5 Steps in Our Buy-To-Let Finance Strategy

Text to Speech

Do you have a buy-to-let finance strategy?

According to Wikipedia a strategy is defined as:

Strategy (from Greek στρατηγία stratēgia, "art of troop leader; office of general, command, generalship") is a high level plan to achieve one or more goals under conditions of uncertainty.

Within the same article is a definition from Henry Mentzberg that I personally prefer to define a strategy:

a pattern in a stream of decisions

I prefer the second looser definition in this context as it implies it to be more general (a pattern not an absolute) and dependent on several interdependent factors (a stream of decisions). For me, with regard to a buy-to-let finance strategy it should have these two elements:

1. General and yet certain to describe - just like a pattern

2. Dependent on a range of variables and desired outcome - just like a stream of decisions

Why we should have a strategy regarding our buy-to-let finance is so that we have some guidelines to fall back upon to assist our planning and long-term goals. Having a strategy means we know what we intend to do and can articulate this to other people...in particular mortgage advisors and lenders. If we know what our strategy is, then we have a degree of certainty and predictability in our decision-making and implementation that we can rely upon without having to waste countless hours deliberating.

To identify our finance strategy we need to evaluate a number of considerations, following a 5-step process as follows:

1. Our overall property investment strategy, plans and goals
2. Our plans for each individual property
3. Our view on interest rates & credit conditions
4. Our view on the current and mid-term housing market
5. Our attitude to risk

Taking each of the points in turn, we can dig a little deeper.

1. Our overall property investment strategy, plans & goals

It probably goes without saying that our finance strategy needs to align with our overall property investment strategy. Generally, if we have a long-term buy and hold approach then we may be more inclined to have a longer-term finance strategy as well. However, if we are a property trader, turning property around quickly, then we would naturally have a shorter-term finance strategy that fits in with this approach. At a top level, long-term financing would be buy-to-let mortgages and short-term financing would be cash, bridging finance and private financing sources. Sitting somewhere in the middle we might find commercial mortgages / loans and the 'new' peer-to-peer and crowdfunding providers popping up.

Similarly, if our goal is income it could lead to a different decision with our finance strategy to if it was long-term capital growth. For example, the finance product that is likely to leave us with the largest amount of net monthly cashflow is an interest-only mortgage. However, if we are looking to build or generate long-term capital or equity, then perhaps a capital repayment mortgage would be more suitable.

In conclusion, the first step is to try and align our financing strategy to our property investing strategy. This would be what is known as a 'macro level approach'.

2. Our plans for each individual property

In the first point above, we considered the macro level decisions relating to our property finance strategy and how these align to our overall property investment strategy. Here, we look at the 'micro level approach' i.e. what we intend to do with each individual property.

It is quite conceivable that our long-term goal is to achieve wealth accumulation through a large net equity position with a largely passive income stream. This is certainly part of my own personal strategy. This may imply going for capital repayment mortgages over long-periods of time if we consider this in isolation. However, it is also perfectly conceivable that we may take on the odd property investment that we know will most likely not form a part of our long-term portfolio, or even be acquired specifically to trade on or 'flip' instead. This might imply looking at short-term, interest-only financing for those turnaround properties even though our overall finance strategy is a long-term, repayment one say.

Similarly, if we have a value-adding approach with the intention of recycling as much of our own funds as possible, either generally across the portfolio, or specifically to an individual property, then we might want to split our finance strategy decision into two clear phases. Phase one would be the period of time where we undertake the initial upgrade work on the property and phase two might be the long-term buy and hold period. Typically, we would realise the added value or 'forced appreciation' in such an approach within the first 1-2 years of owning such a property. Here, once again, it would mean looking at shorter term financing as we would not want to be locked into heavy exit penalties (early repayment charges) for terminating a loan before the end of any fixed-rate period for example.

This could imply a mix and match approach where our long-term buy and holds are funded on a different basis to our shorter-term intentions for new property acquisitions.

3. Our view on interest rates and credit conditions

The Bank of England base rate is currently 0.5% and has been since March 2009. Many investors, or even home-owners might be under a false illusion of low interest rates given this has been the case for the past six years now. However, less than two years before that the Bank of England base rate was 5.75%. In 1998, it hit 7.5% and even in 1992 they were in double digits after the last major financial & economic crisis. Add to this that we are only talking about base rates - actual mortgage lending rates will always be higher than this by something like 2% to 5% typically, as I outline in this post on interest rates. When you consider that many mortgages are arranged over a 25-year period this would cover all of these different interest rate changes. In other words, it can be quite unpredictable in the long-term. The long-run average for Bank Base Rate has been around 5%, however average imply that times they are higher or lower than this.

Then we have general credit conditions to consider. Today, today there are 817 different products available for us to choose from according to Mortgages For Business. In addition, it is not difficult to find mortgages with a loan-to-value (LTV)  ratio of 80%. Contrast this with 2008/9 when in 2008 the market peaked with buy-to-let lending at £27.2Bn only to crash to £8.5Bn in 2009 as products were withdrawn by the week and lending criteria tightened severely, with a maximum LTV of 70% if you even qualified for lending at all. Prior to the financial crisis and housing market crash around that time, it was even possible to get 110% LTV lending from some lenders, along with 'self-certification' of income (i.e. no proof required).

As we can see, we have another cycle to understand - a financial cycle as well as a house price cycle which will will look at also. This then presents the decision of how much to borrow - our LTV, whether to go with a fixed or variable rate mortgage and for how long. As we can see, things can change quite quickly and significantly.

On a related point to this is the concept of the 'total cost of borrowing' over a period of time. Apparently, over half of buy-to-let investors go for a 2-year fixed rate product (as per Mortgages for Business article above). However, when we take into account the fees involved in mortgaging and remortgaging (lender, broker, valuer, legal. surveyor, etc.), then is the interest rate and monthly repayment the best way of measuring what represents a good deal? I would suggest not. Instead, I would always look at a longer time horizon of at least 5 years and more probably 10 years plus. If we take into consideration that over a 10-year period we would effectively pick up these fees 5 or 6 times, then it would makes sense to factor these into our 'total cost of borrowing' calculation. Of course we would have to make certain assumptions but it is still wise to tot up the potential costs including fees over a longer time period and compare this against different products...there are even 10-year fixed rate products becoming available now. Equally, many fixed-term products have exit fees or early redemption penalties, so taking out a 5-year or even a 10-year loan should only be done if we are confident we will not need to settle the mortgage before then.

What this means is perhaps a bit unclear but I guess my personal golden rule is to weigh up the total cost of borrowing over a 10-year period and pick the best value, longest term fix available without over-committing myself on the LTV, so a maximum 75% LTV...providing we are not planning to sell or refinance sooner. I have rarely found a 2-year fixed rate mortgage to meet this test. I am certainly not advising that you do the same here, as you should always obtain financial advice on these matters. Similarly, as I have said, we also need to take into account the other factors.

4. Our view on the current and mid-term housing market

As we drill deeper into the subject, we can see how there is a lot of overlap. The housing market is often linked to the financial market, many say one affects the other...either way around! For this reason, an elaboration on house prices over the past 5-25 years is not going to be helpful. However, what is helpful is to take account of the fact that over history, the housing market - at a national or regional level - has followed a repeating cycle of upswings and 'corrections' or crashes. Understanding, where we are in the cycle is therefore useful - Fred Harrison has contributed much to this understanding as a co-contributor to the 18-year Real Estate Clock or other analyses from RICS that refer to 4-12 year cycles.

One of the problems we face here is that as seen above, whilst there is a general agreement that there is indeed a cycle, there is clearly different research and understanding of how long it typically lasts. The safe bet is therefore to not look too far down the line here but do have one eye on the trend for as sure as a long-period of growth will come either stagnation or collapse and vice-versa.

5. Attitude to risk

To some extent I have referred to this throughout in one way or another. Risk is the likelihood of something happening that will affect our investment. Risk is often associated with a negative event but it could also be positive too. For the purposes of this discussion I shall use the term risk to mean having a negative impact and upside (potential) meaning a positive effect instead.

As investors, we are interested in maximising the upside, whilst minimising the downside risk. There is often a trade-off, where larger upside potential carries larger downside risk. This is a balance that must be worked out for each individual investor. However, I will say this. In property investing in particular we do carry some additional risks over and beyond other types of asset class if we are using mortgages, which we are assuming we are throughout this discussion. If we buy shares or art say, then even in a market crash the worst case scenario is often a loss of our original investment - known as our capital. However, with a leveraged property investment (one with a mortgage), we also run the risk of losing MORE than our original cash investment. To illustrate, consider buying a property in 2007, at the top of the market for £100,000 using a 90% mortgage. Here our capital (excluding fees, etc.) was £10,000. By 2010, the market had fallen by an average of 25% to 30% in many parts of the UK AND lending was restricted to a maximum LTV of 70% (along with stricter terms & criteria). If we had to remortgage at this point in time, then our property would be worth around £70,000 to £75,000 with an outstanding loan of £90,000. If we had to remortgage at the maximum 70% LTV then we would only secure a maximum loan of £52,500 resulting in a capital loss of £47,500 when our original capital was £10,000. That's leverage in reverse!

I don't mean to scare you and this set of circumstances is close to being the worst combination possible, so do not let it put you off....but DO take this into consideration and try to mitigate this happening to you by being diligent, not over-extending on credit and having an eye on the financial and housing market cycles. As sure as leverage can make us wealthy with careful application, it can make us bankrupt with reckless abandon.

For this reason, again personally speaking, I try and fix long and limit my LTV to a reasonable level, without being so cautious to throttle my growth plans completely. Once again, no financial advice is offered here.

Putting it all together

We can formulate our buy-to-let finance strategy by working through each of the steps outlined above and deciding what works best for us as a general finance strategy as well as allowing for some flexibility. This allows us to have a clearly defined strategy but one that can be varied depending on the nature of our views and plans as outlined throughout this discussion.

I have hinted at my own approach but by no means am I suggesting that you adopt the same finance strategy as me, as your approach, goals, plans and circumstances will no doubt be unique to you. However, if we sit down once a year and evaluate our views on the subject, we should be able to come up with a pretty decent finance strategy that will aid us the next time we come to mortgage a new investment or remortgage an existing one.

So, tell me - what is your approach to this subject? I am all ears...