The Power of Gearing
In a sense these figures show the raw returns from capital growth, but this is very much an artificial situation used purely for illustration purposes.
In reality there would be a few more things going on.
For a start, most investors would probably buy using finance and would “gear-up”. Instead of buying one property for cash they would probably spread their cash across a number of properties, using their money as ‘deposits’ and financing the balance using mortgages.
The appropriate measure of comparison would then be the cash-on cash return, the return they make on their own money invested.
As each investor has £100,000 we’ll also assume that they will split this between 4 properties, each worth £100,000.
If we assume a current LTV of 75% then each investor will borrow £75,000 and put £25,000 of their own money in when buying a property worth £100,000.
We will also assume, for simplicity, that each takes out an interest only mortgage and so, at year 20, there will still be a £75,000 mortgage outstanding on each property.
On day 1 each investor will have £100,000 in equity, total mortgages of £300,000, and four properties with a total value of £400,000.
Equity, for our purposes is the value of the property less any mortgage outstanding.
Assuming the same rates of returns as before, here’s how each of our investors financial positions will look after 20 years.
We’ll use 20 years, not only to compare with the un-geared scenario we just looked at, but because 20 years is a fairly typical term for a buy to let mortgage (although just for your curiosity and interest we’ll also calculate the position after 30 years so we can see the power of compounding really kicking-in).
Investor No 1 will have property with a total value of £1,061,320, but say £1m with equity of £700,000 (after 30 years the property is worth £1,728,760, but say £1,750,000, with equity of £1,450,000).
Investor No 2 will have property with a total value of £1,864,400, but say £1,850,000 with equity of £1,550,000 (after 30 years the property is worth £4,025,080 but say £4,000,000 with equity of £3,700,000).
Investor No 3 will have property with a total value of £3,858,520, but say £3,850,000 with equity of £3,550,000 (after 30 years the property is worth £11,983,960 but say £12,000,000 with equity of £11,700,000).
Let’s summarise the investor’s equity position so far, having looked at the power of capital growth and the power of gearing:
|Investor 1||Investor 2||Investor 3|
We can also calculate each investor’s return on equity, or ‘cash-on-cash’ return:
|Investor 1||Investor 2||Investor 3|
So we can now see another of our timeless principles
The return on an investors own money invested will be significantly increased through the use of gearing or, put another way, the less of your own money you put in to a deal, the greater the return you’ll make on your own cash.
Something all investors should take note of is the cumulative effect of applying these principles together.
At one extreme we could have Investor No 1 who decides to buy a property. Perhaps being debt averse, and not understanding the ramifications, he decides to buy for cash and not use finance. Rather than take time to research what and where to buy, he decides to buy a property in the next street, which will be ‘handy’ as this will make it easier to manage.
By contrast, Investor No 3 understands the power of gearing and splits his initial capital over several properties. He also takes time to research areas which are good for renting (as he wants to cover his costs) but where there is a good expectation of capital growth in the long-term.
The outcome for each investor is dramatically different.
After 20 years Investor No1 has a property which he owns outright with no mortgage which is worth £265,000.
By contrast, Investor No 3 has properties worth £3,850,000 with mortgages of £300,000, and equity of £3,550,000.
Investor No 3 has made 13 times more equity than Investor No 1!
And they both started with the same £100,000.
After just another 10 years the relative positions are even more extreme, as Investor No 3 now has four properties worth just under £12m, equity of £11,700,000 and is worth a staggering 27 times more than Investor No1.
But as we’ll see in future posts, even this isn’t the end of the story.
Here’s a final thought for now. The ultimate expression of gearing is The Nothing Down deal where an investor buys a property using none of their own money, but enjoys all the returns. Just a few years ago many investors wouldn’t contemplate a deal unless it was “Nothing Down” which we can define as being a deal where the investor put none of his or her own money in.
With none of their own money in the deal it was, by definition, impossible to measure the return on the investor’s own money, and this gave rise to the view that any positive return was infinite.
Next time we’ll look at how our returns can be significantly just by buying at a cheaper price.
Here’s to successful property investing
Peter Jones B.Sc FRICS
Chartered Surveyor, author and property investor
PS. By the way, I’ve rewritten and updated my best selling ebook, The Successful Property Investor’s Strategy Workshop, which is an account of how I put together my multi-property portfolio, starting from scratch and with no money of my own, and how you can do the same. For more details please go to: