The Property Speculator » interest rates

Property Development Finance

Many aspiring Property Developers procrastinate over their plans because they believe they will not get finance to fund their project. This is clearly an extremely important point, because as I’ve written in many posts, even if you can afford to, it does not make good business sense to use 100% equity (capital that is not borrowed) in a venture. One of the main advantages of working in property is that because it is a tangible asset (i.e. not a paper asset) it can be borrowed against.

In the current economic climate, you might be mistaken for believing that it would be impossible for you to get a mortgage based around a property that needs substantial work to put it into a marketable condition. This is not necessarily the case. The vast majority of mortgage providers will be sceptical when you mention ‘property development’. This is because the sum that the developer borrows is secured against the property itself. This is why mortgage debt is the cheapest of all loaned cash; the bank/building society massively reduces its risk by ensuring that it has a legal ‘charge’ over the property in the event of a default of mortgage payment. Essentially meaning it can sell the property to settle your debt if it needs to. If the property were to be repossessed in an uninhabitable state, the banks chances of recouping its loss would be severely compromised.

Another likely scenario is that the mortgage provider might only release a very small proportion of the total amount being borrowed for land/property purchase, and only release the remainder when the project is completed. This obviously means that the developer has to fund the individual build stages out of his own pocket. This can be catered for when you are an established, experienced professional developer. However a novice is likely to be financially stretched.

The alternative to this is to have each payment released at each (pre-agreed) stage. This is a fairly common approach because it’s an established way of only paying interest on what is being borrowed. These payments will however, be released in arrears; meaning that the individual stages must be covered by the developer, but the funds to pay costs and fees will be released in arrears at each stage boundary.

At this point, I’d like to take the opportunity of pointing readers in the direction of my posts on Financial Leverage in Property Investment and Development, and carrying out a Property Development Appraisal. This is so that you are aware of how to calculate how much you need to borrow and why it’s not a good idea to use all your own cash.

Be aware however, specific conditions still apply. Mortgage lenders are now more than ever, quite risk averse. All the usual conditions of obtaining a mortgage approval still apply:

You should definitely not be overstretching yourself too far. This is (arguably) one of the causation factors for the recession, too many people borrowing beyond their means to buy more and more expensive properties. This is currently the most common reason for rejection of mortgage applications. You simply have to be creditworthy.
You must have a good proportion of equity to invest. This is now usually around 10% minimum with the most generous of lenders on an owner-occupier mortgage (this level of gearing would not even be considered for a development project). A realistic figure for a property developer is around 50%-60% of the GDV. An alternative to this would be if you already own the land or pre-development property yourself.

In common with all professional developers, the novice must accept that full compliance with lenders conditions for each individual project is vital. It’s not like a conventional owner-occupier mortgage, where you simply pay the instalment each month and the provider more-or-less leaves you alone. Developing for profit is almost a joint venture with the bank. They must be absolutely 100% happy that you know what you’re getting into, or at the very least employing an experienced professional who does.

Apr 10th, 2011

Interest Rates and how they Effect You

Interest rates are currently at an all-time low. This obviously makes it very cheap to borrow money in the form of a mortgage. However, many mortgagors (borrowers) do not fully understand the influence of mortgage interest rates on the payments they are obliged to make each month.

The Base Interest Rate in the UK is assessed every month by the Bank of England’s Monetary Policy Committee. Many factors are taken into consideration when deciding whether to reduce, maintain or increase it. One major influence is the rate of inflation or deflation. The interest rate is varied to regulate consumer demand; if the rate is increased then goods and services appear more expensive and subsequent demand reduces. This ultimately tends to ensure that price inflation is less likely. If the interest rate is reduced, then prices appear to be cheaper; this is used to stimulate consumer demand.

The other side to fluctuating interest rates is the effect they have on savers. If interest rates reduce, it might stimulate the retail aspect of the economy but investors will be less inclined to place their capital with the banks as the rate of interest the investors receive will be poor. Likewise if interest rates increase, savers will be more inclined to leave money in a savings account because of the more favourable return.

Another influence on interest rates is LIBOR (pronounced Lybor) which is an abbreviation for ‘London Inter-Bank Offered Rate’. This is the interest rate that banks use when they lend money to each other. This rate of interest is announced daily and is determined by the money markets in London. The behaviour of LIBOR can provide the banks with a useful indicator of a forthcoming interest rate change. If LIBOR is significantly above the bank base rate, then it can be a sign that the base rate will increase. If LIBOR is below bank base rate, it might be an indication that the markets feel that the base rate will decrease.

These changes in the Bank of England base rate directly effects borrowers. Mortgage providers (mortgagees) usually arrange Variable Rate loans at around 1%-2% above the base rate. If the base rate goes up, a mortgage is also likely to increase by the same rate. Although this is not ‘set in stone’; it is up to the mortgage provider to pass on reductions or increases.

A Fixed Rate mortgage is often used by landlords, as it is very easy to budget and plan for repayments into the future. Landlords that have access to this facility are often recommended to fix the rate for as long as possible e.g. If this term is 25 years; then that’s 25 years of mortgage repayments that will not change over time. Although in practice, it is highly unlikely you will find a mortgage provider that provides this for a period longer than about 5-10 years.

A Tracker Rate mortgage will closely shadow the base interest rate and stay around 2%-3% above the base interest rate. This allows the borrower to take advantage if the interest rates drop, though it will get expensive if the interest rate increases by a great deal.

On a typical repayment mortgage, the borrower pays a particular sum each month which covers a percentage of capital but is mostly made up of interest (though this ratio will change as the term of the mortgage progresses). So for example, if a total monthly mortgage payment is £1,000, this might comprise £750 in interest and the remaining £250 goes towards paying off the capital. The amount of interest paid depends upon the amount of the loan still outstanding and the interest rate applied to it. The capital portion of the repayment depends upon the amount borrowed and the term of years the mortgage is to be repaid back over (for example 20 years). So if a borrower makes overpayments, this reduces the capital aspect of the loan far quicker and therefore substantially shortens the mortgage term and therefore the total amount of the mortgage.

The following tables offer illustrations to compare the effect on monthly mortgage repayments when the interest rate varies. Far too many property speculators and conventional homeowners do not consider the effect that a substantial rise in interest rates would have.

These tables show the difference that a significant change in interest rates would have on mortgage repayments. Almost all mortgagors would experience difficulty to some degree if rates increased, however some element of flexibility should always be considered.

Aug 6th, 2010