Steve Olejnik, sales director, explains gearing and why investors often use it.
Borrowing to support an investment is known as “gearing” or, if you are American, “leverage”.
Gearing is a common strategy used by property investors to grow their portfolios. The borrowing is the buy to let mortgage and the investment is the rental property. For the strategy to work successfully, the rental income must be able to service the debt and provide some cash flow.
Even if you only take on one buy to let mortgage, you have geared your property.
Advantages of gearing buy to let property:
Gearing can improve the return on your capital investment. It makes your money work harder for you and helps you to earn more.
Gearing and capital appreciation: Say you have £100k to invest. You could buy one property for £100k without the need for a mortgage. Alternatively, you could buy four properties worth £100k with a £75k mortgage on each. If property values were to go up by 10% you would make £10k if you had one property but £40k if you had four.
Gearing and cash flow: If the cost of owning property is less than the rental yield then your cash flow would be higher if you owned four properties rather than just one.
Gearing can also help you to grow your property portfolio quickly.
Risks of gearing as a property investor:
The main risk of gearing is not being able to service the debt, so investors should make contingency plans for shocks such as void periods, unexpected maintenance costs, tenants who fail to pay the rent and rates rises. A sensible contingency would be to put aside a certain amount of cash to cover any unwelcome shocks.
According to Stephen Johnson, managing direct of Shawbrook Bank, if an investor is paying a mortgage rate of 7% at 75% LTV, the property would need to be generating a minimum of gross yield of 6.6% just to service the debt – a sobering thought.
Another risk is the threat of a decrease in the value of the property.
Investors with larger property portfolios not only pay more to borrow but also there are less lenders out there who are willing to lend to them. Lenders are nervous of highly geared landlords. It’s also worth noting that you are likely to be offered a lower rate with less gearing.
So should you gear your properties?
That depends upon your appetite for risk. Only you can make this judgement, so it is very important to assess carefully the risks for your situation.
How much gearing should you take on?
Again only you can decide. Most mainstream buy to let mortgages are available to 75% LTV. However the lower your LTV the better the mortgage rate you can expect to achieve. Borrowing to 75% LTV is fairly realistic if you only intend to have one buy to let mortgage; however, if you plan to grow a portfolio it might be prudent to gear to say, 60-65%.
To chat through buy to let mortgages and gearing for your personal situation, talk to our expert mortgage brokers. Call 0845 345 6788.