Here’s a situation that many property investors find themselves in: you have the ambition of owning 10 properties, but you can only afford the deposit for one. What do you do?
One option is to empty your bank account to buy that first property, then start saving up from scratch for property #2. By re-investing the rental profits from property #1 it should take you less time to save up than it did the first time around…but depending on your level of income, you could still be looking at years before you’re ready to buy again. Not great.
The next option is to hope that capital growth will lift the value of property #1, allowing you to increase your borrowing against it and take out cash to use as your next deposit. But hope isn’t much of a strategy – and while property prices historically double every 9 years, there are no guarantees that it will happen to your particular type of property in your part of the country.
But there is a third option: to recycle your cash by having a firm plan for getting your deposit back out of property #1, without being reliant on the property market helping you out.
It’s a concept I wrote about in Property Investment For Beginners, but I still get more questions about how to actually do it than almost anything else. So in this post, I’ll describe the main opportunities and challenges – and in future posts I’ll get into more detail about some exact methods you can use.
The basic concept of recycling your cash
Recycling your cash relies on being able to buy a property for a certain price, then refinance it at a higher valuation so you can release the cash you originally put in.
For example:
- You buy a property for £100,000 by putting in a £25,000 deposit and taking out a 75% loan-to-value mortgage with Lender A for £75,000.
- Later, you get the property revalued at £133,500, allowing you to take out a mortgage for 75% of the new value from Lender B – which works out to a loan of £100,000.
- You pay the original £75,000 back to Lender A and put your initial £25,000 back in the bank to use again.
Et voila: your initial cash input is back in the bank, and you still only have a mortgage at 75% LTV. You just need to take into account that your mortgage repayments will, of course, be higher because you’ve increased your borrowing by £25,000.
So that’s the explanation, but in the current property and lending environment it isn’t easy to pull off: it’s highly unlikely that you’ll be able to buy a property for £100,000 just because you’re some kind of genius negotiator, then quickly get it revalued at a 30% higher figure. You’ll have to work hard to increase the value – and even then, it’s far from inevitable that you’ll get all your money back out (including transaction costs like legal fees, which I excluded from the example above).
Although it isn’t easy, it is powerful: if you can use the same money over and over again, there are no financial barriers to you building a portfolio of whatever size you want. And even if you can’t re-use all of your initial funds, just think how much faster you could go if you only needed to find £5,000 towards your next deposit rather than £25,000.
How can it be done?
There are only two ways to get a property valued at higher than you paid for it, assuming that local prices in general are unchanged:
- Buy it cheap (sometimes called “below market value”, although some people take issue with this term)
- Add value (sometimes called “forcing the appreciation”)
In practice, successful recycling normally requires both: buying at a good price – often because of some kind of problem that’s preventing other people from buying – then solving that problem to add value.
The most common and straightforward form of adding value is to refurbish a property where the value is being held down by its internal condition. For example, you can buy a property for £90,000 and spend £10,000 improving its condition to be the same as the house next door – which you know is worth £135,000.
But refurbishment isn’t the only way – you could also add value by extending the property, extending the lease, solving a structural problem, solving a legal problem, and plenty of other ways too. These are all factors that are holding the property back from realising its full value, and there are people who specialise in identifying properties which everyone else will pass over because they don’t realise that the problem can be solved.
How do you finance a property where you’re planning on “recycling”?
Once you’ve increased the property’s value by whatever method you chose, you need to release your funds by refinancing – normally taking out a mortgage based on its “new” value. In the earlier example, for simplicity, I talked about buying the property with a mortgage, increasing the value, then refinancing at a higher value with another mortgage. In fact though, if you’re buying a property which you intend to refinance in less than a couple of years, you shouldn’t buy it using a standard mortgage.
Why? Because even if you buy using a mortgage that doesn’t come with a penalty for redeeming it early, lenders don’t like you doing it: you’re essentially using what’s intended to be a long-term source of finance for a short-term project. You’ll get away with it once or twice, but lenders do share between each other a “blacklist” of people who’ve abused their products. So if you shouldn’t use a mortgage for the initial purchase, then what?
- Cash. If you can buy a property wholly with your own cash (whether that’s with savings, or equity released from your own home or another property in your portfolio), you can then take out a mortgage on the newly improved property to get your cash back out. Most lenders won’t allow you to start the remortgage process until you’ve owned the property for 6 months, so you can plan on having your cash tied up for around 8 months by the time the refinancing is completed.
- Bridging finance. Bridging is a specialist type of short-term finance, normally intended to be borrowed for 6–12 months. Just like with a mortgage you’ll still need to put in a deposit, but you can use bridging finance for the rest of the purchase price then – again – start the remortgage process after 6 months to repay the bridging loan and release your cash.This is a little more risky, because bridging isn’t cheap – often in the range of 0.75%–1.5% per month – so if for any reason you can’t remortgage as planned to repay the bridging loan, it can start getting very expensive…
- A specialist mortgage. It’s possible to get both “light refurbishment” and “heavy refurbishment” mortgages, where the lender gives you a loan based on the original purchase price then agrees to advance you funds based on its new value once you’ve finished the program of works.These aren’t as common as they once were, but they appear to be coming back. The lender is unlikely to structure it so you can get all your money back out (on the quite reasonable assumption that if the property hasn’t cost you anything you might not be too fussed about making the repayments if you get into trouble), but the rates are lower than bridging finance and it saves you from paying two lots of arrangement and broker fees.
What are the barriers to recycling your cash?
Clearly, if this was easy then everyone would be doing it – and while there are many people who are routinely doing this very successfully, there are many others who’ve failed and ended up with their cash trapped in a deal that they were hoping to extract it from. So what are some of the things that can go wrong, and what can you do to reduce these risks?
Rental income needs to support the higher borrowing
If you’re increasing your borrowing against a property, your monthly mortgage payments will get higher. Lenders need to see a certain level of “rental cover” – meaning that typically your monthly rent payment needs to be at least 125% of what your mortgage payment would be if you were on the lender’s standard variable rate.
Even more importantly, the property needs to still be making you money rather than costing you money each month once the higher payment is taken into account. Having none of your money left in a deal is fantastic – unless you’re then having to put money back into the property every month because the rent isn’t enough to pay the mortgage and bills!
You might get your figures wrong
If we take the common situation of doing a cosmetic refurbishment to “force the appreciation” and secure a higher valuation, there are two main pitfalls. Firstly, the end value might not be as high as you think – so it’s important to thoroughly do your research and establish what the property will be worth once you’ve done the work. The property next door might have sold for £135,000, but does it have more square footage or superior features – or was it just a complete one-off aberration, and similar properties normally sell for £20,000 lower?
And secondly, it’s always possible that the refurb will cost more than you expect. You need to realistically cost up what you can expect to spend, but even then you can’t be sure that you won’t find a nasty surprise that totally throws out your budget. So rather than working off estimates like “well, a new bathroom will probably cost about £2,000”, get your builder to assess the site in as much detail as possible – then add a 20% buffer for contingencies, and see if the figures still work.
You might not get the valuation you want
Even if you get the project done completely on budget and you end up with a property that any buyer would happily pay £135,000 for on any day of the week…there’s absolutely no guarantee that your lender’s surveyor will agree. I don’t think I’m slighting surveyors to say that they tend to be on the “pessimistic” side of “brutally realistic”, and sometimes they make judgements that are just flat-out bizarre. I know of a block of flats where two identical units on the same floor were valued 20% apart from each other within a couple of weeks: one of the surveyors must have been wrong (or they were both somewhat wrong in different directions), yet you’re never going to get their decision overturned.
If you don’t get the valuation you want, you’ll have no choice but to start again with a different lender – with no guarantee that the outcome will be any different, and in the meantime having your cash tied up and/or being on expensive bridging finance. However, there are steps you can take to increase your chances of getting the valuation you want: far from guaranteeing it, but giving you a far better probability of the outcome you want than if you just left it to chance.