The Power of Gearing


With the outlook for savers looking grim, growth in the buy-to-let sector looks set to continue, despite mounting speculation that interest rates will soon increase.

While the average easy access savings rate is currently paying under 0.75%, landlords are receiving an average rental yield of 6.2%, according to Paragon Mortgages.

Greater yields are being supported by higher average UK rents, led by London where rents rose by an eye-watering 11.2% to £1,412 per month in the year to May, according to the latest Homelet Rental Index.

With housing supply falling short of rental demand, rents will almost certainly continue their upward trajectory; it’s a ‘landlord’s market’, which explains why many existing landlords are actively looking to add to their rental portfolios.

High returns
Aside from high yields, buy-to-let investor appetite is also being fuelled by attractive mortgage borrowing rates and rising property prices.

Research shows that landlords in the PRS are enjoying high annual returns from property in England and Wales, with capital growth and rental yields combined - both important components of a rental property investment - producing an average return of 12.2%. Lenders now perceive buy-to-let to be less risky than standard mortgage products and are currently offering over 650 different buy-to-let mortgage products, with record low interest rates being charged for both fixed and variable deals.

Many people feel anxious and uncomfortable when getting themselves into debt and understandably this is why many of us strive to pay off our mortgages as quickly as possible. But financially, this is not always the best decision, especially when long-term debt is used as a tool to create wealth. Effective use of gearing - a term to describe the ratio of mortgage debt to the total value of your property portfolio - is the key to getting the most from your buy-to-let properties.

“ investor appetite is also being fuelled by attractive mortgage borrowing rates”

The following two examples demonstrate a different gearing approach with a seed fund of £100,000.

By ‘gearing up’ their initial cash investments with mortgages, landlords can make superb levels of returns on their cash. As the capital increase on the property runs across it’s total value (including borrowed money)and not just the value of the cash they put into the deal.

Example 1:
If you used £500,000 cash to purchase a flat costing £1,000,000, with the aid of a £500,000 mortgage, you would effectively be 50% geared through borrowed money. If the value of the property then appreciated by 10%, or £100,000, after one year, you would have made a 20% gross profit on your initial investment, in addition to rental income.

Example 2:
However, investors can increase their level of borrowing and use gearing to generate higher returns. For instance, if you’d purchased that same property with a £750,000 mortgage (75% geared through borrowed money), then the actual profit on your initial investment of £250,000 would be 40%, assuming the capital value of the property appreciated by the same 10%.
Furthermore, you would still have £250,000 (half of your initial £500,000 cash budget) to invest in buying another buy-to-let property, enabling you to start building a property portfolio.

Historical analysis
To truly understand how influential gearing can be, you only need to refer to a recent study by buy-to-let specialists BM Solutions which revealed that the average buy-to-let landlord now owns a portfolio of eight or nine properties with a total value of £1.2 million, and could typically expect to receive an annual rental income of almost £60,000, more than twice the average UK wage of £27,174.

However, beware. Although gearing is a great way to make money, the heavier geared you are, the more risk you run; while property prices can rise, they can also fall, potentially leaving you in negative equity.

But buy-to-let returns have significantly outperformed every other asset class for investors - including equities, bonds and saving rates - since lenders launched the first property investment mortgages 18 years ago, according to Paragon Mortgages, and there is no reason to suggest that history will not repeat itself.