Debt / equity ratio in property investment – what is right?

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A common dilemma faced by property investors is this: Now that I have started to build my BTL portfolio and achieved some equity growth; should I pull out the increased equity and reinvest by refinancing or leave it there to reduce the debt / equity ratio and enjoy some of the steadily rising cashflow benefits instead?

This makes us consider, among other things our debt / equity ratio. The debt / equity ratio is simple to calculate:

Debt (meaning outstanding mortgage balance) / Equity (meaning the difference between the property market value and the outstanding mortgage)

A similar and yet slightly different way of looking at this is the Loan to Value percentage or LTV:

Outstanding mortgage balance / current property value

Example:

House value £120,000

Mortgage balance £80,000

Equity £40,000

1) Debt / equity ratio = 2 (£80k / £40k)

2) LTV = 67% (£80 / £120k)

They are actually two different calculations that effectively say the same thing, so some may prefer to use the Debt / Equity ratio and others the LTV instead...it matters not that much which one to use but it should be something that we look at periodically in assessing our property key performance indicators (KPIs).  As a rough guide the higher the result the higher the level of debt and so, potential risk.

Next, addressing what is the 'right' result. Well, essentially this will depend...

For example, Mark Alexander from Property 118 has some views on this topic and I have read about his personal strategy...and he has been in property a LONG time, so has lots of experience. For example, he maximises his LTV (within reason) BUT rather than leaving all of that money tied up in bricks and mortar, he has a set sum of money i.e. cash, which is equivalent to 20% of his total mortgage debt set aside at any one time. This gives him a lot of options, such as an ability to ride out a downturn, bag a bargain, manage interest rate rises and so on.

Option one to managing the debt / equity ratio therefore is: High gearing but with high liquidity cash reserves

On the other hand, I have heard of some investors, such as Rob Bence from RMP Property & The Property Hub, who adopt a hold forever and refinance every x years say...I also fall into this camp currently but I won't max out on my Debt / Equity Ratio either. If I can refinance each property every say 5 years to 75% LTV (debt / equity ratio of 3). Then due to the natural cycle of renewals being spread over time, some in the portfolio will have lower LTVs (or debt / equity ratios) when any new one to refinance pops up. This will mean that my average debt / equity ratio is probably around 2 (LTV around 67%). I would then reinvest the equity released to acquire more properties using more leverage to grow my asset base.

I am also still in 'growth' phase and so a higher average LTV or debt / equity ratio may be more common in that case. It could be that when in 'consolidation' or even 'exit' phase that the LTV or debt / equity ratio will and possibly should be falling. I hear many say 60% is a comfortable LTV (debt / equity ratio: 1.5) across a portfolio, in the consolidation phase with perhaps 50% LTV (debt / equity ratio: 1) in exit. Exit might include handing down to the next generation and a beneficiary of a property portfolio is likely to be able to get finance at 50% LTV, or if not could sell half to retain half - so a useful rule of thumb there.

Inheritance tax and estate planning could play a part in your decision and so you might want to discuss this with a Chartered Financial Planner or Estate Planner.  Attitude to risk is another very personal factor - I was speaking to an investor recently who bought a property mortgage-free and he thought 50% LTV (debt / equity ratio: 1) was high risk, whereas some think nothing of 80%+ LTV (debt / equity ratio: 4+). I would however take a look at long term trends and suggest that a 50%-60% LTV, equivalent to a debt equity ratio of 1 to 1.5 should be sufficient to ride out most market 'corrections'.

Option two to managing the debt / equity ratio therefore is: Modest gearing, released periodically with equity reinvested

In yet another situation, take an accountant I know, who himself has around 50 properties and has a plan to sell one a year until death! He is around 50 years-old now, so I guess he should be OK. For him, now that he has the portfolio built up, he will let the mortgages run down naturally and will choose which property each year to sell to fund that year's cruise or sports car. He is passing into the 'exit' phase.

The idea here is that the mortgage debt will not increase and so as time goes by his debt / equity ratio will gradually fall as house prices rise. In addition, he will start to see increased cashflow as rents increase and mortgage balances remain fixed (also depends on interest rates). The selling of properties provides additional capital lump sums, however there could be tax to pay on any capital gains, which is different to option one and two where no tax is paid on debt released by remortgaging. This final strategy is perhaps the lowest risk one but also one that is best suited once a portfolio target size has been achieved, unless deposit funds come from other places like savings.

Option three to managing the debt / equity ratio therefore is: gradually run the debt down, using house price inflation to lower the debt / equity ratio and so maximising the capital and cashflow from each individual property.

This gives the three of the main permutations to this conundrum...the 'right' one as I referred to earlier is the one that fits in with our personal plans. goals, financial situation, attitude to risk and our stage in our property portfolio journey - making make one option to managing the debt / equity ratio more 'right' for us than another.