Are You Sitting on a Property Time Bomb?
Many investors are quite literally sitting on a property time bomb, unaware of the financial devastation that may hit them in a few years’ time. In this article we have asked experienced property investor Simon Zutshi to explain what the problem is – and more importantly what you can do about it now.
The UK property market has seen unprecedented changes over the last twelve months, which could cause serious problems for many investors in the next few years.
There are two main factors which could cause difficulties for buy-to-let (BTL) investors.
- Potential interest rates rises
- The proposed changes to BTL mortgage interest tax relief.
The combined effect of these two factors could cause a ‘Double Whammy’ effect which results in many BTL properties turning from a positive cash flow into a negative cash flow, which many investors will not be able to subsidise and so may be forced to sell.
Let’s consider each of these factors in turn and then consider what you can do about it.
Potential Interest Rate Rises
The Bank of England Base rate has been at the record low of 0.5% per annum for over seven years. Many of the pre-credit crunch mortgages interest rates, where Bank of England base rate + 1.5% to 2%, mean that landlords have become very used to a pay rate of between 2% and 3% per annum, which has given them healthy cash flow over the last few years. However, if interest rates start to creep up over the next few years, the landlords’ cash flow will drop to the point where I suspect many landlords will not make any profit from their properties, especially single let properties such as flats, which also have ground rent and service charges to factor into their costs.
Investors who are buying properties now and calculating their cash flow profits based on the current mortgage rates may also be in for an unpleasant shock. I advise all of my students to make sure that any property they are considering purchasing must give a positive cash flow, even if the cost of their mortgage is 6%, to make sure they plan for possible interest rate rises.
Simon’s rule of thumb
The rate of 6% per annum is useful to use when calculating how much a mortgage will cost you. This rule of thumb is so easy that you can do the calculation in your head. At 6% interest rate, every £20,000 you borrow on your mortgage will cost you £100 per month in interest.
For example, a £140,000 mortgage will cost you £700 per month. The rent must cover this mortgage interest and all the other costs for you to make a positive cash flow. In reality, the mortgage will cost you less per month than this, because you can obtain mortgages at a lower rate than 6% now, but this will help give you peace of mind that as rates increase up to 6%, you will still make positive cash flow.
Proposed Changes to BTL Mortgage Interest Tax Relief
There have already been some excellent articles in past editions of YPN about this so I am not going to go into too much detail apart from the fact that some investors may find themselves in the position where their property does not actually make much cash flow, but as far as the HMRC are concerned, it still makes a profit and so tax would be due. This means a net effect of negative cash flow. Multiply that across a portfolio of properties and you can see how some landlords could get into difficulty.
If you are a lower-rate tax payer or you have unencumbered property (ie no mortgages) then you will be unaffected by the proposed tax changes. If you are a higher-rate tax payer with mortgages, then you will undoubtedly be paying more tax.
The Double Whammy
It is the combined effect of potential interest rate rises and the changes in mortgage interest tax relief that could cause serious problems for many investors. For the rest of this article, I am going to explain what you can do about this to avoid these potential problems as much as possible.
Understand Your Current Position
The first step is to understand where you are right now in termsof exactly how much you make from each of your investment properties. If you don’t already have one, I suggest you put together a simple spreadsheet which lists all your properties and carry out some sensitivity analysis so that you can see what could happen to each of your properties as interest rates go up. This will help you identify which properties may cause a problem when positive cash flow turns negative as interest rates rise. You then need to decide what to do with these properties.
Maximise Rental Income
When did you last review the rents you charge? All too often landlords don’t raise the rents on their property, especially if they have good tenants. Rents have generally gone up over the last few years. Unless you have put your rents up, you may be receiving less than the current market value. Could you carry out some light cosmetic improvements such as painting your property to increase the rents?
Repurpose Your Properties
Just because you have used a property in a certain way historically, does not mean that you couldn’t make a change going forward. If you have a single let property, could you change it into serviced accommodation? Or, if it is in a suitable location with the right number of rooms, could you change it into a House of Multiple Occupation (HMO)?
If you have a student property and find that there is now an over-supply in the area, could you change it to an HMO for young professionals? Look at each property in your portfolio and work out if you could repurpose it to increase the rental income.
Fix Your Mortgage Interest Rates
Whilst rates are low right now, many investors are taking the opportunity of fixing their interest rates. I am not qualified to give any financial advice and this is just my opinion but I don’t think it is worth fixing interest rates for just two years, as I don’t believe they will change much in that time. However, I am starting to fix some of my mortgages for a five-year period. Yes, the rates might be higher than I am paying right now, but I would rather have the peace of mind that my rates are fixed for the next five years.
Sell Your Worst Performing Assets
I have been investing in property for over twenty years and so some of the properties in my portfolio are not great investments. I certainly would not buy some of them again knowing what I know now. But you do what you do at the time with the knowledge you have at that time. So maybe it is time to sell some of them especially given all the recent changes.
Personally, I don’t like selling property as I have done this in the past and then regretted it as I have seen values go up over time. But I am a firm believer that you should only own property that will give you a monthly positive cash flow and so right now I am selling a few properties that could become a problem when interest rates rise. I am reinvesting the equity in other properties which generate a much higher cash flow.
If you do sell some of your properties, bear in mind that if the property is not your main residence then you will pay Capital Gains Tax (CGT) on the capital appreciation. You have a personal CGT allowance each year so you may want to stagger the sales over a number of years. Also if you are married you can use your personal CGT allowance and your partner’s CGT allowances if you both own the property. It is a wise idea to get some specialist property tax advice to make sure you minimise the amount of tax you pay.
When deciding which property to sell, first I consider factors such as the current cash flow, the length of the existing mortgage, any mortgage early redemption penalties, etc. to identify which is the best one to sell first this year, and then which do I want to sell in the next tax year and so on.
Once you have released some equity from your existing properties it is best to re-invest this in assets which will give you a better return on investment. The obvious strategy is HMOs due to the high cash flow.
Generate Additional Cash Flow
Remember that you don’t necessarily have to purchase properties to increase the cash flow on your portfolio. You can use strategies such as Rent-to-Rent, and Purchase Lease Options to gain cash flow from property without the need for mortgages or big deposits. Also the profits from these two strategies are not affected by the proposed tax changes as you don’t actually have mortgages, but instead are paying amonthly rent to the owner which can be offset against your income for tax purposes. If you don’t understand these strategies it may be time to educate yourself about how you can utilise them to your benefit.
Change Your Tax Structure
And finally, lots of people have been thinking about moving their portfolio from personal ownership into a limited company to mitigate effects of the new proposed tax changes. There are a few challenges with this and you need to seek professional advice based on your personal tax situation. The main challenge that many people have faced is paying stamp duty and CGT when they transfer their assets into the limited company. However, the structure that I favour is moving the portfolio into an LLP (Limited Liability partnership) and then into a limited company. When done correctly this means that you pay no stamp duty and no CGTat all. If you would like to have a complementary 45-minute assessment with one of the top 100 accountant firms in the UK, we have arranged some complementary consultations for members of pin. All you have to do is email your contact details to this email address and they will set up an appointment for email@example.com
The best part about this particular method is you reset the base value of all your properties to the value at the time they are moved into the limited company. This can be particularly valuable to anyone who has had good capital growth since they purchased their properties. Definitely worth booking a complementary session to find out just how much you could save. There are only a limited number of these complementary sessions available so I suggest you book now before they withdraw the offer.
Summary of Action Points
So here’s what you can do to defuse the ticking property time bomb. It is best to take action now, don’t wait until it is too late. Actions for you to consider:
- Update your property details spreadsheet.
- Include sensitivity for interest rate changes.
- Identify which ones could cause you an issue.
- Check for mortgage redemption penalties and end dates.
- Can you maximise the rental income?
- Can you repurpose any of your properties?
- Which do you need to sell?
- Can you generate extra cash flow from Rent-to-Rent and Purchase Lease Options?
- Do you need to change your tax structure?
- Book in a complementary tax session.