by Rob Dix
So, I hope by now you’re a believer in the wonders of the property cycle. You don’t have to scrap “buy and hold” and start timing the market instead – although you can if you want to. Even if you just stick to the very basics, you’ll do very nicely indeed.
As I said, the most fundamental lesson of all is to be aware that it’s an inevitability that a crash will happen at some point. That’s why I’ve dedicated the next chapter to making sure you’re able to survive it – because after all, there’s no point in going to all the trouble of building up a property portfolio just to lose it when the economy takes a turn for the worse.
Chapter 17
Surviving a property crash
Most people are terrified of falling house prices – but as we now know from the property cycle, it’s inevitable that prices will slump at certain points. If you’re holding for the long term, it doesn’t matter all that much – as long as you’re able to hang on until they pick up again.
Preparing for a crash, then, involves putting your portfolio into a position where you won’t be forced to sell, and can calmly ride things out until the inevitable recovery arrives. Let’s look at how to do just that.
Why do investors go bust?
To know how to structure your portfolio to survive a crash, it helps to understand the sequence of events that leads to a property investor “going under”:
The portfolio is in a “negative cashflow” situation, meaning that rents don’t cover expenses and the investor must subsidise the portfolio with cash from elsewhere. This could result from a spike in interest rates – which didn’t happen with the 2008 crash, but often does. Alternatively the investor may have been in negative cashflow even at low interest rates, because they were speculating on capital growth rather than keeping an eye on income.
At some point, the investor can’t put in any more cash, and therefore can’t afford to meet the portfolio’s expenses. In order to avoid repossession, they’re forced to sell quickly at a low price – low because prices will be falling anyway, and even lower because of the need to sell fast.
If the sale price is greater than the mortgage balance, the investor has “survived” the recession but is left with a smaller portfolio and less equity than they had previously. But if they were highly leveraged and they can’t sell at a high enough price to cover the mortgage, that means repossession and possibly bankruptcy.
The key then is to avoid progressing beyond the first point by making sure the portfolio is never losing money. As long as it’s at least breaking even, you can hold on for as long as you need to – allowing time for prices to increase again. Yes, the bank could call in your mortgage or request extra collateral if the loan-to-value is now higher than it was originally, but in reality they’re unlikely to force a repossession at a time when everything is falling apart. Repossessing a property actually costs them a lot of money, so they’d rather have the income from the repayments than be left having to take it over and dispose of it when prices are low anyway.
A recession-proof portfolio
There are two ways to survive a recession. One is the risk-free option of buying properties only in cash, so repossession isn’t an option and you survive by default. If you can do that and still reach your financial goals, that’s great – but most of us will want to use leverage to boost our returns.
The other option is to use your knowledge of the property cycle to make sure you’re taking on the right level of risk at the right time. Clearly, this is the option I prefer – and in this section, I’ll show you what that looks like. The only prerequisite is that you believe that the property cycle exists (not necessarily the length of the cycle – just that it’s cyclical at all) and that you have a basic ability to look around and form a somewhat accurate opinion about what’s going on around you.
In this section I’m borrowing heavily from ideas put forward by my friend Ed Atkinson in his April 2015 report, “House of Cards? How property investors can avoid future recessions”. You can download a copy at thepropertyhub.net/crash – along with a spreadsheet that allows you to model how your portfolio would have performed during the last five major recessions.
Hold property that yields well
A portfolio that yields well will keep you out of trouble by giving you plenty of “headroom” for expenses to increase while you still remain profitable. This is where the notion of “stress testing” your portfolio comes in: with other expenses held constant, at what interest rate would you stop making money and start breaking even?
There’s no right answer to what “break even” interest rate is acceptable. Interest rates have historically been as high as 15%, and that could happen again. However, I consider that unlikely, and it’s even more unlikely that they would stay that high for more than a few months – meaning that my cash reserve would only need to make up the difference for a short period of time.
There’s no right answer, but there is a wrong answer: “no margin for error at all”. I see people buying properties (often in London) that just about break even at a mortgage interest rate of 3%, which just seems crazy to me. Or I suppose, it’s not crazy as long as the buyer is aware of the risk they’re taking on: it’s a pure gamble on future capital growth, and they need to be prepared to throw in extra cash to keep it running if their mortgage rate rises before the growth arrives.
Maintain cash reserves
A loss-making portfolio caused by a spike in interest rates isn’t a disaster as long as you’ve got enough supplementary cash to throw in to meet mortgage payments. You should have cash reserves anyway to cover void periods and unexpected maintenance expenses, so it’s just a case of making sure the fund is large enough to see you through.
How big should the reserve fund be? Disappointingly, I don’t have a satisfying answer to this – although of course, the more highly leveraged you are the more cash you might need to put in if interest rates increase. One investor I know argues for having 20% of total borrowings in available cash at any one time. I understand his logic, but I can’t bear to see so much cash sitting around losing money in real terms after factoring in inflation.
Conversely, I know another investor who holds back very little because he claims he could move all his personal spending to a 0% credit card if needs be, and cover the portfolio with what he normally spends on himself. I take the middle path and just keep a reassuring lump of money in my current account, which is sufficiently large to be comforting while not giving me anxiety at the opportunity cost of not having it invested elsewhere.
If your portfolio is only moderately geared, you could always boost your cash reserves by remortgaging to release equity. I’m about to warn against expanding at the wrong time, but taking on debt to hold cash in reserve is an exception: in a crisis, an extra £20,000 in the bank will do you a lot more good than having monthly expenses that are £100 lower.
Don't expand at the wrong time
As you’ll remember from our discussion of the property cycle, the (roughly) two years leading up to the peak and the crash are known as the “winner’s curse” – because bidding is out of control, and whoever “wins” ends up holding a hopelessly overpriced property and will struggle when values fall.
Even if the only thing you take away from this chapter is to avoid over-extending yourself during this period, you’ll have removed a massive portion of the risk that property investment entails.
That’s easier said than done, because banks will be throwing money at you and the value of your portfolio will have increased – and in a way that makes it a good time to take on new debt on good terms. The problem is that anything you can buy with that debt will be worth substantially less in a couple of years’ time.
So don’t remortgage to buy overpriced property, and certainly don’t remortgage to upgrade your lifestyle because you think you’re rich now. What you can do is to strategically remortgage to put more cash in the bank if the circumstances are right – because as I’ve said, in the event of a c
rash you’ll be better off with a lump of cash in the bank than slightly lower monthly outgoings.
Distribute equity unevenly
You can also strategically remortgage to redistribute equity throughout your portfolio. If you have two properties of similar value, you’re better off having one mortgaged to 75% and the other to 25% than you are having both mortgaged to 50%.
Why? Because if you’re forced to sell a property to raise cash to cover your other outgoings, you only want to sell one property. If you’ve got just a little equity in several properties and prices fall, you might need to sell all of them to meet your obligations.
This point is a little more advanced and probably won’t be necessary if you’ve been sufficiently cautious in other respects, but it’s another tool to use if you want to make sure your portfolio is totally bulletproof.
Chapter 18
Exits
So far in Part 3 we’ve talked about financing the growth of your portfolio, nurturing it through the property cycle and making sure it stays intact in the event of a crash. All being well, you’ll approach the Werther’s Originals phase of your life as the owner of a collection of properties that have given you great financial success – but then what?
Given the title of this book, it’s only appropriate that we conclude by giving some attention to exit strategies – by which I mean exiting the stage of being an active investor and turning your thoughts towards retirement. I’m going to assume that you’ve been buying properties with interest-only mortgages, because if you own your properties outright there’s really nothing to think about – you can just hold everything for the income until you shuffle off, then pass them on to a lucky relative/cattery. When there are mortgage balances involved though, the matter requires a bit more thought.
There will be tax consequences for each approach too, but I won’t get into this in detail: it depends far too much on your personal circumstances and how you’ve structured your portfolio for me to say anything useful. And in any case, the rules might all have changed by the time you get to this point in your life. I’ll just remind you to get professional advice at the appropriate time before taking any drastic action, and leave it at that.
So, what are your options?
Hold forever
There’s a popular misconception that you can’t get mortgages beyond the age of 60ish. This is true for residential mortgages because the assumption is that you need to be earning a wage to pay it off each month, but isn’t the case for buy-to-let. You can take out loans that don’t need to be repaid until you’re more than 100 years old – which means you could conceivably just keep on going until you drop, with no need to exit at all.
(Your heirs would then be left scrambling to refinance or sell the properties to pay the inheritance tax bill, but it’s for you to decide how much you like your heirs and how bothered you’ll be about their inconvenience once you’re dead.)
The risk to this approach is circumstances changing once you’re already retired and relying on the income that your properties produce. I don’t personally want concerns about interest rates to put me off my bingo game, but for some people this strategy will be a totally valid option.
Sell half
OK, not necessarily half, but a common exit strategy is to sell enough properties to pay off the debt on the rest – so that you hold your remaining portfolio free and clear. Then, as long as you’ve made appropriate allowances for expenses, you’ve got a pretty much bulletproof source of income in retirement. Whatever happens to capital values isn’t of any concern (because you’re never going to sell them), and your income should theoretically be inflation-proof because rents tend to rise in line with incomes (and incomes rise with inflation over the long term).
The thing to remember is that for all the years you’ve held your properties, their value should have increased while your debt remains static. If you haven’t been refinancing too aggressively, what was originally a 75% loan-to-value portfolio could have fallen to well below 50% by the time you’re ready to retire. You might even find that you could sell just one property to clear the balances on the rest.
There’s capital gains tax to factor in if your properties have made strong gains over a large number of years, but that doesn’t mean there’s necessarily anything wrong with this strategy. It’s just something to take into account, and to attempt to minimise by selling gradually over a number of years and making use of personal allowances.
The only real cause for concern with this strategy is that you might end up without appropriate diversification after selling whatever is necessary to shift the mortgage balances. Being left with just one or two properties that cover your expenses is nice and simple from a management point of view, but also risky: non-paying tenants in one of your properties would cut your “pension” in half until the situation is resolved.
Liquidate
It could be that in your old age, you want nothing to do with property at all. In that case, there’s nothing to stop you from selling the lot and investing the proceeds in another asset class. No, it’s not particularly tax-efficient because of capital gains tax, but there’s more to life than paying as little tax as possible.
In terms of diversification, this isn’t a terrible idea. If you could make roughly the same net return from a couple of unencumbered properties or a globally diversified portfolio of stocks and bonds, the latter might give you better peace of mind.
Restructure
The options above are all totally valid strategies, but the best option of all is likely to be a mix-and-match of all of them, depending on your risk tolerance and income requirements. For example, you could:
Sell a couple of properties to raise cash to put into stocks and bonds for diversification.
Sell another to reduce your loan-to-value.
Keep the rest for income, with very low mortgages so you’re not overly worried about changes to interest rates.
If you’re relying on income from your portfolio in retirement, there’s a strong argument for restructuring in some way. The game has changed: your focus may previously have been on capital growth, but now what matters is rock-solid income. You might be holding properties that don’t yield particularly well, or even properties that you bought just because there was an opportunity to do a refurb and recycle your funds. Maybe you even want to offload your leasehold properties in favour of freehold, so you don’t have the uncertainty of service charges and dwindling leases to worry about.
This is why the advice to “buy and hold forever” makes sense in some respects, but is incomplete: if a property was bought for a particular purpose and it’s no longer doing that job, selling might make sense. As investors, we shouldn’t be emotionally attached to any property.
CONCLUSION
If I had to guess, I’d say that having read this book, you won’t do anything with it. You won’t end up investing in property, and your life will look much the same in a few years as it does now.
It’s nothing personal – it’s just that statistically speaking, most people won’t. As great as the rewards of property investment sound, it’s just too risky/intimidating/time-consuming for most people to bother with. Far safer to just keep going to work and doing what everyone else does, even if you know deep down that the outcome won’t be as good.
In this book, I’ve done everything I can to boost your chances of taking action. I’ve started out by showing you what results are possible – even if you’re not the greatest investor in the world, and even if you’ve got limited time and resources to dedicate to it. I’ve taken you step by step through the process so you know what to expect and can see that every obstacle can be overcome, and I’ve given you a vision for going beyond that first property to create something really meaningful.
If you do pull it off, you’ll have done something truly rare. Many people have no real assets to speak of. Most people own nothing more than their own house and maybe a small private pension. Only a tiny percentage of the UK
population owns more than one investment property. Some people picking up this book will be in a position to achieve this goal easily and others will have to work very hard – but in every case, it can be done and it’s well worth doing.
Let me leave you with what I think are the two most important ideas in property investment – even though I almost never see them discussed.
The first is something I’ve touched on several times in this book: the triangle of capital, timeframe and effort. The less you have of one, the more you’ll need to lean on the others.
If you’re working 60 hours per week, have £20,000 in savings and want to have a monthly income of £5,000 from property by this time next year, can you do it? Almost certainly not, because you’re low on all three key elements. What if you start with a million pounds in the bank? Then you probably can. Ditto if you extend the timeframe to ten years, or quit your job to work 100-hour weeks in property to make it happen, or some combination of the three.
I consider this to be the absolute key to having realistic expectations about what you can achieve. And realistic expectations are important because otherwise you run the risk of getting discouraged and quitting early, or embarking on harebrained schemes that involve taking on too much risk.