Leverage In Property: Associated Risks & How Much Is Too Much?

At this point in time all properties in my portfolio are unencumbered (bought outright).

It’s an unusual set up but it was done intentionally.

The intention being to use property as a vehicle to safely store wealth while generating exponentially higher returns than bonds can currently offer.

However if I’m going to keep buying and building the property business, at some point in the next 12-18 months, one of the only ways to do this will be to introduce leverage into the portfolio (remortgage some of the properties).

With leverage comes risk and the sole purpose of this post is to highlight those risks to help you, and help me, understand and plan for any potential future problems associated with leverage in property.

Risks Associated With Leveraging Property

Please Note: I’m not an omnipotent source of information and there might be risks I’m overlooking here – if I am do me, and everyone else a favour, and drop them in the comments section at the foot of the page.

Rising Interest Rates

One of the two primary risks you face when you buy a property using a mortgage (leverage) is rising interest rates.

Everyone’s super blasé about this at the moment because interest rates are at an all time low… in my opinion a big mistake.

Our current Chancellor is worried about a potential rise and others too are worried about rising inflation and interest rates on the back of Covid-19 fiscal policies.

Regardless if you have leverage and interest rates rise then your mortgage payments cost more each month until you reach a point that rates get so high that your rental income doesn’t cover your mortgage cost.

Here’s an example of what rising interest rates could do to a standard buy to let deal costing £100,000 with a 25% deposit that rents for £600 per month:

As you can see the deal has a breaking point – granted in this case it’s a high one but if you’re relying on your property income to pay your wage your breaking point is likely well before the deal itself actually turns negative.

6% interest rates could put a deal like this on the edge. All you’d need would be a boiler replacement and your yearly profit would be gone.

What’s your defence?

If you’re considering leverage then stress testing your deals at different interest rates and understanding the impact that rising rates can have on your bottom line is essential.

You can use these stress tests as an early warning system when rates start to rise and considering selling properties where margins are tight.

To mitigate rising interest rate risk further you can also look to fix your rates for specific periods of time but the length allowable is going to depend on the mortgage product you have.

Note: the longer you want to fix the higher your rate will likely be.

On top of stress testing and fixing your rates you should also make SURE that you aren’t over exposed to one lender.

If you space out your leverage across multiple lenders then if one starts to put pressure on you to repay it only affects a small proportion of your overall portfolio. If you’ve got all your properties with one lender and things go south the entire show is over.

Falling House Prices

The second biggest risk where leverage in property is concerned are falling house prices.

If you own a property that’s currently valued at £100,000 on a 75/25 LTV ratio you have £25,000 worth of equity and owe the bank £75,000 in loans.

If the housing market falls substantially, lets say 20% which wasn’t uncommon in some areas during the 2008 crash, you now have a property worth £80,000.

Your loan amount of £75,000 remains the same so you’re only left with £5,000 in equity. That represents a 6.25/93.75 LTV split.

NB: In 2008 some landlords and homeowners even fell into negative equity when house prices crashed.

Some, not all (but I bet you haven’t checked), lenders have a minimum LTV clause or covenant in their terms and conditions which means the loan is repayable in full if your equity in the property drops below a certain point.

If falling house prices trigger that clause and you’re not in negative equity then you sell the house, pay the bank back and pocket whatever is left over.

If you are in negative equity then you have to sell the property but still owe the bank money… you’re on a one stop train to bankruptcy.

Falling house prices are more damaging the less equity you have in your property. Some people have BTL mortgages with only 10% or 15% equity in the deal… not much wiggle room there.

How Do You Protect Against This?

The first thing you can do is make sure you fully understand and are aware of any LTV clauses in your mortgage agreements – they are even more common on commercial property.

At least if you know it’s coming you can start to plan and rebalance or sell up before your worse case scenario is realised.

The second course of action is simply to keep funds in reserve so that you can rebalance your LTV ratio if such a crash was to occur. If you’ve got the cash to top up your equity in the property then you won’t be forced to sell up.

A final solution would be to have a much more even LTV balance so a crash wouldn’t put you below your minimum threshold.

Clustered Mortgage Expirations

If you do all your buying over a short period of time and then sit on your properties and collect the rent thereafter you’re going to find that all your mortgages will expire around the same time.

Assuming you have interest only mortgages that’s going to mean that the current market conditions are going to dictate if there’s any capital appreciation or not.

In a worst case scenario the market will drop right before your mortgages are up and you’ll be left having to sell your properties and put in your personal money to pay back the loans.

Obviously in a best case scenario you’re quids in here but this is an article about risk remember.

How do you fix this?

This is a really simple problem to fix.

Even if you’ve bought all your properties at the same time (or remortgaged them all on the same day – not uncommon) there’s nothing stopping you remortgaging for different periods of time to stagger your expirations.

Mortgages are flexible so often you can extend or remortgage for longer if required. Alternatively if the market is hot you can sell up when nearing expiration to lock in your capital appreciation.

As long as you’re aware of this issue you can completely nullify this risk by making sure there’s plenty of time between your mortgage expiration dates.

Void Periods & Problem Tenants

This issue falls more in the worth mentioning column than the above but it’s still worth considering.

Stacked up against other property leverage risks it’s minor but obviously when you don’t have a tenant or your tenant isn’t paying rent you’re losing money.

Short term void periods are going to happen during tenant changeovers and/or when finding new tenants but longer term problems can occur if you’ve got a tenant who isn’t paying rent and you’re struggling to get rid of them.

Obviously not paying rent will mean eventually your tenant will have to leave but it isn’t uncommon for this kind of situation to take as long as 12 months to resolve itself.

That’s 12 months without rent coming in when a mortgage still needs to be paid.

What’s the solution?

Holding cash reserves is one solution for this so even if money isn’t coming in you can still pay down the mortgage.

Alternatively you can take out Rent Guarantee Insurance which will cover you against this type of incident. Obviously this cover is an extra cost but often policies will not only cover non rent paying tenants for 6-12 months but also any legal costs associated with removing the tenants.

So… How Much Leverage Is Too Much?

The bottom line is that the answer to this question is going to depend on your appetite for risk, how you perceive that risk and what you do to mitigate it.

Falling house prices and rising interest rates are the two risks that concern me the most.

Even though currently my portfolio is unencumbered I have stress tested all my deals and they work at interest rates as high as 10%. Personally I wouldn’t be prepared to do a deal, unless I was only in it for a short period of time, that didn’t stress test to that 10% rate.

Why?

Simply because there’s plenty of wiggle room before we get to those highs and hopefully I’d have plenty of time to react and rebalance before the situation became a problem.

Similarly I believe that a 60/40 LTV ratio is enough of a cushion to mitigate the risk of falling house prices but I’d be prepared to go lower than that as long as the terms and conditions set out in the mortgage agreement had low or even no minimum LTV thresholds.

I’d also go lower on the LTV if I was only planning to hold the property for a short period of time.