BORROWING TO INVEST

This article has been inspired by a recent newspaper article, which ignored the additional risks of borrowing to invest in property. Property investment is great for many people, but newspaper articles often simplify the investment issues surrounding property. The end result can mean these articles are unintentionally misleading. We explore the additional risks of borrowing to invest in property, and also explore the dangers of using statistics on returns without a wider context.

Key points:

  • Borrowing to invest in property or any other investment leads to additional risk
  • Be careful when acting on article recommendations – they don’t always cover all the investment issues
  • How borrowing to invest increases risk
  • Borrowing to invest magnifies gains and losses
  • How different loan percentages affect the risks of borrowing to invest
  • Could my property investment lose value?
  • Which other investment types use borrowing to invest?
  • Using statistics to make an investment case
  • The case for property – some comparative data

Background

I recently read this article in the Guardian, which paints a rosy picture for property, and a lousy one for shares, based on data over 1 year up to a particular cliff-edge for property. The article is not inaccurate, as far as I can tell, but neither does it give the full context I would hope for.

Property returns are better than share returns?

The article points out that, on the basis of a property index, average house prices have risen by 9.6% in the year to the end of March 2016, while the FTSE 100 index of shares dropped in value by 4.6%* over the same period. See more on this below.

*Actually, the FTSE 100 index of shares dropped in value by 5.8% over the year to the end of March 2016. The FTSE All Share index dropped by 4.4% over this period.

How is the index calculated?

The property index used is not a mainstream one, and seems to be used by the creators as a marketing tool to justify their own activities selling property investment. I prefer to use well-established and robust indexes for comparison purposes. In essence, I want to understand how the data is collated, and the longer the index has been running, the better. See more on this below.

Ignoring additional risks

The article uses comments from the property index creators that “assuming the [property] buyer took out a 60% mortgage, … the return would have been nearly 27%, far outstripping almost anything else available to conventional investors.”

What the newspaper article neglects to mention is that this 27%** return would be achieved only by borrowing to invest, and this would have significantly increased the risks.

**I calculate the return to be 24%, but I may be missing something as the article does not break down how the figure was calculated.

Borrowing to invest – gearing or leveraging

On the face of it, buy to let investment seems perfect. You put down a relatively small deposit, pay a few fees, get a tenant, and that tenant then pays the borrowing costs. Over time, you make an increasing profit on the rent, and also get a long-term capital growth. What could possibly go wrong? The reality is slightly different, as explored in our articles on property vs investments and the new rates on buy to let stamp duty. Many newspaper articles gloss over issues such as tax, borrowing costs, fees, legislation, and tenants. Property investment can work for many people, but it is not as perfect as sometimes portrayed.

What is gearing or leveraging?

When you borrow to invest in any asset, you generally increase the risks of that investment. Borrowing allows you to put less of your own money down as you can use the borrowed money to buy more of your chosen investment. In the case of a buy to let property you may put down a 25% deposit and the lender will loan you the remaining 75%. The downside is that you need to repay that loan, and the interest payments reduce your profits (and also therefore increase the risks). You are liable for those borrowing costs whether or not your tenant pays you enough rent to cover your costs. Clearly, this increases the risks. If you understand those risks and are prepared to accept them, then property investment should be right for you.

Borrowing to invest amplifies the growth or losses you make, as was demonstrated in the article quoted above. Unfortunately, this was not explained, so we will show you how we think this was calculated below.

In the newspaper article, the quoted return was 9.6% over a year. The commentator assumed that an investor had a 60% mortgage, so put down 40% of the money. If we put some theoretical figures on this:

  • Purchase property – £100,000
  • Investor’s stake (deposit) – £40,000
  • Loan (interest only) – £60,000

After 1 year, the situation looks much better:

  • Property value – £100,000 + 9.6% growth = £109,600
  • Investor’s stake (deposit) – £40,000 + growth of £9,600 = £49,600
  • Loan (interest only) – £60,000

If we now calculate the percentage growth of the investor’s stake, we get these figures:

  • Original investor’s stake – £40,000
  • Investor’s stake after 1 year – £49,600
  • Growth in investor’s stake = 24% (not quite 27%…)

This makes the positive case for borrowing to invest. What it does not do, is take into account all the other property investment factors, which you should consider, such as landlord’s responsibilities, difficult tenants, mortgage interest, other costs, fees and taxes. The fact that the buy to let stamp duty threshold has changed has clearly increased the annual growth to the end of March 2016, but this will probably reverse now that the new tax rules are in place, which make the cost of buy to let even greater.

Borrowing to invest magnifies gains and losses

My biggest concern with the figures quoted in the article is that they paint only a positive picture of borrowing to invest. The uninitiated reader might conclude that borrowing to invest can only be a good thing. The reality is that borrowing to invest magnifies gains and losses. Let’s examine a scenario where the reverse took place, and the theoretical property investment lost 9.6% in value. Don’t believe this is possible with property? See the data below which uses actual property returns from the credit crunch of 2007 to 2008.

  • Purchase property – £100,000
  • Investor’s stake (deposit) – £40,000
  • Loan (interest only) – £60,000

After 1 year, the situation does not look so rosy:

  • Property value – £100,000 – 9.6% loss = £90,400
  • Investor’s stake (deposit) – £40,000 – loss of £9,600 = £30,400
  • Loan (interest only) – £60,000

If we now calculate the percentage loss of the investor’s stake, we get these figures:

  • Original investor’s stake – £40,000
  • Investor’s stake after 1 year – £30,400
  • Loss in investor’s stake = 24%

How different loan percentages affect the risks of borrowing to invest

The greater your loan is compared to the initial deposit, the more the returns will be amplified (growth or losses). Effectively, you have a greater risk the smaller your deposit. This is demonstrated by the table below, which examines the fluctuation in growth or losses with a 5% or 10% change in either direction.

Borrowing to invest - gearing table

How to read this data

Imagine you buy a rental property with a 20% deposit. If the property increases in value by 5% overall your original stake (deposit) would increase by 25%. If the property loses 5% of value overall, your original stake would decrease by 25%. The amount you borrow as a percentage of the overall asset amplifies the effect of growth or losses in either direction.

Could my property investment lose value?

Like any investment, the value will fluctuate according to demand as well as other factors. See below for more comparative data on the past performance of property as an investment versus shares.

You will remember the credit crunch, which happened across 2007 and 2008. Access to loans dried up quickly, and this had a dramatic effect on property and share investment returns as confidence dried up.

Borrowing to invest - 1 year data from Sept 2007 to Aug 2008

Source: Financial Express.

This data shows that, according to the Halifax Property Index, if you had been unfortunate enough to buy an average property investment at the height of the property market in September 2007, a year later it would have been worth 12.77% less than when you bought it.

What if you had used borrowing to invest in this property in 2007?

Let’s apply the same calculations to the example above, but using a 75% loan to value (25% deposit), which was common for buy to let investment at the time.

  • Purchase property – £100,000
  • Investor’s stake (deposit) – £25,000
  • Loan (interest only) – £75,000

After 1 year, the situation does not look so rosy:

  • Property value – £100,000 – 12.77% loss = £87,230
  • Investor’s stake (deposit) – £25,000 – loss of £12,770 = £12,230
  • Loan (interest only) – £75,000

If we now calculate the percentage loss of the investor’s stake, we get these figures:

  • Original investor’s stake – £25,000
  • Investor’s stake after 1 year – £12,230
  • Loss in investor’s stake = 51%

Clearly, this demonstrates the additional risk of borrowing to invest. A property investor who did not borrow to invest would have been smarting at a loss of 12.77%. The same investor who used a 75% buy to let mortgage would be been much worse off in percentage terms with a loss of 51%, and still sitting with a liability to the mortgage as before.

Which other investment types use borrowing to invest?

Borrowing to invest is not limited to investment property such as buy to let. You can borrow to invest in any investment, provided you can obtain the loan for the purpose required. Borrowing to invest is relatively rare in investment portfolios such as the type that we recommend. The reason for this is that it vastly increases the risks involved! Very few regulated investment advisers would recommend that you borrow to invest in an investment portfolio, since this should really be only for sophisticated or wealthy investors. It is interesting to note that this practice is common-place in the unregulated world of property investment, where investments are often made by cautious investors looking to beat poor bank account returns!

Investment trusts

Investment trusts are one type of collective investment that can use borrowing within the investments. As a result, on average, investment trusts tend to be seen to be more volatile. Actually, this may not be the case, and investment trusts should be viewed individually to see the level on gearing that is taking place within the fund.

Using statistics to make an investment case

Most financial articles use statistics to make their case, and to lend authority to their argument. This is fine and recommended, so long as the proper context and explanation is given.

In the article mentioned above, the stated returns on property were 9.4% in the 12 months to March 2016, and a loss of 4.6% for the FTSE 100 index of UK shares over the same period. The article fairly reminds the reader about Government changes to the buy to let market such as stamp duty increases. However, this comes towards the bottom of the article after repeated headlines about the relative merits of the property versus shares.

How is the index calculated?

The article makes reference to the Property Partner Residential Market Index (PPRMI). I confess, I had never heard of this index, but the firm behind it operates a crowd funding model which allows investment in property schemes using borrowing. I do not know the full methodology behind the data, but their website states that data sources include “Land Registry HPI, ONS Household Expenditure Survey 2004-2015 and the VOA Private Rental Market Statistics quarterly report”.

I prefer to use long-established indexes when comparing investments. I also like to understand how the data is compiled. I am not saying that the index used is not valid, just that I used alternative indexes.

The data below uses the Halifax property index, which is a measurement of residential property in the UK (operating since 1983), and the IPD index of UK commercial and residential property (operating since 1986).

All property indexes are particularly vulnerable to commercial influences, simply by their nature. They can be created to back up an investment case, and can have limitations in the data used, simply because whole of market information is not as readily available as with quoted investments like shares. For example, the Halifax Property Index uses Halifax mortgage sales data. While Halifax is a large lender in the UK, it does not represent the whole of the UK property market. Therefore, the data could be skewed towards certain transactions based on the commercial practices of Halifax.

The case for property – some comparative data

The whole point of a headline is to grab your attention. Clearly, this one did for me: “House price rises see buy-to-let returns outstrip FTSE 100”. Of course, the headline only gives part of the story, so you need to read the whole article to get the full background. But, if you see an authoritative source like a national newspaper quote some figures you probably feel justified to take them at face value. We have set out what we hope is some wider context to the data used below.

We have compared 3 indexes of data over 1, 5 and 10 years. We have used the average return of UK shares unit trusts (red), plus 2 property indexes, the Halifax Residential Property (blue) index, and the IPD commerical and residential index (purple). The wide differences between the 2 property indexes should show you the flaws of relying on one source of information unless you buy in to their particular methodology.

Source: Financial Express.

1 year data

Borrowing to invest - 1 year data

This chart appears to back up the case for property investment. Over 1 year, property has outperformed shares significantly. Of course, what this data does not show you is that at the start of April 2016 all new buy to let property purchases will now attract increased stamp duty costs, in addition to other changes to tax rules for the sector. This will certainly reduce demand in the sector, which will probably reduce returns. Using this data in isolation risks ignoring the full picture.

5 year data

Borrowing to invest - 5 years data

This data shows a mixed result, with UK shares performing as well as residential property, based on these measurements. Of course, this data does not include other costs. See this article for more details.

10 year data

Borrowing to invest - 10 years data

Over this period, the returns of shares look much more attractive than residential property as shares appear to have recovered from the credit crunch of 2007 and 2008 at a much faster rate, despite the recent volatility (linked to the EU referendum?).

Conclusion

Clearly you should only invest in anything when you understand all the issues, costs and risks involved. Please contact us if you would like to discuss your own investment position.

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Dan Woodruff

Certified Financial Planner & Chartered Wealth Manager at Woodruff Financial Planning
Financial Planning helps you to navigate and anticipate significant life changes. I want to help you to ensure your money is managed wisely to give you the financial security that will fund the future and lifestyle that is important to you.

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