Why do property investors gear their investments?
By: James Newland
Many property investors successfully gear their property portfolios using debt vehicles within pre-developed investment portfolio structure. While this particular type of investment does not work for everyone, many successful property investors are able to use debt to maximise their returns.
Gearing refers to the level of a company’s debt related to its equity capital, usually shown in percentage form. It is a measure of a company’s financial leverage to illustrate the funds that are available, utilising debt vehicles such as; mortgages or property loans.
Scenario 1: Say you acquire a property for £200,000 then there would be no debt to take into consideration. However, the value of the property increased by £20,000 you have a 10% return on your investment, but there are other ways to use your £200,000.
Scenario 2: Rather than just buying one property outright (like scenario 1) you can look to utilise various debt vehicles such as mortgages or property investment loans to maximise your exposure. For example, if you work with a 75% loan to value for each loan, then it is possible to put down a £50,000 deposit on four different properties (valued at £200,000) and use gearing to cover the additional £150,000 per property. If property prices were to increase by 10% rather than a straight £20,000 profit you would have a £20,000 profit on each of the four properties, totalling £80,000.
There is a cost to using debt to acquire property and the prevailing interest rate will depend upon the market at the time. In an ideal scenario, you would benefit from a rise in property prices across four different properties as opposed to one property if you did not utilise debt finance. There are obvious risks when looking at gearing up your portfolio such as a reduction in rental income, an increase in mortgage rates and a fall in the value of your properties.
While these two examples are extremes, there are opportunities to utilise debt instruments to maximise your exposure and your potential profit. However, this potential reward does come at a price because a significant fall in property values and/or rental income may impact your ability to finance your debts. This then opens you up to a whole array of potential risks.
In reality you need to take a balanced approach to property investment and gearing, ensuring that you have a backup plan in the event that additional funds are required at relatively short notice.
Sources: Development Today and Property Forum