The Power of Renovation
The next way to super charge already impressive returns is to buy a property ripe for improvement and renovate it.
The key, of course, is to make sure that the works increase the value of the property by more than the cost of the works themselves.
If an investor can find the right property, which means a property requiring the right type of work, then gearing-up and using finance shouldn’t be a problem. Even post credit crunch, some lenders are still offering ‘light refurbishment loans’ which allow an investor to buy a property requiring work and refurbish it prior to letting.
That might not sound like much of a big deal but many, if not most, buy to let lenders will not lend on a property which can be deemed to be ‘unlettable’ on day one, and they can be extremely picky in imposing that definition.
Also, note that this type of loan is typically referred to as ‘light’ as in ‘light refurbishment’ – lenders will not lend where major works of repair or improvement are required.
With a typical light refurbishment loan the lender will make a mortgage offer based on, say, 70% or 75% of the end value of the property following completion of the works but will initially advance only 75% of the lower of the purchase price or the valuation. The initial advance might also be subject to a ‘retention’ against the cost of the works, which will be released on completion of the works.
So, in this instance let’s assume our investors buy property requiring a light refurbishment.
In their current, un-refurbished condition each property is worth £134,000 (as before) but our investors are able to buy at a genuine discount of 25% below market value, and pay £100,000 per property.
Each property requires £20,000 of work and will be worth £175,000 when works are completed.
The lender will lend 75% of the completed value, in other words they will lend 75% of £175,000 which is £131,250.
Initially they will lend 75% of the lower of the purchase price or the value. As we know, the purchase price is lower than the value and so they lend £75,000.
However, this is subject to a retention of £10,000, which will be released on completion of the works.
Let’s look at each investor’s position after 20 years (and 30 years).
At year 20 Investor No 1 will have properties worth say £1,850,000 and equity of £1,325,000
At year 20 Investor No 2 will have properties worth say £3,250,000 and equity of £2,725,000
At year 20 Investor No 3 will have properties worth say £6,750,000 and equity of £6,225,000
At 30 years the Investors will have equity of £2.475m, £4.275m and £11.375m respectively.
Now, there are a couple of things to note in this scenario.
Up until now we have assumed that each investor will have £100,000 in available ‘cash’ which is split as four deposits.
However, we are now assuming that the bank will impose a £10,000 retention per property. Although this will be released when the works are finished the investors will need to cover this cost in the short-term.
Also, we are assuming each property will need £20,000 of work, again a cost which each investor will need to cover until the works are completed and the full mortgage advance is released.
As this is a totally hypothetical scenario you are entitled to assume that an investor may look at this option but decide they don’t have enough money to cover the extra costs, or you can assume they will use their ingenuity to borrow or to release the extra cash from other sources.
One thing to bear in mind is that in this instance the investor will be the beneficiary of a ‘cash-back’ when the full mortgage amount is released.
How does that work? Well, initially they will need to put in £35,000 of their own money, being £25,000 for the deposit and £10,000 for the retention. This secures them a mortgage of £65,000 which allows them to buy the property.
On completion of the works they can draw down the full mortgage which is £131,250 (being 75% of the end value of £175,000).
This will give them £31,250, the amount by which the new mortgage exceeds the purchase price, plus will repay the £35,000 of their own money which they have put in.
This scenario is ‘No Money Left In’ – once the works are completed there is none of the investors own money tied up, it is all the bank’s money, and the investor gets a cash-back of £66,250.
So there is plenty of incentive for the investor to beg or borrow the extra funds required to make these deals happen.
Increasing the value of a property through repairs or improvements or both makes a lot of sense as it is a relatively easy way to increase your equity, and the base value of the property, just as long as you know what you are doing.
Do your sums first, cost the works as accurately as possible and research how much value the works will add. If the works add more than the cost, then do the works.
Enhancing the property is an easy way of creating equity and at an opportune moment, should you wish, you can remortgage and withdraw the equity to use for another property, or you can remortgage to get better finance terms.
Which takes us nicely onto our next power-play, but before we do, let’s quickly summarise where we have got to and see how the figures look:
|£ Equity after 20 years|
|Investor No 1||Investor No 2||Investor No 3|
|With gearing & BMV||1,100.000||2,200,000||4,870,000|
|With Gearing, BMV, and Renovation||1,325,000||2,725,000||6,225,000|
Next time we’ll look at how our returns can be significantly increased by refinancing.
Here’s to successful property investing
Peter Jones B.Sc FRICS
Chartered Surveyor, author and property investor
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