Let’s start off this series three off proper by considering some of the more obvious ways of financing our property investments, however, with a bit of a twist as it will perhaps be coming from a less conventional angle. Today, we will talk a little bit about cash and what I call ‘institutional finance’ and how to apply it a perhaps little differently. The focus will be more on creative and practical application rather than the nuts and bolts of BTL mortgages…so tune in to hear how these more familiar property financing options could be applied in slightly different ways.
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Resources mentioned
Several links to previous shows are mentioned in the show notes below, along with mention of the ‘home as a tax-efficient asset calculator’. All of these resources can be shared if you drop me an email podcast@thepropertyvoice.net
Link to the Podcast feedback survey
Today’s must do’s
Open your mind and get the creative juices flowing in terms of what property financing can do for you. When to use cash and when not to, how to use consent to let as an alternative to a BTL mortgage and how to look at further advances or remortgage to accelerate the rate of expansion of your portfolio. It’s all about doing more with less and being smart in how we use our property financing options.
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Transcription of the show
Hello and welcome to another episode of The Property Voice podcast. My name is Richard Brown and it’s a pleasure to have you join me on the show today.
You may know that I have sought some feedback on the show, there is still time to have your say…just look out for the survey link in the show notes or drop me an email and I will send the link to you. One of the comments was to reduce the intro and get straight into the heart of the matter…so here goes with this week’s show looking at cash and institutional finance in property.
Property Chatter
Let’s start off this series three off proper by considering some of the more obvious ways of financing our property investments, however, with a bit of a twist as it will perhaps be coming from a less conventional angle. Today, we will talk a little bit about cash and what I call ‘institutional finance’ and how to apply it a little differently.
In series one we covered financing your property investment in a reasonable amount of detail. We revisited the topic again in series two with a two-part episode, including a subject matter expert guest contribution from the highly respected finance broker Simon Allen, where we explored the main characteristics and structure of some of the common methods of finance available from institutional lenders. The link to these episodes are in the show notes so you can revisit them there.
Given that we have covered the topic a couple of times already, two questions probably come to mind:
- Why bother doing a whole series on the subject?
- What more is there to know?
Dealing with the first question – the answer to that is simple…in this series I plan to go deeper into the alternative and creative financing options and their practical application than I have done previously. I will also have other subject matter expert guests on the show that are either specialist service providers that offer these alternatives, or real property investors applying them in their own property businesses now.
As for the second question, aside from what I just mentioned about some new aspects of finance and their practical usage, I would like to consider some more creative ways of applying financing than is perhaps commonly thought of.
Using Cash
Let’s start today’s discussion off with cash then.
Well, it is difficult to add too much more than I have covered before without too much repetition I suppose. At the simplest level, buying a property with cash means that we are using our own personal cash resources to acquire an investment property…probably using savings or a windfall of some sort.
Paying in cash offers two main benefits to us as investors at face value: speed and reduced cost of acquisition.
Speed is a true benefit, and whilst there are some other finance options around that can be completed quickly, cash is still king here. Even with other fast to arrange financing, such as auction or bridging finance, which we shall cover next time, cash buyers have less complexity and outside interference in their purchase, which has a distinct benefit to a vendor and to us too.
So, what else is there to say about cash then?
Well, first of all, using cash allows us to position ourselves ahead of all other investors who are using some sort of financing, in the minds of an agent and a vendor.
Here are some tips for you to consider when thinking of using cash…whether directly or indirectly.
Quite often, to secure a great property opportunity, we will be asked to provide ‘proof of funds’ to the agent or vendor in order to verify our cash buyer status. This means having the funds readily available in a fast access bank account, including being able t0 share a copy of a recent bank statement to prove this. So, the first step is to have the funds set aside and have the statement ready to be presented.
From a tactical point of view, we could consider attaching the proof of funds to any offer we are making, if we feel it will elevate our standing and help to offset the discount we seek as a result.
Next, we could consider using cash for the initial purchase in the interests of speed, but then backing into a financing facility, such as a mortgage or bridging loan, soon after completion. I used this tactic to bag a good deal before the stamp duty rise at the end of March this year and then sorted out the lending in April once the stampede had died down.
You could also try the ‘swtcharoo’ technique of saying you are paying cash, having the proof of funds available to verify it, but then switch to using say bridging finance later on instead. The downside of this is as a minimum a loss of credibility with the agent, potentially damaging future relations and / or also with the vendor, potentially risking them pulling out of the deal. For these reasons, I do not advocate this approach, as I prefer to maintain a good reputation for doing what I say I will do…the property community is surprisingly small and also very well connected, so word does seem to get around.
Buying in cash can work particularly well with smaller property purchase values, when compared to some kind of financing. The main reason for this is that many of the costs of acquisition are not directly proportional in percentage terms to the purchase price. Examples can include legal, broker and lender fees, which can sometimes be either fixed fees or banded according to a purchase price range rather than a set percentage of the actual purchase price. The effect of this can be to increase the proportion of total costs associated with financing on smaller transactions. As a result, small deals particularly lend themselves to cash purchase I have found.
However, perhaps on the downside of fully using our own cash are some of the economic arguments. In particular, two terms to keep in mind are opportunity cost and leverage.
Opportunity cost basically means, how much of a return we may need to give up in order to use our cash for the purchase. If we estimate that we will make a return on investment of say 8% on our cash in a property transaction, we should look at how else we could use that same cash in order to work out the opportunity cost.
If we have the cash on deposit earning less than 1% per annum in interest at the bank, our 8% ROI from the property deal looks like a no brainer. However, if say we are offered the option to become a private financier with an annual return of 10%, then the decision becomes far more marginal. Looking at returns alone, we may decide against using cash to buy our property and instead lend it out to other investors instead. In this simple example, the opportunity cost of using our funds for the property transaction is either 1% per annum by withdrawing it from the bank, or 10% per annum by using it as a private lender instead.
There is a growing market for this type of private financing, as we ourselves have found with some of our own projects, which can offer a win-win outcome for both parties. However, as always consider the risk reward trade-off and do your research and have adequate security from who you are lending to. It may or may not meet other investment objectives too, such as a desire to own assets, so it’s not for everyone all of the time either.
With regard to leverage, this is also a topic that I have covered in various ways and at different times in the past. The simplest explanation is that leverage can increase the returns on our own cash by using the funds of someone else instead, provided the total return on our project exceeds the total costs of using the other party’s funds.
As an example, say we are looking at buying a £100,000 property, which we will rent out for £500 per month. Ignoring all other costs for the moment, that would produce an annual return on investment or ROI of 6% on our £100,000 cash investment.
Now, if we took out a BTL mortgage at 75% LTV with an interest rate of 3.5% let’s see the difference. To keep things simple, again ignoring all other costs…here’s how it would look:
- Purchase price £100,000
- Deposit funds £25,000
- Mortgage £75,000
- Mortgage payment £2,625 per annum
- Rent £6,000 per annum
- ROI 13.5%, which is more than double the equivalent for a purely cash purchase in this illustration.
Theoretically then, we could buy 4 of these same properties with the same £100,000 investment fund, also increasing our total return as a result. The debt would be fully serviced by the rental income received.
This partly explains why many investors like to use mortgages and other forms of finance, but it is a trade-off when a particularly advantageous cash buying opportunity presents itself.
Generally speaking, many vanilla property purchases would simply not justify using valuable cash resources and so they would not come into play for many acquisitions. Where cash can come into its own more frequently is when the level of discount or the benefit of elimination of our competition is high…that’s when we should be considering using cash to secure a property purchase.
One last point on cash is a slight tweak of technique I have used before. If we buy an investment property, rather than our own home in cash, we still have the possibility of financing it later on. I have touched on financing the target property for a long-term BTL mortgage, or even a bridging loan for this particular project. However, we could also look at either of these options to fund an additional purchase of another investment property purchase as well.
This could allow us to secure that juicy flip deal using cash and then say a more conventional BTL purchase using the equity released from a BTL mortgage or bridging loan on another project altogether later on. This can therefore accelerate our ‘deal velocity’, meaning getting more deals done with the same initial cash funds in an efficient way.
In summary then, cash is great in the following situations:
- To move quickly on a great deal
- To secure deep discounts or locking out other finance-backed purchasers
- On smaller transactions in particular, where the proportional cost of finance can be higher
- When we are less concerned about opportunity cost and leverage
- When we know we can still access the cash equity later on for whatever reason
Institutional Finance
After cash we can take a look at institutional finance.
In the most part here we are talking about BTL mortgages, commercial loans and bridging finance. As I have a great guest coming up to deep dive into bridging finance, let’s stick to the BTL mortgage and commercial loan options here today.
Or perhaps not!
Rather, I do not plan to go into exactly the same aspects that I have previously covered. Instead let’s share some alternative ways of looking at what has become quite a common form of property investment financing. For ease, I will use the term BTL mortgage to cover both BTL mortgages and commercial loans as they are very similar finance offerings.
First, a quick definition. A BTL mortgage is a first-charge, secured-loan provided by a bank or similar institutional lender on a rental property. The idea is to identify a property, buy it and then apply for a BTL mortgage on that property to in order complete the purchase, before renting it out to cover the costs of repayment to the lender.
But wait a minute, there could be some alternatives we could consider here to suit some specific situations. Let’s walk through a couple of these now.
Many of us starting out in property have our own home, where we may be thinking about how we could utilise this to get involved in property investing. We may even be considering selling the property to raise funds to invest. One variation to this approach is to use the asset we already have, namely our home, and raise r release a mortgage against it to release funds instead. Granted, we won’t be able to realise the full market value of the property this way due to loan-to-value restrictions. However, once selling costs are taken into consideration, perhaps this fund-raising gap is not quite so great. Plus, we get to have a rental property and potentially crucially a couple of tax-benefits only available to homeowners as well.
A couple of generous tax breaks only available to residential homeowners are as follows.
Rent a room scheme allowance
This is a tax-free income of up to £7,500 each year where we rent out space in our own home. Admittedly, it means taking in a lodger or Airbnb-type short-stay guests into our home, so it won’t suit everyone. However, the tax-free rental income is extremely generous and should be considered seriously, especially when we are starting out as it could help us save for the deposit on our next investment property more quickly.
If we also consider a mix and match approach of remortaging our home and renting out space within it, we can leverage our home as an asset with a tax-free income this way.
Lettings relief
if you don’t fancy sharing your home with strangers, then an alternative is to move out, renting or buying somewhere else to live and then renting your former home out in full.
HMRC offer a rather generous relief, which at the simplest level is worth up to £40,000 should you later decide to sell your former home and realise a capital gain arising after you moved out. Just by delaying the sale for a couple of years, a basic rate taxpayer can generate the equivalent of over £220,000 in tax savings when compared to the gross equivalent in income.
Capital gains tax
Similar to lettings relief, capital gains tax can be a more tax-efficient investment approach when compared to income tax. It can get complicated, but at the simplest level, would you rather pay 18% in tax with the first £11k being tax-free or a flat 20% tax rate on your property sale profits instead? You would prefer the first option right. This compares to 28% versus 40% for higher rate taxpayers and don’t forget the increased tax-free element increases with joint ownership.
Well, you can do this when you rent your former home and sell it at a profit later using a combination of private residence relief, lettings relief and annual CGT exemptions in order to offset a significant part of the gain achieved. It effectively accelerates what you could have done by trading property or renting other properties quite a bit and is one reason why I am a fan of using your home as an asset…if you can persuade the other half to go along with the idea obviously!
This is a more complex topic but if you wanted to pick up the thread with me personally, including getting a copy of my home as a tax-free asset calculator, just drop me an email podcast@thepropertyvoice.net and we can continue that way.
Tax is not the only situation where we could consider a variation when it comes to looking at accessing the equity in our home. Here are some other potential permutations to consider.
Consent to let
If we decide we want to rent out our home, we often think about getting a buy to let mortgage. In fact, it will breach the terms and conditions of a residential mortgage if we let it out without the lender’s formal consent. An alternative is to ask for what is called ‘consent to let’ instead. Some lenders will allow you to rent out your former home with no or little changes to their terms. This could preserve an attractive mortgage rate, reduce additional deposit requirements or reduce remortgage fees as a result. Therefore, it could be a lower cost entry point into BTL.
Equity release by remortgage, further advance or second charge
Selling the property can introduce a lot of costs and BTL loans carry higher rates and deposit requirements that residential loans in the most part. So, releasing additional equity for property investing purposes can be attractive by accessing equity in our home either by a remortgage with the same or a new lender, a further advance with the same lender, or a second mortgage with a new lender instead.
There are pros and cons in each situation. However, I have used the further advance option a couple of times on both residential and BTL properties as a way to retain my asset for long-term wealth creation, whilst releasing additional cash for my portfolio expansion too. One thing to watch here is to always make sure that the ROI on the application of the additional funds released exceeds the interest rate on this same amount.
These are some of the possibilities that could give rise to applying institutional finance in alternative ways. Some of these possibilities also apply to existing BTL property. In particular, the idea of further advances, remortgage or second charges.
Remember that selling property crystallises any tax due at that point in time and also carries additional transaction costs, such as estate agent and conveyancing fees. Therefore, looking at raising finance from an existing asset without selling it can help to reduce these taxation and transaction charges, even when there are limits linked to loan-to-value and interest rates to consider. Once again, it’s a trade-off.
Some investors also elect to never sell property, choosing instead to refinance several times in order to release funds to expand their portfolio. This can be an effective way to keeping the tax and sales transaction fees under control as mentioned. However, please do be careful about how these funds are used. It should be OK if the funds are reinvested into the portfolio, as that way a return on investment over and above any refinancing charges can easily be calculated and justified. Although, I would not recommend this approach where the debt is used in substitution for an income, as there are a number of negative tax consequences that could arise here. I have dedicated an entire podcast episode to this potentially flawed strategy if you want to know more about this, the link is in the show notes.
Finally, here are a couple more perhaps less well known applications of the conventional BTL mortgage. Equity release from an existing rental property to fund new acquisition deposits, works costs & fees. Equity release from an existing rental property to fund existing property upgrades, conversions, lease extensions and other added value projects. Equity release could come by remortgage, further advance, a second charge or even a temporary bridge…but that is taking us a little further into a slightly different domain.
In short, the aim and intention here is to use cheap money such as BTL mortgage loans to invest in higher returning property investment return assets instead. It’s a kind of debt / investment arbitrage in other words.
Make sure that you are comfortable with the new higher debt level and that the property being refinanced can still service the debt repayments on the new lending wherever possible. Even so, the new acquisition should also produce a higher net profit and cashflow position to stay on the right side of debt servicing ratios and to avoid highly-leveraged over expansion.
My golden rule is to make sure every single property in my portfolio can stand on its own two feet when all costs and provisions are taken into consideration. However, there may be an opportunity to consider refinancing a property every 5-10 years, subject to undertaking a sensible risk assessment of the situation at the time.
There you go then, a slightly different approach to the subject of property financing using some of the conventional financing methods available to us, namely cash and BTL mortgages. I have tried to apply some practical and sometimes more creative ways of looking at these types of financing methods that could help us to expand our portfolios more rapidly, growing the snowball at a faster rate if you like.
This type of creative or applied practical thinking is going to be a running theme in this more specialised series I think you will find. For now though, let’s leave it there. Next time, we will take a close look at bridging finance. I will be joined by someone with bags of experience as both an investor and a finance broker. Not only that, he has a terrific and inspirational personal story to share as well, so make sure you listen in next time for that episode for certain!
By all means do email me personally if you want to talk about anything from today’s show or more general in property investing to podcast@thepropertyvoice.net, the show notes will be over at the website www.thepropertyvoice.net
Now all that remains is to say thank you very much for listening again this week and until next time on The Property Voice Podcast…it’s ciao-ciao.
[…] Let’s start off this series three off proper by considering some of the more obvious ways of financing our property investments, however, with a bit of a twist as it will perhaps be coming from a less conventional angle. Today, we will talk a little bit about cash and what I call ‘institutional finance’ and … […]