Buying Investment property – Cash or Finance : Which is best?

For long-in-the-tooth investors, they know that borrowing money from the bank to buy property can make you a lot more money than paying cash. The only question that you need to ask yourself is if you are comfortable going to sleep every evening when you owe the bank money, and there are instances when it has gone horribly wrong for some investors.

This can be due to a lack of overall strategy and an over-optimistic view of the property market. In this article, we will start with a few comparative examples that explain what the different returns are for cash and property that is financed.

If you are looking for some independent advice on mortgages and property loans then why not head over to our financial page by clicking here and speak to our partner, Capricorn Finance.

Paying Cash

If, as an investor, you have an investment fund of £250,000, and want to pay cash, then this would probably be a single property in a UK regional area such as Birmingham or Manchester.

The cost to purchase will be 5% stamp duty (3% second home and 2% Overseas investor) plus legal fees. This will be around £15,000 in addition to the purchase price.

The rental yield will be an achievable 6.5% or 16,250 per annum (£1,354pcm). We are using gross yield as opposed to net yield in this example (to make a like for like comparison).

If we assume a 5% year on year increase in the value of the property for the next 5 years, and rents also increase 5% year on year. In 5 years’ time your investment would look like this:

The property value would have increased to £319,000 and the rent collected over 5 years would amount to £89,790 (5 years rent increasing by 5% per annum).

If you sell the property and receive £317,000 (less legal fees) then you will make £77,000 in property appreciation and £89,790 in rent, a total of £166,790. Your initial investment was £265,000, this represents an ROI of 63% over 5 years, or 12.5% per annum. A good return?

Using Bank Finance

Take the £250,000 to buy 4 properties, 80% financed and 20% deposit. Total investment would be: 4 x £50,000 deposit, and 4 x stamp duty and legal fees @ £60,000. Hence, a £260,000 investment to buy 4 properties.
The finance rate would be around 4.5% as an example and the interest per annum would be £28,000 (£800,000 finance @4.5%).

The rental income would be £16,350 x 4 which amounts to £65,400. Let’s compare this to the cash purchase after 5 years.

The properties would be worth £319,000 each, totaling £1,276,000 and the total rent collected would have been £359,160 for 4 properties. The profit would be calculated as follows – Appreciation would be £268,000 together with the rental income would be £627,160.

After deducting the mortgage interest of £180,000 over the 5 years the profit is £447,160, which is a ROI of 172% or 34% per annum.

Please remember - for the ease of illustration we have used gross yields and not net yields, and you will need to consider any management fees (if you use a property management company), mandatory safety checks, maintenance requirements, void periods, and taxation. These do not disproportionately affect either option and the equation is roughly the same.

Borrowing money from the bank will generate a higher return of investment but as stated at the beginning, in this example, you will owe the bank £800,000 against the properties that you own. To minimise your risk and exposure you need to stress test your investment before going ahead.

What do we mean by “stress testing” the investment?

This is to make sure that if the market changes, then you are still able to cover the loan payments from the rental income and not having to supplement the payments with your own income.

In general, interest mortgage payments need to be less than 75% of the rental income (many banks will stipulate this as part of their lending criteria), what happens if mortgage interest rates increase? Do you have a fixed interest mortgage? What happens if the rental yield decreases? What margin do you have before they will not cover the interest payments?

In terms of finance, it’s not critical if the house prices fall, as they can increase again, the tests are based on the interest rates and rental income.

With the finance option you can also use the increase in property values to increase the mortgage against the property and invest in more properties (releasing equity). Using the example, the houses have increased by £268,000 and you can ask the bank to release 80% of this and purchase more properties in the same way, maybe another 4 or 5!

You must remember that this will increase the mortgage interest payments and you must make sure the rents can now cover these additional commitments. It is always good to maintain a loan to value ration of no more than 60% to make sure you have enough safety, should the market change.

We have seen examples of landlords who have continued to release equity and continue to buy property with a loan to value of 80%, and in the end, were using equity releases to pay the mortgages (rents did not cover the rents) rather than investing in new property. When the financial crash came along, they could not cover the mortgage payments and ended up in the bankruptcy courts.

With a well-balanced portfolio, and a good loan-to-value ratio, you have opportune exit routes that can produce a worry-free retirement. If you have a good-sized portfolio with bank finance, then you can sell a part of your portfolio, take the profit, clear the finance on the retained properties, and then simply draw rent as your retirement income, without worrying about interest rates, loans etc.

Property investment can be complex, and it takes a savvy investor to maximise the returns by building a balanced portfolio based on their requirements and the risk that they are comfortable with. A lower return may make it easier to sleep at night, with all these things being considered.

If you want to book a meeting with Magnate to discuss any questions that you may have, then please click here. We are an independent UK property Portal, and we are happy to provide you with any information or advice you may want for your UK property investments.