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Using 'Other Peoples Money' to buy Property
15 March 2012

"It's the law of supply and demand. Real estate, especially residential property, is a commodity that is in critical shortage and for which there is enormous demand. It is a necessity, not a luxury. People can't print up 100,000 new homes as they might print up a stock offering. That's why I continue to say 'Don't wait to buy real estate, buy real estate and wait'" Robert Allen, American self-made millionaire property entrepreneur.

A Very British Obsession

Have you noticed that the British public are almost totally obsessed with their homes, or at least the value of their homes? Perhaps it's because we remember the excitement experienced in the late 1970's, 1980's and 2000's when house prices were moving so fast that paper fortunes were being made almost overnight. Everyone was a jackpot winner and you didn't need a lottery ticket; if you lived in your own house or flat you were guaranteed a bumper pay-out.

Now things have changed. Prices have come down and flattened out, or are still on the way down, depending on who you believe. But money from property can be made in any market, and there are certainly more genuine bargains around now then at any time I can remember. Everyone seems to know how much their house is worth, almost to the last penny. What makes this so surprising is that the professional valuers, who tell the Building Societies how much your house is worth when you ask for a mortgage, spend at least five years training, including three years at university, and yet most home-owners seem to be able to get to the right figure instinctively.

When they retire most people's largest asset is the equity in their home; in a survey in the USA a few years ago it was found that the average home-owner's assets were worth thirty times the value of a home renter's assets. Just look at how much the capital value of homes has increased in this country over the last 30-or-so years, even despite the current recession.

And despite coalition proposals (ie LibDem proposals) to radically overhaul the Capital Gains Tax system, owning your own home and "trading up" is still the most tax efficient way to make money in property; if your home is your main residence for tax purposes, when you sell at a profit you pay no tax at all.

So, if you are serious about making money in property the first step is to own your own home. It's probably the most important investment you'll ever make. It isn't just for living in. As the capital value accumulates it's also a cash machine, a savings account and a source of equity for your future deals.

But that is by no means the end of the story; it's only the beginning. As the British public are so naturally good at property I am always surprised that their interest stops at their own front door. Most people don't seem to realise that there are all sorts of opportunities in the property world for everyone to explore and exploit, which with a little bit of creative thinking everyone can afford.

I've been lucky enough to have spent most of the last 25 years working in commercial and residential property and have been able to follow the careers and fortunes of individuals in the property world who never seem to put a foot wrong, and who have been tremendously successful in making money from property.

It's probably true to say that property has created more millionaires than any other type of business. And it seems that business people who are successful in another area are more often than not tempted into trying their hand at property, even if it is only as a side-line. You would probably think all property entrepreneurs must have had at least a small fortune to start with and could afford to play with property. For some of them that may have been true, but certainly not for all. Many successful property investors have started almost literally with nothing, but by knowing just a little more than the average lay person have built up large property fortunes.

There are several powerful secrets all successful property people use which give them a better than even chance of being successful, and I will now examine one of them, so that you can start to build a property empire of your own. At the moment this may seem like an impossible dream, but if you have the time and the desire, and if you put these secrets into practice, you too can be a successful property investor.

An Introduction

Let me start by telling you something that may surprise you. Anyone can afford to be a property investor. It really is true that you can start your own private property empire tomorrow by buying properties for as little as 500, perhaps even less if you shop around. And if you are really clever you can start by getting someone else to pay for them for you, perfectly legally. I know this sounds almost incredible but I'll tell you how to do it later in this series.

Without giving away too much now, how successful you will be depends upon how you perceive property, so now is as good a time as any to start you thinking the right way. You need to understand that most people don't think of property as something they can be involved with. Perhaps it's psychological and they are overwhelmed by the physical size and scale of property. Perhaps it's because they assume that all property is too expensive and out of their price range and they don't realise that they don't have to pay the whole purchase price themselves.

But the key to building your property empire is to start thinking more laterally, and to start to see the opportunity and not the building. So this is the first point to remember, the value of a property depends on the interest being sold and not on the physical accommodation it provides.

Flats are a good example. Many people in this country own flats and most flats are sold on long leases. It is quite usual for the lease to be for 99 years or 125 years and for the "flat owner", who is technically a long leaseholder, to pay a ground rent of, say, 50 a year to a freeholder.

A cheap two-bed flat in my town costs on average about 70,000 if you want to buy it to live in. So for the purposes of this example we will assume that this is the value of the flat to the flat owner.

Now think of the value to the freeholder. Is the value of the flat also 70,000 to the freeholder? Try thinking of it this way: how much would you pay to get an income of 50 a year in ground rent from the flat owner? You certainly wouldn't pay 70,000. In fact at current prices property investors are paying between ten and fifteen times the amount of rent received for freehold interests of blocks of flats. So in this example, assuming a ground rent of 50 a year, you will probably only have to pay between 500 and 750 to own the freehold.

Why would anybody want to buy the freehold of a flat? Well, if they paid 500 for an income of 50 per annum they would be earning 10% on their money. Even if the investor paid 750 they would still get a 6.7% return on their money which is still better than they will get in a building society savings account. And there are other ways to increase the return, which I will tell you more about later.

So, you can see that it is possible to own a 70,000 flat for a few hundred pounds, although of course you won't be able to live in it, yet. It's true that to be successful in property you need to engage in some creative thinking but don't worry, I believe that it is a skill most people can learn with practice.

I have written this article especially for small investors who may have a few hundred pounds put away for a rainy day and want to do something more interesting than leave it in a building society. Even with interest rates creeping up they pay such a small amount of interest at the moment that waiting for your investment to grow really is as exciting as watching paint dry.

In this article I am going to tell you why it's better to buy property using other peoples money, and how to get them to lend it to you, a rough rule of thumb which will show you how to value investment properties and work out whether you are getting the best return on your money, and about the different types of properties that are available and why they should be of interest to you.

And last, but certainly not least, I am going to tell you in detail those little known secrets of property investing which will allow you to succeed where others will fail.

The Secret Almost Every Successful Property Investor Has Used

I'm now going to tell you probably the most important secret known by, and used by, all the great property investors. I think you are going to be surprised. "Nobody ever rises above mediocrity who does not learn to use the brains of other people and sometimes the money of other people too ... it takes a combination of the two". So said Napoleon Hill, the man who, through his philosophy of personal achievement, probably helped to create more selfmade millionaires than any other person in history.

The trouble with using other people's money is that debt makes us squeamish. From an early age we are told that debt is bad and should be avoided. And that is true, or at least partly true. There are certain types of debt that we should avoid at all costs, but like it or not any businessman will tell you that most businesses cannot grow without the proper use of investment debt.

This is especially true of property where the sheer scale of the figures involved mean that only the super rich can afford to be seriously involved without some form of debt. If you want to build a sizeable and profitable property investment business the truth is that you will require some short-term debt.

So, the first rule is ...

Investing In Property Works Better When You Use Someone Else's Money

There are two main elements to this first rule that I would like to show you.

Firstly, when you are looking at a potential property to purchase don't be put off by the purchase price. Remember that you don't need to have the monetary equivalent of the asking price; or put a better way, you don't need to be able to afford to buy the whole property outright.

Most people don't take the idea of themselves as being property investors seriously because they assume that they can't afford to buy properties. You may think that they have a valid point, after all property is expensive. But the simple fact is that you don't need to be able to afford the asking price, you just need to be able to pay the part of the price that the bank won't lend you.

I'll show you later that even if you do have enough money to buy an investment property outright, it will almost certainly be to your benefit not to use all your own money.

You may be able to apply this rule in other contexts but I think it is best illustrated if we look at investment properties. For simplicity I shall refer to residential investments but the principles apply equally to commercial properties.

Most banks or other lenders participating in the buy-to-let scheme will lend between 75% and 80% of the lower of the purchase price, or the value of the property, depending upon the individual circumstances of the case.

This means that when you want to buy a property the question to ask is not "can I afford it?" but "can I afford 15% to 20% of it?"

Looked at another way, if you have a sum of money which you intend to invest in property, for example let's say 10,000, rather than looking for a property worth 10,000 you should be asking yourself "if I can borrow 80% of the purchase price where can I find a suitable investment costing 50,000?"

As a purely hypothetical example, suppose you see a nice flat that you think would make a good investment when it is let to a tenant. Because it's in a good area you are sure it will be worth keeping for a few years because the value is almost certain to go up. You have found out that the asking price is 62,500 but you think you can get it for 60,000. You ask yourself "Can I really afford a property worth 60,000?" Wrong question. If you can borrow 80% what you should be asking is "can I raise 12,000?"

This is why I think that probably the most important part of raising money for property isn't to finance the purchase as such, but is to finance the balance not covered by the loan. If you can find the first 20% to 25% of the purchase price, and as long as your existing income and the rental income from the property you want to buy cover the lenders criteria, you will be on your way.

If you have sufficient savings you will be ready to put in an offer and start talking to a broker about a loan for the balance. If you don't have the cash in the bank a flexible lender may allow you to use equity in your home as security against which you can raise the money for the deposit through a second mortgage, or an equity release loan.

Now, let's look at the second reason why investing in property works better when you use someone else's money. The reason is gearing, and this really is the star of the show. Let me show you the amazing and powerful affect that it can have on your personal finances.

If there is a key to success in property this is surely it. When you understand what happens you will see why buying property with other peoples' money is much more profitable than buying property with your own money. Remember I said that even if you do have enough money to buy a property outright it would pay you not to use all your own money? Let me prove it.

Going back to our earlier example of the flat let's assume that your offer of 60,000 is accepted and your purchase goes through. As you are cash rich you don't bother with a loan and you buy the property outright. The flat is let to a decent tenant at 500 per calendar month which you know is the going rate in that area. We can easily calculate that if the property cost 60,000 and the income received is 6,000 per annum, you will be getting a return of 10% on your capital invested. Not bad.

But now let's compare this with the return you will receive on your money if you borrow to fund part of the purchase price. Still using our earlier example, we know that you have access to 12,000. Your mortgage broker has told you that it will be possible to borrow 80% of the purchase price of a property and so, applying the rough rule of thumb, you start looking for a property with a value of five times the amount of cash available to you.

You are offered a flat which is let at 6,000 per annum, and from your research you calculate the property is worth around 60,000. As you can get an 80% loan you can afford to pay this.

To keep things simple let's assume that you can obtain an interest-only loan at 7.5%. As the purchase price is 60,000, you will be able to borrow:

  • Purchase Price 60,000
  • Loan ratio 80% 0.8
  • Amount Borrowed 48,000
  • The interest you will pay on the loan is:
  • Amount Borrowed 48,000
  • Interest charged at 7.5% 0.075
  • Annual interest payments 3,600

The interest will be paid out of the rent so you will make a profit of:

  • Rent received 6,000
  • less interest 3,600
  • Profit on rent 2,400

After paying the interest on the loan you will be left with 2,400 each year.

As before, we know that the gross rent (that is the rent before the deduction of interest charges) represents a return on the full purchase price of 10%. The return on the purchase price represented by the profit left over after the payment of the interest is only 4%.

But let's see what the return is on the money you have actually put into the deal. You have put in your available cash of 12,000 and you are now receiving a net profit of 2,400 each year. We can calculate that the return on your capital is:

Profit (net rent)/capital (own money) x 100 = 2,400/12,000 x 100 = 20%.

So, by paying only part of the purchase price yourself and borrowing the balance you have been able to increase the return on your money from 10%, which is all you would get if you paid for the whole property outright, to a massive 20%. In effect you have doubled your profit just by borrowing the majority of the purchase price.

This means that even if you had 60,000 and could afford to buy the property without borrowing, you would be better off splitting your capital to fund the purchase of several properties, and borrowing the balance to increase your total return. In this instance if you bought five identical properties, the profit you would receive in actual rent would increase from 6,000 per annum to five times 2,400, in other words 12,000 per annum.

This is a very simplistic example just to illustrate the point. In real life the calculations would be more complex and would have to reflect extraneous matters like stamp duty, and the costs of arranging the various loans. It's also unlikely that you'll find five identical properties let on identical terms. But it does prove that in property you don't want to put your eggs all in one basket; it's better instead to spread your capital over several purchases.

This is the power of gearing and the effect is even more pronounced with higher yielding properties, and when you are able to arrange loans at lower interest rates.

I remember a letter in Property Auction News a while back PAN reader Min was able to buy Lot 27 of an Edward Mellor auction for 8,000. As the rent turned out to be 65 a week and not 60 a week as printed in the catalogue, the gross yield on the purchase price is a whopping 42%. But just think what the yield on Min's investment will be if Min now takes out a loan to release more cash for more property purchases. Just for fun let's assume that an 80% interest-only loan could be obtained at 7.5%. Min would have to leave in 1,600, but the return on that would be 211.25%! That's the kind of return that makes property so attractive, and gearing a property investor's best friend.

These kinds of returns aren't the sole preserve of residential properties. A few years ago I was offered a secondary shop in a fashionable and historic South East town, let to a sole trader. The lease was a little bit short having only about 9 years left to run, which some lenders may feel uncomfortable with, and the rent is 20,000 a year which is still slightly more than the current market rental value, having been agreed in the late 1980's. However, retail rental values in the town were picking up and it seemed that they should catch up again fairly quickly if things kept going the way they were.

The freehold of the shop used to be owned by a property company but they went bust and a Receiver was appointed to dispose of the assets and pay off the creditors. This property sold for 75,000 representing a return on the sale price of 26.6%. But assuming that the purchaser was able to loan-fund this purchase, the return on his money would be substantially more.

Let's assume that the buyer was able to borrow at 9%, which is a fairly usual commercial rate, being 2.25% over the base rate as it then was. Also, that as this is a fairly tertiary shop with a less than substantial tenant the bank would want to reduce their risk by restricting the loan-to-value ratio (LTV) to 60%. For simplicity, let's again assume that the loan will be interest-only.

If the investor could borrow 60% of the purchase price, i.e. 45,000, he would have to put in 30,000 of his own money. We can calculate that the return on his own capital is 66.6%.

In the property world the expression "you get what you pay for" is often proved to be true, and I wouldn't recommend a purchase like this for a first time buyer or inexperienced buyer. In this instance the yield reflects the risks of ownership. For example, if the tenant went bust this shop could have taken some considerable time to re-let, and then almost certainly at a lower rent.

This is the type of property you'd want to tuck away in an existing portfolio, if it works out you're quids in, if not the rest of the portfolio will cover it until it comes good. Nevertheless, there are plenty of properties out there which are suitable for smaller investors, and where the benefits of gearing can be reaped big time. So start looking and in the meantime start saving up for your deposit. With any luck you'll need it sooner than you think.

Peter Parfait

The Ideas Factory