Why do we need to have a buy-to-let slush fund?
There are a number of costs and expenses we know in advance, or at least are fairly predictable with buy-to-let investments. For example the interest on a mortgage is quite easy to calculate, as too are letting fees, insurance, regular checks like gas safety checks and such like. We should know the likely market rent and so calculating most of what we need to arrive at a net cashflow position is not that tricky therefore.
However, that is not all there is to it unfortunately. What about other less known expenses like: maintenance, voids, contingency for interest rate increases and such like?. How much should we provide for and set aside into a slush fund to cover such variable items?
1. Let's start with voids. Void periods are the times when buy-to-let property is empty and not achieving any rent. It is therefore more a loss of revenue than a cost as such...but the impact is the same...less money left in our hands. According to the National Landlords Association, some the typical void period now stands at 60 days but this is not every year on average. Some 41% of landlords experienced a void in the last 12 months, so if we take 41% of 60 days we get an annual average of 24.6 days void. I personally factor in 21 days, so that's pretty close. As a percentage of the annual rent the average would be around 4% into the slush fund therefore. However, whilst I allow for 21 days void per year, across a portfolio this for me has been lower in reality, as I tend to aim for desirable properties in strong rental demand areas.
2. Next, maintenance...this can vary wildly and depends on lots of things such as the property's: age and type, condition at the time of purchase and level of any works to bring it up top date. A few minor things each year are almost inevitable even with newer properties but in addition provision should be made to repair appliances, the odd electrical or gas issue, some building fabric upkeep (gutters, decor, redecorate, etc.), at some stage the boiler will probably need replacing and on many properties eventually the roof as well. So, lots to consider but how much is a typical amount each year? Well, finding meaningful data here is a little tricky. For me, my annual actual spend last year was around 3% of my gross rental income but I did not have any major repairs and replacements to contend with that year. I would safely provide for more to set aside to cater for those larger ticket spend items for when they will eventually materialise...say 5% into the slush fund then.
3. As for interest rate rises...well who knows really? The consensus view and mine also, is that interest rates will surely rise sometime in the near future. Many people expect the rise to take base rate to around 3% within 2-3 years. Mortgage rates are not always on the same path as the bank base rate as I have commented on in the past. So, whether buy-to-let mortgage rates will be around 3%-4% above bank base rate as they are today is another matter, I would think a premium of around 2.5%-3% would be likely, taking average mortgage rates to around 5.5%-6% in that time. Personally, I don't set aside a specific sum to cover interest rate rises as a) I fix my mortgage rate for 5 years on longer-term buy-to-lets, after undertaking an initial refinancing soon after adding value and; b) I set a target of return on debt at at least 3% more than the cost of my mortgage to cater for such rises, with inflation as my likely protector on rents over this same period.
So, I imagine we could settle on around 9% of the gross rent as an average into a buy-to-let slush fund based on these figures.
But is it as simple as that even?
One thing that we have not discussed here is the possibility of a house price 'correction'. Just look at what happened in 2008-2010, where the market 'corrected' (read fall) by around 20% to 30% on average. We know that a fall in house prices won't affect us unless we sell right? Well, no, not exactly. If we are buying buy-to-lets using mortgages then we will have what is known as a loan-to-value (LTV), being the percentage of the property value represented by the mortgage balance outstanding. If we were to try and refinance at the same time as a market downturn, then we may find that we do not have sufficient equity to refinance at the same LTV, if at all. With this in mind, we should make some provision for such an event happening...but how much should we provide for into our buy-to-let slush fund then?
A lot will depend on the LTV we had in the first place. Say, we had a 75% LTV mortgage and house prices were to fall by 20%, that would leave our real LTV at just under 94%...a level unlikely to get a new loan on, especially in a downturn. So, does that mean we should set aside something like 20% of the value of the property as a slush fund to cover this contingency? Some say yes, we should actually do this and if we look back at the last downturn, a lot of highly leveraged property investors hit hard times. The safe approach would therefore be to adopt one of the following contingencies:
- Set aside a lump sum capable of covering a remortgage shortfall in case house prices take a tumble. It might not need to be 20% to 30% of the entire portfolio as often remortgaging will be staggered but there is an argument for perhaps half of this sum perhaps?
- Alternatively, we could go for long-term fixed rate mortgages of 5, 7 or even 10 years...providing there is no minimum LTV clause in the terms and conditions of course.
- Or, we could make sure that our average LTV is at a more comfortable level of 60%-70% say. Inevitably, each property will vary if we acquire them and refinance at different times, so we are talking about averages here but we should try to make sure no single property is too exposed ideally. Similarly, if we are able to have one or more properties totally unencumbered then that could help in times of need, as we could sell it to raise funds, even if we could not refinance it.
- Finally, we could go for repayment mortgages or shorter terms on at least some of the properties to force the debt levels down.
Of course, this won't be great news to anyone that has done the number-crunching on buy-to-let in the first 3-5 years of ownership, as rental profits are usually squeezed the most during this period. In conclusion, unless we fancy setting aside a large cash pile just in case of all of these things happening, we should probably adopt a mix and match approach instead.
So, perhaps a sensible approach to setting up a buy-to-let slush fund could be:
- Set aside some cash to cover void periods - the 4% of gross rent figure is probably prudent
- Set aside some cash to provide for regular repairs and maintenance - a further 5% of gross rent may seem high but when we consider replacement boilers and redecorating every 3 years of so it can add up. If we find ourselves not using all of it after some years then we can always put it to good use in another property investment or start to ease the level of contribution a little I am sure.
- For the interest-rate cover, this could be a large figure at one extreme but if we set aside 10% of gross rent say then that should cover it.
If we adopted these principles that would mean having a buy-to-let slush fund of around 19% of our gross annual rent...which has probably made your eyes water right now, however it would probably be safe.
Do I do this myself? Well, not exactly no. I do provide for voids and maintenance but I have found 5% of the annual rent to be adequate for both. I hedge against larger refurbishment costs by undertaking a good standard refurbishment when I take on a property and locking in some equity at the onset. I fully expect to be able to release some equity from at least some of my portfolio after 5-10 years to provide for more substantial works if required.
As far as interest rate protection is concerned, I adopt a mix and match approach instead. I have a reasonable portfolio LTV, some longer-term fixed rate mortgages, some higher cashflowing properties like houses of multiple occupation (HMOs) and some repayment mortgages or low/no debt properties as well.
I guess my solution could be summarised as: part buy-to-let slush fund and part contingency planning...how much of a buy-to-let slush fund do you have for your properties then?