Is Property Borrowing Good?

Oct 3 • Home Improvement • 362 Views • Comments Off on Is Property Borrowing Good?

It used to be a cardinal principle of property investing that you use leverage to boost your returns. Leverage is borrowed money and the idea was that the savvy borrower would take money at say 5% and get a 12% or 15% return on it, so making a 7-10% profit on the borrowed money. There was almost distain for the poor, stupid, saver who only got say 4% for his money.

Property investors love to boast about the size of their portfolio, all built on leverage. All of this works well in a rising market. In a falling market property investment looses it’s attraction, yield may become negative and because it is a non-liquid asset which is falling in value, if you get the timing of the sell decision wrong you can loose capital big time.

The main problem with leverage is that it amplifies market movements. Prices in the property market should be a function of supply and demand, but leverage involves bringing in money from outside of the property market, which fuels rising prices, ultimately creating a bubble. When the bubble bursts the consequent removal of leverage depressed prices by removing liquidity from the market.

Malcolm Frodsham, former head of research at IPD (Investment Property Databank) speaking at last weeks Real World conference in Cambridge, said that the IPF(Investment Property Forum) had commissioned research into how effective leverage is. He said that they concluded that leverage was material in “destroying value”.

The research looked at 68 Property Funds, of which 22 are balanced funds (mainly property unit trusts), 9 managed funds and 37 specialist funds. It found that managed funds returned 6.2% before leverage, but this fell by 19 basis points once debt was taken into account. Meanwhile, the risk – or volatility – increased by 10%.

Specialist funds saw their returns increase from 7.7% to 8.6% when accounting for leverage, while their volatility increased by 52%, which when you adjust the return for the risk, also gave a negative return.

The problem seems to be that investors cannot manage their leverage, so that the could have more in a rising market and less when returns are weak. That is an argument for having short term borrowing, but short term borrowing has always been more expensive than long term, because of the costs of setting up the loans. Asit was, lenders fees accounted for 1% of the returns from the portfolios, of the £11.1 billion surplus made by the funds over a decade £2.1 billion went on fees.

Averaging out the findings across all three fund categories, Frodsham told the conference: “Leverage, overall, frankly added absolutely nothing – 0.03% – but it did inject an awful lot of volatility and I’m sure it also injected an awful lot of angst into the industry as well.”

So if you follow Mr Frodsham’s advice, sell a proportion of your portfolio to repay the debt you have, then you can forget LTV covenants, facility reviews and monitoring your compliance with all the small print in your loan agreement. You will sleep soundly and will not have to spend valuable time dealing with lenders. A win-win situation? The only thing better would have been to have sold the entire portfolio at the top of the market.

Carlo Rossi is a London based realtor and blogs for UK Business Property. In particular he writes on office design, real estate tips, and savings.

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