Over the past few years we have all heard about the rise and fall of the Buy to Let concept of property investment. Starting off very positively, the whole idea gained extensive momentum, spawning numerous privateers, followed by management companies, seminar providers, corporate and individual millionaires and a never ending selection of tv shows insisting that buy to let was the be all and end all of investment for the masses.
As time as shown though, hindsight being 20-20 and all that, a large number of partakers in the idea have fallen a little foul of the market conditions. In the beginning house prices were still on the rise, interest rates were amenable and all was good. Once the tv and mainstream media, coupled with the vast amount of “become a property millionaire” propaganda swamped our daily life, the investment blinkers really kicked in.
Not for the first time, we saw an investment idea preached to the masses as being so simple a 5 year old could manage it and subsequently we saw people buying up parts or even complete streets of property and dreaming of retiring by sundown based upon what they had been told.
What wasn’t explained at the time though was the use of leverage and the incumbent dangers that go with it. Everyone had long forgotten the term “negative equity” and those that hadn’t confined it to the cupboard of “doom words” not to be used.
Leverage, or gearing as it is also known is a remarkable tool in the investment world. It can make you ridiculously rich in minutes, or so poor you cease to exist. Leverage is primarily used to amplify profits in low spread investment tools such as currency or commodity trading. Rates of 100 to 1 can be acquired in currency trading. This particular sector needs this because the difference between 2 currencies might only vary by half a cent. Investing into 10,000 dollars for example to see a gain of half a cent shows a profit of 50 dollars, a huge outlay for minimal return. However, beef it up with some leverage, say 100 times and all of a sudden that 50 dollar profit is now 5000!
Now if we were to stop the article here, I don’t doubt that those not familiar with the rest of the story might think it’s a good idea to go online, open up a trading account, sit back and be a millionaire next week. What was never really cited by any of the media, banks or regulatory bodies at the time was the downside of leveraging your investments.
Turning your 50 dollar gain into 5000 on a half cent positive move is one thing, what happens though if the market goes against you? Well, lets say a bad day hits the market, and your trade drops by 1.5 cents (not unlikely in the current markets!) Without your leverage, you have only lost 150 dollars.
With the leverage? That loss has now turned into 15000, 5000 more than you started with, and the costs of the borrowing on top!
An extreme example I know, but in this particular case we have only covered the initial pitfalls. With property, and especially buy to let, you are relying upon actually letting and receiving payment to cover your position as well. At least with the currency trade if you are called, that’s it. With physical property acquisitions if the market slumps and there are no buyers you can’t even get out.
Leverage is a fantastic tool when it is understood and used within the limits of the investment vehicle and the investors tolerance. If the investment vehicle has a built in stop (or call) or a defined exit strategy, this further reduces the exposure to the investor. Leveraging also relies heavily upon not taking physical acquisition of the commodity, as soon as you do, that’s where the trouble starts because you have to fund your way through and out of it, in the case of buy to let, the mortgage.
According to EveryInvestor a survey of landlords conducted by LSL Property Services stated that although 49% said the current market was attractive for investment again, only 27% said they would be able to this year due to poor availability of mortgages. The surveys summary goes on to point out that 11% would be reducing their holdings. Most interestingly though, the survey states that “Landlords’ confidence in the market is driven by their desire to maximize returns in a low interest rate environment, with a third of them attributing their positive sentiment to the superior capital returns of buy-to-let as compared with other forms of investment. In 2009, a typical landlord made a total return of 7.6% – higher than many other forms of investment.”
The fact remains that buy to let has some areas to it that you should understand before wandering in to. A 7.6% profit is not bad for last year, if that is the only figure you look at. If you take into account the risk level, possible negative equity and extreme long term illiquidity of the investment vehicle as a whole, it is inclined to look a little less appetizing when you consider that it is possible to take advantage not only of leverage within the property market, but also a guaranteed exit strategy at the same time as well as a short to mid term commitment.
- Wednesday 10 February 2010