by Rob Dix
In theory, if everything goes perfectly, six-month projects like this could be run back-to-back – allowing two to be completed per year. That would give the company £32,000 in post-tax profit, although, like with any company, there may be additional tax to pay when taking money out as a wage or as dividends.
So, ready to quit your job right now and start trading? I wouldn’t recommend it – because even for people who are highly experienced, it’s never the case that everything goes perfectly. If you end up with a property where everything goes wrong and you only break even, or which you can’t sell at all and are stuck with, you’re stuffed: your cash is tied up and you don’t have enough money to pay the bills.
A more sensible approach would be to keep your job temporarily, and do some flips on the side to start with. If you can execute three successful flips like the one we’ve just been through, you’ve pretty much doubled your money – leaving the company with £48,000 post-tax to add to your original £50,000.
At that point (which could be less than two years away), you’ll then have nearly £100,000 with which to kick off your career as a full-time flipper – meaning you can either run two projects at once, or (with a greater concentration of risk) trade in properties that are twice as expensive so you make twice as much profit for the same amount of effort.
Of course, if you have more cash to start with – or the contacts who are willing to lend you more money – you can be full-time from the start. But the point is that once you start living off your profits instead of re-investing them, you’re more personally vulnerable to things going wrong: a house that takes twice as long as expected to sell isn’t just annoyingly slowing down your plans – it’s potentially affecting your ability to meet your personal financial obligations.
Lessons
The trading model is pretty simple, but that doesn’t necessarily make it easy. Executing this successfully involves:
Identifying the opportunities
Arranging finance
Acquiring the properties
Correctly estimating the costs
Running an on-time and on-budget refurbishment project (either by doing the work yourself or managing a team of contractors)
Presenting the property correctly so that it sells at the price you need within the desired timeframe
… All while simultaneously looking out for the next one, so you can get started as soon as the cash comes back into your bank account. This only emphasises the point I made in the previous model: that rapid profits need to be earned through hard work or hard-won knowledge.
So it requires a fair bit of effort and successful execution, but as a means of escaping your job and getting full-time into property in a couple of years with only a modest amount of capital? It’s not for everyone, but for the right kind of person it’s likely to be a much more enjoyable way of making a living.
Conclusion
Excited? You should be – because although we’ve only looked at a few of the many possible strategies out there, you should be seeing how there’s an approach to suit every goal, timescale, budget and skill set.
It’s nearly time to move on to Part 2 and put the theory into action, so let’s just quickly recap some of the general themes that we’ve encountered while looking at these strategies.
The tighter the timescale to reach your goal or the smaller the amount of money you can put in at the start, the more hands-on you’ll need to be, and the less certain you can be of getting your result. For example, if you’re trying to generate immediate cash through trading property (Strategy 5) you’ll have to work hard and there’s a lot more that can go wrong than if you’re just buying and collecting the rent over the years (Strategy 1). Appreciating this and understanding your constraints in these areas is the key to setting realistic goals.
Each example I gave started with an investment of at least £25,000 – so what do you do if you have less than that? The obvious answer would be to save up, but you could also team up with a friend or family member who has the money. Later in the book we’ll look at how to correctly structure a joint venture like this.
What you buy and where you buy has a large impact on the relative contributions that rental income and capital growth make to your total returns. You can target investments that produce a strong rental return if that’s your preference, or instead target those that are most likely to benefit from strong capital growth – and there will always be some degree of compromise. You’ll continue to notice this as you start researching your own options in more detail.
All the strategies described in this chapter involve very different skills, preferences and attitudes to risk. Coming up with your own plan is a matter of finding a strategy that matches not only your goals, but your personality too: there’s no point working out a brilliant plan that involves flipping a house every six months if you work 18 hours per day in the City and have absolutely no interest in construction projects. Finding the sweet spot that matches up all these different factors isn’t easy, but it’s worth the effort of getting it right.
At the heart of choosing the right strategy, as we’ve seen, is setting an appropriate goal. As part of the free “extras” for this book, I share the spreadsheet I use to set my own goals – and talk you through my annual goal-setting exercise. It’s totally free – all you need to do is sign up at propertygeek.net/extra.
So, there you go – we’ve given a lot of thought to the final destination, which was vital to do before setting off. Between here and there, there’s much to be done – starting with lining up the finance and finding a property to buy, and progressing all the way through the acquisition process to management and beyond. It’s a lot of work, but it’s (mostly) all good fun too – and Part 2 will cover all of it in detail.
PART 2:
THE INVESTMENT PROCESS
With your strategy in place, we can turn to the mechanics of property investment: getting financing, deciding where to buy, analysing potential opportunities, then following the process all the way through to either management or sale. As a special treat, we can even talk about tax for a bit.
I wouldn’t describe the process as “easy”, because there’s a lot to it and there are plenty of potential setbacks, but there’s no one particular aspect where you need to be a genius. You’ll find different parts of the process challenging depending on your strengths and weaknesses: some people really struggle to find good opportunities, others get bogged down in the research, and many find the management and record keeping to be a real chore.
Whatever your particular abilities though, this whole process becomes easier once you’ve got a strategy in place. For a start, it answers a lot of questions about the type of property you should be looking for – and therefore removes a good deal of uncertainty. It will also keep you motivated, because you’ll know how worthwhile it will be once you’ve achieved your goals.
So, let’s dive in – starting with the all-important financing of your investment…
Chapter 6
Finance
When I was in my teens and early twenties, I’d always read the “Money” section of the newspaper at the weekends. I couldn’t get enough of anything to do with dividends, savings and interest rates… but I was never able to muster up any excitement for the (seemingly endless) articles about mortgages.
In truth, I don’t think I fully understood what they were – I just knew they were scary, and that adults seemed to spend disproportionate amounts of time stressing out about them. I remember repeatedly thinking, “I’m never going to have one of those… I’ll just wait until I have enough money of my own to buy a house outright.”
Fast-forward a decade and, much like my “This Twitter lark seems like a silly fad” prediction of 2007, I turned out to be spectacularly wrong. I now have a number of mortgages – far more than the average “normal” person. Even more strangely, I actually find the whole business of finance totally fascinating.
Your view of debt is probably less warped
than mine used to be, but you’re still likely to have all sorts of hang-ups and uncertainties around mortgage lending (and its alternatives). This chapter is here to help.
By making this the first chapter of Part 2, I seem to be suggesting that you should consider how to fund a purchase before you even go out looking for something you might want to buy – why is that?
It’s a common newbie mistake to rush out and look at properties, only to have to back out of a deal later because you can’t borrow as much as you thought you could. It’s a waste of your time, and it destroys your credibility with the estate agent you were dealing with. That’s why I recommend understanding the basic factors that influence lending and looking into your options before you begin.
Focusing on finance first will give you (justified) confidence that you’ll be able to go ahead when you find something suitable. It will also give you as much time as possible to address any factors that might restrict your ability to take on borrowing.
We’ll start with the most basic question of all: if you have a decent amount of cash saved up, should you take out a mortgage at all?
Should you get a mortgage?
Say you have £50,000 sitting in your bank account. Should you buy one small terraced house in the cheapest part of town with that cash, or take out a mortgage to buy two bigger and more desirable houses for £100,000 each?
Answer: the latter. Almost always.
To explain why, let’s say property prices go up by 10%. In the first scenario your portfolio has increased in value by £5,000, and in the second the value has increased by £20,000 – even though your own cash investment is the same. After a 10% increase in prices, you could theoretically sell both houses immediately and bank a 40% return on your investment (the £20,000 gain divided by your £50,000 cash input) – ignoring transaction fees and so forth.
That’s leverage. As this simple example shows, it’s exceptionally powerful – and it should be treated with the caution it deserves.
There are two dangers to be mindful of. First of all, leverage works against you when prices fall: if property values had dropped by 10% in our example, you would have lost 40% of your investment. This is only an issue, however, if you’re forced to sell at that point. If you can ride out the dip and wait for prices to pick up again, you’re all good. How do you make sure you can ride out the dips? By protecting your cashflow at all costs. If a property is making a profit, you should be able to hold on to it forever, through good times and bad.
However, the second danger is that having a mortgage decreases your cashflow (compared to if you bought with cash), because you have an extra cost to contend with: the cost of repaying the mortgage. This is why it’s dangerous to be over-leveraged: if you have huge borrowings and interest rates go up (thus increasing your monthly payments), you could be stuck in a situation where the property is costing you money every month. If you run out of ability to subsidise the property at the same time as prices have just collapsed and you can’t sell it for a high enough price to repay the mortgage… bad news. Like, “bankruptcy” bad.
(In Part 3 we’ll look at property crashes and how to ensure you have a sufficient safety margin to survive in almost any circumstances.)
Despite the dangers, using leverage responsibly will still do wonderful things for your long-term returns. Unless your personal situation is such that you wouldn’t be comfortable with any kind of debt, it’s something you should strongly consider.
Deciding on interest only vs capital repayment
When taking out a mortgage on a buy-to-let property, you’ll be able to choose between repaying a small amount of the loan each month until you owe nothing at the end of the mortgage term (a “capital repayment” loan), or just paying off the interest each month so that at the end of the term you still owe exactly as much as you borrowed in the first place (an “interest only” loan).
If you’re not overly comfortable with debt, capital repayment will seem like the “safe” choice. But I’m going to try to convince you that “interest only” is actually safer.
Why? Because if you’re repaying a chunk of the capital each month, it means your monthly payments will be higher and your cashflow will therefore be lower. And, as we’ve already seen, the real danger is that you’re stuck in a position where prices have crashed and the property is making a loss (because your rental income doesn’t cover your expenses).
Paying off just the interest gives you more income each month. Yes, you need to find the money to repay the mortgage in the distant future when you’re unable to extend the loan term any further – but you’ll get a major helping hand from inflation.
Inflation is an extremely powerful force, but it’s easy to miss because, year to year, it’s barely noticeable. Over a 25-year mortgage term though, its effect is huge. Let’s say you borrow £75,000 today (to buy a house worth £100,000) and pay off nothing but the interest. Assuming annual inflation of just 2%, its “real value” by the time you pay it back in 25 years will be only £45,000. At the same time, let’s assume house prices increase by 2% per year too – so the house you bought for £100,000 will be worth £164,000 in 25 years.
As a result, even though you haven’t paid off a penny of the amount you borrowed, your loan-to-value proportion has dropped from 75% to 27%. Looked at like that, paying off your mortgage in the future seems a much less scary prospect.
Still uncomfortable with the idea? Here’s the point that most people miss: having an interest-only loan doesn’t mean you can’t repay chunks of the capital if you want to. Yes, fixed-rate deals (to be explained shortly) will have an initial period when you’re penalised for overpaying, but after a while (when the fixed-rate period ends or you remortgage) you’ll be free to pay off capital at will.
That’s truly the best of both worlds. Benefit from the extra monthly cashflow with an interest-only deal, let the cash build up in the bank, then you can decide to use those savings to pay off capital or not – depending on what seems like the best idea at the time. All you’re doing is giving yourself more flexibility, because you’re not locked into a set repayment schedule.
Making use of equity in your home
Many people get started in property investment by extending their residential mortgage and releasing equity that’s built up in their own home. They then use the money to put down a deposit on a property, or even buy it outright.
It’s common, but not for everyone: if you’ve dreamed for years of finally paying off your mortgage completely, you might not appreciate the idea of ramping it up again to buy more property. Whether you want to bring your own home into play is a completely personal decision for you (and your partner). But if you do, there are a few things to keep in mind.
Firstly, yes, it’s possible. Lenders vary, but most won’t be fazed if you say you want the money to buy another property. The amount you can borrow will be determined by two things:
The value of your home. With residential mortgages, you’ll often be able to borrow around 90% of the property’s value – which is more relaxed than buy-to-let where (as we’ll see in a minute) the maximum “loan-to-value” is usually around 80%.
Your income – because residential mortgages are offered as a multiple of your salary. Again, this is different from buy-to-let mortgages where (as we’ll see) your income is only a small factor, and the amount they’ll lend is based on the rental income the property can generate.
So let’s say you have a home worth £500,000, of which you have £100,000 still outstanding on the mortgage. Based on its value, a lender might allow you to borrow up to £450,000 (90% of its value). But they might also cap the amount they’ll lend at 5x your income. If you earn a salary of £50,000, that would cap your borrowing at £250,000. So in this case, as your loan is already £100,000, you’d be allowed to borrow an extra £150,000.
The obvious upside of extending the borrowing on your own home is that you can use the cash you release as a deposit on a new property, allowing you to buy even
if you don’t have any savings to put in. You’ll also find that the interest rate you’ll pay on a residential mortgage is generally lower than on a buy-to-let loan. The disadvantage is that pretty much all new residential loans are going to be on a capital repayment basis. This means that £100,000 borrowed against your own home might have a lower interest rate than the same amount borrowed against a buy-to-let property, but your monthly repayments might end up being higher because you have no choice but to pay off the capital as well as the interest.
Something else to bear in mind: if you release equity from your home to serve as a deposit, and then use a buy-to-let mortgage to fund the rest of the purchase, the property you’re buying is effectively 100% mortgaged. That’s fine, but it means you’ll need to consider both sets of payments when calculating whether the deal stacks up – and it’ll therefore be more challenging to find purchases that will make you a monthly profit.
How much can you borrow?
The amount you can borrow on a buy-to-let property is determined by both its value and the rental income it brings in. Your own circumstances aren’t irrelevant, but the lender is far more interested in the property than they are in you:
They want to be sure of its value because if they need to repossess, they’ll sell it to get their money back.
They want to know its income-generating potential to be sure that the investment will be self-financing (so you can meet your repayments regardless of what else is going on in your financial life).
The maximum loan-to-value (the proportion of a property’s value that you can borrow) on a buy-to-let loan at the moment is 85%, and the most typical level is 75%. So if you want to buy a property for £100,000, you’ll need to put down a £25,000 deposit from your own funds and they’ll lend you the rest. Of course, you can always borrow lower amounts – and as you get down to 60% loan-to-value and below, the interest rates often decrease.