The best way to treat buy to let as a “business” is to plan for the long term. And, whilst it can sometimes be tempting to cash-in early and take your profit, you have to remember that the greatest benefits of property are obtained in the later years NOT the early years. To catch all the benefits of compounding growth, you have to “keep” your properties.
But, what if you do need to sell? Perhaps circumstances are pushing you to free up cash. The simplest alternative is to refinance and to take your equity out as a loan. Let’s think about the advantages of this.
A major advantage of refinancing over selling could be that it avoids a lot of tax. Whilst I’m not a tax expert, my understanding is that if the properties are held in your name, it follows that any equity you take as a loan will be tax-free. Because it is not earned income, there will be no income tax – and, as you’re not selling, there will be no Capital Gains Tax. (Don’t take my word for it and do chat with your accountant about your own situation).
And, if you have your properties in a limited company, which is probably the best way nowadays for most investors, the loan to the company is tax free and can be used to ramp-up and build your business even bigger.
Refinancing your property and taking the equity out as a loan is effectively “harvesting”. Although the concept behind this is very simple, it can be a very effective plan for taking income. Here’s
how it works:
First, buy a property which you can let out at a high enough rent to cover your costs. Preferably take your time and, if you can, find a bargain you can pick up substantially below market value. Next, repeat the process annually for at least the next four years until you have a minimum of five properties. By year six, assuming properties grow in value at historic average growth rates, property number one should have increased in value substantially – and with it, so should your equity.
The next step is to re-mortgage and release say 75% of the increased equity, which you can then pocket as a tax-free lump sum. The extra finance charges you’ll have to pay should be covered by the rent, which should also have risen over the five-year period.
In year seven, repeat the process by refinancing property number two, and so on until year ten by which you will have refinanced all the properties. In year eleven, you repeat the cycle by refinancing property number one again for the second time.
Like all good plans it is simple and it seems relatively easy to implement. But is it realistic? I think it is, but obviously only in a consistently rising market. We already know that it’s possible to buy properties at below market prices for a variety of reasons. It’s also easy enough to find properties where the rent covers all the costs. However, we do need to be a bit careful because for the plan to work, we have to buy properties with good prospects of capital growth.
The clue to look for is the yield. Now, in simple terms it is generally true that: “the higher the yield, the less expectation there is in the market of capital growth. Conversely, the higher the likelihood of capital growth, the lower the yield”.
If you try and guarantee a positive cash flow by purchasing high yielding properties, inevitably you will be reducing the chances of benefiting from substantial capital growth. Obviously, this negates the whole point of the plan. As such, you will need to find the right balance between the yield and anticipated capital growth by researching the sales market and the rental market in your chosen location.
Assuming that you can find a property where the rent covers all costs, and where there are also good prospects of capital growth, you’ll then have to wait for prices to go up. This is the crunch part of the plan. If prices don’t go up, you won’t have any extra equity to pull out. Having said that, if you have bought at below market prices there will be some – but realistically, you’ll also want to benefit from market movements as well.
Now, if we take the average rate of growth of 8% per annum for the UK, the value of property number one should have increased by 47% by the end of year 5. Of course, this is only an average. Remember, property prices don’t move according to a straight-line graph. Some years they go up a bit, some years they go down a bit and sometimes they just stay the same. And, the average is the average for the whole of the UK! In some areas, the values will go up more than 8% and in other areas the values will go up less than 8%. But, assuming that by the end of year five that the property has gone up in value, we should now be ready to take out our equity.
This is quite straight-forward because most buy to let lenders will allow you to refinance and to borrow more if the rent still covers the mortgage payments by the appropriate ratio of 130% or 150% (or whatever your particular lender requires).
However, for the plan to work effectively, rents need to rise as well as capital values so that your increased monthly mortgage repayment costs are covered. The trouble is that in “normal” market conditions, increases in rents tend to lag behind increases in capital values by a few years. If you started with some ‘slack’ this shouldn’t present a problem but ultimately, the rent receivable will limit the amount you can borrow.
Here’s to successful property investing.
Peter Jones B.Sc FRICS
Chartered Surveyor, author and property investor
By the way, I’ve rewritten and updated my best-selling e-book, 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: www.ThePropertyTeacher.co.uk/the-successful-property-investors-strategy-workshop.