all of the rental income offset by the expense of the interest payment, so there would be no tax to pay.

Finding a mortgage

The next question, then, is where to find your mortgage. The market has developed significantly since buy-to-let mortgages were introduced 10 years ago, and that growth has accelerated in recent years.

Much of that growth has come from the entry of the high-street banks into the market. However, although the big banks are present in the market, the building societies often have better buy-to-let mortgage deals. Cheltenham & Gloucester, Bradford & Bingley and Portman are particularly active. The advantage of using a well-known name is that you may already be familiar to them as a customer, and the branch networks mean that you can usually see their advisers close to your home.

There are also lenders that specialise in the property investment market. They include Paragon and The Business Mortgage Company (TBMC). "By coming to a specialist, you'll be coming to a lender who understands business needs," says Nigel Terrington, chief executive of Paragon. "We're a business finance provider. We send our surveyors along who know about rental demand in the area. You're not going to have that discussion with a high-street bank." Specialists might also be more flexible than the high-street lenders when it comes to unusual properties, such as properties with multiple occupancy.

Alternatively, you could make your decision easier by consulting an adviser. They include regular independent financial advisers (IFAs) as well as specialist brokers such as Landlord Mortgages and London & Country. The advantage of these organisations is that they should have an in-depth knowledge of everything that is available on the market, which will save you from doing the legwork. They will also have experience of using all the lenders, so will have a view on the strengths and weaknesses of each one.

Most importantly, the brokers can sometimes offer better rates than are available direct. If the brokers push a lot of business towards a certain lender, that lender might respond by offering better rates to the broker's customers. "One of the main benefits of a broker is pricing," says Mr Grandin. "The rates for a broker are substantially lower. We talk to the lenders about innovations, and come up with excellent schemes, often on a trial basis."

In theory, it's a win-win situation. But it's worth exercising some caution. A broker or intermediary might push you towards a favoured lender, but that lender is not necessarily right for you. Lenders might look to recoup the lower rates on offer by pushing up charges in other parts of the mortgages, so if a deal looks too good to be true, it probably is.

Finally, if you're thinking of investing overseas you'll have to look to local markets in the country in which you're investing. UK lenders are unlikely to want to touch overseas properties as the loans can be difficult to chase. However, they might have overseas subsidiaries that can serve UK investors.

Unlike UK buy-to-let lenders, who focus on the property itself, overseas lenders are likely to put more weight on the borrower's personal financial circumstances when considering a loan. They might also offer different features from those that are available in the UK, such as long-term fixed rates. The other decision you'll have to make is the currency in which you want to take the loan. If you're anticipating renting the property to locals, it's worth taking the loan in the local currency. If you're buying it for your own use or to rent to other UK residents, it might be better to remove currency risk by taking the loan in sterling. Once again, using a specialist international broker, such as Conti Financial Services, might be worthwhile.

The devil's in the detail

Essentially, buy-to-let mortgages are very similar to standard residential mortgages. Affordability is important, as are rates, fees and flexibility.

But there are some important differences. First, buy-to-let mortgages are almost always interest only. This not only minimises the monthly mortgage payment (offering the borrower the chance of some income from the property), but it is also tax efficient. Interest payments on a buy-to-let property can be offset against income tax, but repayments of the capital value of the loan cannot.

On a standard repayment mortgage, most of the monthly payments in the early years pay off the interest, so they can be offset against income tax. But as the mortgage matures, more of the monthly payment is used to pay down the capital, with progressively less used to pay interest. That reduces the amount of the payment that can be offset.

The next difference is the way in which the lender will assess how much you can borrow. In a residential mortgage, it's all about your ability to pay. Salary multiples are usually the key metric. But in a buy-to-let mortgage, it's all about the property's ability to pay its own way. This is usually based on how much the rental payments will cover the mortgage payments. Most lenders will expect the monthly rental payment to be 120 per cent to 130 per cent of the monthly mortgage payment, although in some rare instances they might consider cover of just 100 per cent. It's a big change on the situation two years ago, when lenders expected interest cover of 150 to 160 per cent.

Lenders will also consider the type of tenant you're expecting to have in your property. Rents paid by large companies will be seen as secure, so lenders will be happier to lend – and at a lower rate – than they would if the prospective tenants are students or local housing associations.

Interest rates and fees on buy-to-let mortgages are also changing. "You used to pay a premium for buy-to-let as people cared less about their second property than they did about their first," says Lisa Taylor of Moneyfacts, a mortgage comparison website. "But rates are being driven down as more companies go into the market, and more investors come in."

It's also worth looking at the other conditions of the mortgages. Periods when the property is empty (or void periods in the industry jargon) are common, especially in the residential market. Some mortgages allow payment holidays during void periods, but often only if there have been overpayments in advance. Other flexible options include lump-sum overpayments or withdrawals, and drawdown facilities.

Commercial options

If you're considering buying a commercial property, such as a shop or office development, mortgages are more complex. "The commercial mortgage market is very restrictive," complains Mr Grandin. "It needs some innovation to make it more attractive".

At present, commercial mortgages are organised individually for each property. There are few set products as there are in the residential market. Lenders will consider the type, location and condition of the property, the rental stream, the possibility of rent reviews, the quality of the tenant, the length of the lease and the status of the borrower. All of these factors will be used to set the interest rate, which is usually expressed as percentage above Libor (the London Interbank Offered Rate). For a very secure tenant, lenders might charge 0.5 to 0.8 percentage points over Libor. For a small local tenant, or one on a short lease, the premium could rise to as much as 2 percentage points over Libor.

A selection of Buy-to-let lenders

• Bank of Ireland Mortgages - Tel: 0118 968 4400, www.bim-online.co.uk

• Bradford & Bingley - Tel: 0800 113 333, www.bradford-bingley.co.uk/mortgages

• Birmingham Midshires - www.askbm.co.uk/mortgages/buytolet

• Cheltenham and Gloucester - Tel: 0800 028 0639, www.cheltglos.co.uk/mortgages.html

• Chesham - Tel 08000 684 784, www.cheshambsoc.co.uk

• Heritable Bank - www.heritable.co.uk

• John Charcol - Tel: 0800 718191, www.johncharcol.co.uk

• Landlord Mortgages - www.lml.co.uk

• London & Country - Tel 0800 953 0304, www.lcplc.co.uk

• Moneyfacts - www.moneyfacts.co.uk

• Mortgage Express - Tel: 0500 11 11 30, www.mortgage-express.co.uk

• NatWest Mortgage Services - Tel: 0845 702 3845, www.natwest.com

• Paragon Mortgages - Tel: 0800 375 777, www.paragon-mortgages.co.uk

• Portman (now merged with Nationwide) - www.nationwide.co.uk

• Saffron BS - Tel 0800 072 1100, www.saffronbs.co.uk/mortgages/buy-to-let.mortgages.php

• The Business Mortgage Company (for investment professionals only) - www.tbmc.co.uk

• The Mortgage Business Company (for investment professionals only) - www.t-m-b.co.uk

• West Bromwich - Tel: 0845 456 7511, www.westbrom.co.uk/westbrom/mortgages