Like any investment, buy to let is about striking a balance between risk and reward. Find out how to identify your tolerance for risk and get the most from your property venture with these three top tips.
Tip one: Get to know gearing
In the simplest terms, buying to let entails buying a property, letting it out for the duration of your ownership, and making money through the rental income, the eventual sale, or a mixture of both.
Thanks to a concept known as gearing, however, you can use mortgage finance to influence – to an extent – the level of risk you take when investing in buy to let property, and concomitantly, the level of potential reward you can gain from doing so.
What exactly is gearing?
Gearing refers to the ratio between debt and equity; i.e. how much of an investor's portfolio is funded by loans rather than the investor's own capital.
In property, this is best described using the loan-to-value (LTV) ratio; for example, if you had a loan worth 80% of your property's value, you would have a 80% LTV mortgage and would own the remaining 20% outright.
Using gearing to boost your return on investment
Gearing allows you to invest in an asset with less capital than you would be required to pay if buying outright.
Assuming that you bought a property outright for £100,000 and sold it one year later for £110,000, your return on investment – £10,000 over the initial £100,000 expenditure – would be 10%.
If, however, you had used an 80% LTV mortgage and paid only a £20,000 deposit, your return (after repaying the £80,000 loan) would be 10,000 over 20,000, or 50%.
This simple example illustrates how, by using gearing, you can achieve returns far in excess of the underlying appreciation of the asset – in this case, five times more.
But gearing also increases costs and heightens risk
With the added potential for reward, though, comes higher risk. If you had sold at a loss instead of a profit, your losses relative to your initial outlay would actually be five times larger with an 80% mortgage than without. Such fluctuations are more likely in the short term, whereas in the long term, prices tend to trend upwards.
In addition, more highly-geared investments are more costly, because there are interest costs to service as well as day-to-day running costs. This means that the more debt you have, the narrower your margins are likely to be.
When deciding your optimum debt level it is therefore important to consider both the level of debt you are comfortable servicing, and how long you can afford to maintain doing so.
With the new tax laws for landlords announced in the last budget due to start coming into force in 2017, debt costs could increase for a number of landlords, so strongly consider discussing your strategy with a financial planner and/or a tax adviser.
Tip two: understand your risk premium
For some, the promise of greater reward is always enough to invite a gamble; others prefer to play it safe.
Your risk premium is the amount by which the expected return from a risky investment must exceed the guaranteed return from a risk-free investment in order for you to opt for the riskier option. The 'expected return' is the sum of the probability of each of the possible outcomes multiplied by the outcome itself.
The expected return of a buy to let investment can be hard to determine, as there are many variables at play. You will essentially need to estimate your possible yield, net of all costs, and factor in potential growth in both property price and rental income.
Calculate your risk premium
Let's say you predict that a buy-to-let investment has a 50% chance of returning 5% on your investment in year one, a 25% chance of breaking even and a 25% chance of making a 5% loss. The expected return is 1.25%, calculated as follows:
(0.5 * 0.05) + (0.25 * 0) + (0.25 * –0.05) = 0.0125
This is compared to a savings account that has a guaranteed return of 0.6%. So if you were to invest £100,000, the expected return from the property would be £1,250 and the guaranteed return from the savings would be £600. The risk premium is the difference between the two: £650.
Risk premiums can be positive, negative and neutral
£650 is a positive risk premium, as the expected return from the property is higher than the guaranteed return from the savings account. Someone with a positive risk premium is considered 'risk averse', as the expected payment needs to exceed the guaranteed payment for them to opt for the riskier choice.
If the expected payment and guaranteed payment were the same, then the risk premium would be zero. Someone who would opt for the riskier option in this circumstance might be considered 'risk neutral', whilst someone who would accept a negative risk premium because of the potential for higher returns would be considered 'risk seeking'.
It is important to determine the difference between the expected returns from a buy-to-let investment and the guaranteed returns from a lower-risk option; this way you are best-placed to give due consideration to whether you consider the risks worthwhile.
Tip three: Plan ahead
When it comes to planning a property investment, there really is no such thing as 'too much'. Only by researching as many details as possible can you form an accurate idea of a property's expected return, and in turn, whether it is worth the risk of investment.
Researching the property
As well as the cost of the property, you should determine its age, state of repair and annual servicing costs; the history of price growth in the area, projected price growth and any local factors that may influence prices in the future; and whether it is subject to any special legislation (such as mandatory licensing) that may influence the cost of running it.
Researching local rents
As well as local rents, you should look into local trends into arrears and voids; you should choose a demographic (families, professionals or students, for instance) and work out how best to cater to them; and look into factors that might influence local rents in the future, such as population growth or new residential developments.
Getting the right finance
You should also look into the finance available to you; interest rates, fees, loan to value ratios, maximum and minimum term lengths, whether or not you can make overpayments or switch mortgage without penalty and whether the amount you pay could rise or fall. As your mortgage is likely to be your biggest running cost, it definitely pays to look into all the options available and make sure you get the most suitable loan.
Speak to professionals and experienced landlords
There are a number of experts and professionals who can help you, from buy to let mortgage advisors and financial planners to experienced local landlords who can share what they have learned. The internet is also home to dozens of landlord communities, and there are hundreds of landlord associations up and down the country that you can join.
A buy to let investment is a big step and an important decision – so don't be afraid to ask for help or advice if you need them.
Written by Ben Gosling at Commercial Trust Ltd.
This article is for information purposes only, and should not be taken as advice.