Rental Property - Articles & Advice

The Downside of Buy To Let

is... gearing. The same factor that gives the buy-to-let landlord his massive advantage in a rising property market is one of his worst enemies in a falling market. With housing markets across the world teetering on the brink of a chasm, now may very well be a good time to evaluate exactly what gearing means to the average buy to let landlord.

What exactly is gearing? It's basically another word for leverage. Imagine you want to buy a $100,000 home. The bank or lender, if prudent, will want you to put some of your own money up - to share the risk. If you are buying your own home, they traditionally want you to stump up between 5 and 15% to show you are serious. If you are buying an 'investment' property, until fairly recently the lenders wanted you to cough up about 25% (many lenders have recently relaxed these criteria - they will undoubtedly be punished for it by the market later!).

On a $100,000 property, that would mean $25k - i.e. your leverage or gearing on the property would be x4 (the value of the property divided by the deposit). He has borrowed $75k and put down only a third of that. In a rising market, that means that for every $25,000 the property rises in price, he effectively doubles his money! So the property only has to rise by a quarter, and he reaps a 100% growth in the actual cash put down to buy the property in the first place. Are rises of that size possible? Yes - many parts of the world have recently seen strings of years where prices rose at least 25% year on year.

So far so good, but what does your typical buy-to-let landlord do when presented with a $25k windfall? Yes, that's right. He re-mortgages property #1 and buys property #2 using the extra $25k he just 'made'. Wow. Free money! He can actually buy another $100,000 house with this 'new' deposit (it will be a smaller house, or in worse condition than the first one of course, because houses like #1 now cost $125k!).

Our landlord now 'owns' 2 properties, worth a total of $225,000 for the grand initial investment of $25,000 . That means his gearing is now x9. For every dollar his property rises, he makes a 'return' of $9 on his initial investment deposit. Our buy to let investor now only needs an 11% rise in property prices to effectively double his cash again. Let's imagine it happens.

Property goes up by 11% making his 'portfolio' now worth $250,000. Remember that he can remortgage up to 75% of the value of his properties. That means he can borrow up to $187,500 in total. Seeing as he has so far only borrowed $150,000 (2 x $75,000) he has another $37,500 he can draw on. What's a landlord to do? Buy another house, using the $37.5k as the deposit, on a house worth up to $150,000!

All well and good, you say. He's becoming rich, rather rapidly. Until.... the market turns and starts to fall. Our landlord now has $400,000 worth of property under his control, for a tiny initial investment of only $25k. His gearing is immense - x16 in fact. For every $1 the market rises, he 'makes' $16. For every $1 it falls, he loses $16. In fact, a 6.25% fall in the property market will wipe out his initial cash deposit, meaning that to all intents and purposes, the buy to let landlord owns nothing. The outstanding loans are the same as the value of the properties, so the bank owns 100% or it. The landlord, of course, still has the RESPONSIBILITY.

But, I hear you say, the landlord is only really interested in the rental yield - as long as he can cover the monthly payments with his rents, isn't he ok? Yes - until, for example, the roof starts leaking, or a new boiler is required, or a bad tenant stops paying. At which point he's up a certain creek without any form of paddling implement.

This is the reason why many professional property investors (;-) offloaded the last of their investment properties last summer - the chances of a property crash just looked too large to justify any possible future gains, given the record house prices and low interest rates. As the song says - the only way is down. If you still hold investment properties, it's probably too late to sell. You'll have to hang on grimly until the market turns again - probably around about 2008. Good luck with it!

Peter Parsons writes exclusively for www.mortgagedown.com, the place to get advice on how to reduce your mortgage

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