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Why a Self-Financing Property Portfolio can Make Sense for HNW Investors

A staff reporter

29 January 2005

If you’re sitting on idle assets, then you could be sitting on the seeds of a self-financing property portfolio. It might be possible to transform a £1m home into a £1m home plus a £4m investment property portfolio without spending any additional cash. James Hughes, director City Trading Post Limited, examines how this possibility can become reality. Along the way, he outlines the benefits and risks aligned to the property investment strategy, as well as provides insight into risk diversification through the use of bricks and mortar. There are several good reasons to get into the property game, including: 1) Risk diversification – The returns on investment in property have historically been uncorrelated with the returns on other types of investment, such as equities. Therefore, by diversifying into property, it is possible to reduce overall market risk of an investment portfolio. 2) Good use of idle capital – Mortgage lenders are usually quite happy to advance a mortgage secured against a home, especially if the capital raised is to be invested in other property, as this is regarded as a relatively safe investment. 3) The yield on property investment is roughly index linked, because the value of property generally goes up in line with everything else in the economy. This makes is a suitable investment for long-term income planning; for example, providing income during retirement, the duration of which is, happily, unknown. Regarding straightforward buy-to-let type property investment, average gross rental yields are about 7.5 per cent in the south-east of England at the moment, although that takes account of neither capital gains nor the various transaction costs, vacant periods, and so on. However, ignoring for a moment these various gains and costs, it is worth examining the premium of yield over the average cost of borrowing: probably around 1.25 per cent, possibly a bit more. This does not sound like much, but that is the net return on the value of the property; it is not the net return on capital invested. In order to purchase a property worth £1m, it is necessary to put down around £200k deposit. A total of 1.25 per cent return on £1m translates into 6.25 per cent return on £200k, which sounds much healthier! This is the effect of gearing. And where to find £200k? Well, many high net-worth individuals already live in unmortgaged property, or their mortgage may be relatively small after years of property appreciation and paying down the capital. A banker or lawyer who bought a £100,000 Chelsea flat 20 years ago with a £75,000 mortgage would probably be sitting on at least £1m of property today, and with practically no mortgage, if any. So, raise the capital there and then gear it up by raising another mortgage on the investment property. Obviously there are costs incurred on the deposit money itself, which reduces the net yield on capital invested quite significantly. But whatever the yield, it’s better than zero, which is what it was earning before! Let us look at some real numbers. Take a property worth, say, £1m. Raise a £200k mortgage based on currently available discounted variable rates, around 5.25 per cent. Using this cash one can raise a further mortgage of £800k to purchase property worth £1m. The cost of this money is 6.25 per cent. Transaction costs may amount to five per cent - remember four per cent of this is unavoidable stamp duty, which is just another tax on the wealthy; what exactly, in this day and age, needs to be stamped? These costs can be capitalised too. Anyway, total amount spent is £1.05m at an average cost of 6.06 per cent . A yield of 7.5 per cent on £1m of property equates to 7.14 per cent when spread over the total £1.05m spent. That’s a net yield of 1.08 per cent , or 5.67 per cent return on the original £200k capital raised. Not a bad return on money conjured out of thin air! If there was a capital gain of five per cent on the £1m property portfolio, the £50k notional gain could be used to gear up by another £200k, increasing the total portfolio to £1.25m, and on and on and on… It sounds quite simple, and on the face of it, the numbers certainly look attractive. However, before you rush off to the bank, bear in mind the following: 1) Buying and letting out property can be an administrative nightmare; employ a good mortgage broker, a good solicitor, and a good property management company to take the pain for you. More fees, less profit, but less headaches. 2) The value of property can fall, although this is a rare occurrence, so do not count on capital gains, and remember that if property prices do fall, your geared property portfolio could sting quite badly. 3) Property has historically under performed equities, as well as being uncorrelated with them. Property is therefore good for risk diversification and inflation-proofing your portfolio, but should only constitute part of the mix; discuss with your trusted adviser. 4) Get your timing right. All markets move in cycles, and property is no exception. Watch interest rates, inflation, and general indicators of economic activity; or talk to people trying to buy and sell their homes. And to end on a positive note, one of our clients started investing in the property market with £100k of capital about four years ago; he now has a property portfolio of more than £1m and net assets of more than £500k. Good work!