The Property Voice

Soundbite: Refinancing Risks

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Today’s holiday short comes from Lee, who asks: I’ve read lots of strategies of turning x into y by recycling deposits, etc. and it all sounds great and all, but what I can’t make sense of is that surely by refinancing in this way on one hand you get your deposit back (in theory) but on the other, you’re increasing borrowing and reducing your rental yields?

I am an admirer, advocate and implementer of the BRR or buy-refurbish-refinance strategy myself. However, there are pros and cons and also limits to this model too; and in particular if you plan to continue with the refinancing over time to extract equity, as you will hear.

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Transcription of the show

Hello, and welcome to another episode of The Property Voice podcast. My name is Richard Brown and as always, it’s a pleasure to have you join me on the show again today.

Today’s holiday short comes from Lee, who asks: I’ve read lots of strategies of turning x into y by recycling deposits, etc. and it all sounds great and all, but what I can’t make sense of is that surely by refinancing in this way on one hand you get your deposit back (in theory) but on the other, you’re increasing borrowing and reducing your rental yields?

I am an admirer, advocate and implementor of the BRR or buy-refurbish-refinance strategy myself. However, there are pros and cons to this model and in particular if you plan to continue with the refinancing to extract equity, as you will hear.

Let’s hear Lee’s story and see how I responded to the topic of refinancing to extract equity and the cost of yield or rental income investor now then…

Property Chatter

This comes from Lee…

Hi everyone!

This is my first post on here so go easy on me

My business model is simply to buy 1/2 bed BTL flats with good yields and potential for capital growth. I am in the process of extending leases + renovation which will increase the values. Then I plan to refinance, pull out cash, re-invest… you know the drill.

I’ve read lots of strategies of turning x into y by recycling deposits, etc. and it all sounds great and all, but what I can’t make sense of is that surely by refinancing in this way on one hand you get your deposit back (in theory) but on the other, you’re increasing borrowing and reducing your rental yields?

Surely this is bad long term if we keep refinancing to the point our original nest egg turns in to a non-profitable investment due to larges fees? What are other investors doing at this stage? Do we sell or hold?

Thanks in advance!

Lee

Richard’s Response

Hi Lee

Here’s what I do…set a minimum return on your cash investment after refinancing AND the net monthly cashflow after ALL costs. Then, only refinance to the extent that you get over both of those hurdles rates.

To the wider question as to how far do you go with a refinancing strategy, as it has been mentioned a couple of times, I will share my views on this.

A policy of constantly refinancing does sound very appealing, as it provides additional capital to help grow the portfolio further, as more equity can be released as house prices growth.

However, it can be risky and reckless too!

  • Firstly, HMRC will not let you offset ANY mortgage interest on borrowings above the original purchase price of the property…so it becomes less tax efficient once you refinance above this point. This means, you actually need even better returns when you refinance above the original PP to offset the tax drag.
  • Second, if you listen to those that came unstuck during the last financial crisis (and this is cyclical, so it WILL repeat itself), those whose affordability levels and also those with higher LTVs were the ones that got taken down. I have heard of people with hundreds of properties whose loans could still be serviced from rents, yet still have their properties either forced to sell, additional equity added or repossessed and so lost everything. If you don’t believe me, just spend a few minutes actually reading the terms and conditions of your loan agreements to see what nasty surprises are lurking in there!
  • Third, apart from the compound growth effect, which does make some sense during the portfolio growth phase (also assuming you don’t grow forever!), if you are investing primarily for income, then it does rather defeat the purpose to then reduce your income, merely to add more to your portfolio purely by taking on even greater debt.
  • Fourth, the mortgage prisoner and tax hostage traps. If you find yourself in a position of NEEDING to sell for whatever reason (change in circumstances, illness, lending issues, high interest rates, etc.) then if your mortgage is above your original purchase price by a sufficient enough degree, the CGT bill might not be covered from the net equity at the time of selling…which will be more likely in a downturn, when possibly you NEED to sell the most. Equally, if you want to remortgage and are constantly at say 75% LTV, then a 10% drop in house prices will mean you would be unable to remortgage and maintain the same mortgage debt. Both of these issues would be very uncomfortable or costly to manage through.
  • Fifth, is the potential for a squeeze on rents and so on debt serviceability too. The perfect storm of high interest rates and low rental inflation could give rise to a squeeze on the cashflow of the portfolio. Add to this the aggressive tax changes, such as S24 and you might find yourself under water quite quickly. Have you worked out by how much interest rates need to rise before your net cashflow disappears? It’s not as much as you might think with highly leveraged properties.
  • Sixth, unforeseen external events and policy changes could affect you the most…nobody expected the 3% SDLT premium or the S24 mortgage interest relief restriction nor the removal of the fair wear and tear allowance nor the punitive CGT approach to property versus other asset classes…but they (and far more besides) all happened and so all can affect us adversely; including to our EXISTING portfolio in many cases. What’s next? Rent controls, S24 for companies, wealth taxes, no-deal Brexit, etc. In reality, I really don’t know either! But, that’s why it is better to adopt a sensible approach to lending in my view.

    • So, here’s my policy, which for some is still seen as adventurous…

    BRR strategy, refinance up to the original purchase price of the property OR occasionally up to the gross development cost ONLY. Then let the LTV fall naturally over time to a more comfortable level. I will then reinvest the limited cash / profit released into new projects to allow a more manageable growth strategy. I am hedging the risks in a variety of ways too, such as having multiple lenders (harder for one of them to grab you where it hurts!), different locations (area and country), different strategies (income and growth), long-term fixed rates (5+ years), having at least one property with a very low / no debt on it, having a contingency fund, having multiple income streams and diversified asset classes, allowing an average LTV across my portfolio that will be able to absorb a 20% or so drop in house prices and so on.

    In summary, an aggressive and repeating refinancing model can be extremely tempting but also extremely dangerous at the same time! When the market is buoyant, everyone is piling in, refinancing and spending / reinvesting the cash, but each summer is followed by a winter and some winters can be brutally harsh!

    OK, as you can tell, this is something I have thought about a fair bit and it worries me how some investors do not really consider or even know of many of the points I have raised. There are also some that ‘feel the fear and do it anyway’ but sometimes when you bravely rise above the barricades and charge into battle…you do end up getting shot!

    Off for a cup of tea now lol

    Best

    Richard

    So, that’s my next holiday short…another one is coming up next week.

    As a reminder, the show notes can be found over at www.thepropertyvoice.net. Or, if you want to talk about anything from today’s show, or just talk property investing more generally, email me at [email protected], I would be happy to hear from you!

    Once again, all I want to say is thank you very much for listening once again this week and until next time on The Property Voice Podcast…it’s ciao-ciao.

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