Paying off a mortgage may seem like the ultimate goal for any homeowner, but for high-net-worth individuals (HNWIs), a low-interest mortgage may be utilised as a tool to grow more wealth.
However, in an era of slowing house prices, and both political and economic uncertainty, does it still make sense for luxury property owners to capitalise on the equity in their real estate portfolio?
Here are some things to consider:
1. Low interest rates
The Bank of England base interest rate has been at record lows for nine years, which is good news for those wanting to borrow money. At the same time, the stock market has been on the up and investors are finding themselves in the sweet spot of cheap leverage and bull-market returns.
Katherine Waller, director, Relationship Management, RBC Wealth Management in London, explains, “Whilst interest rates remain low — we don't see them rising again until at least next year — and as markets continue to rally, there is an arbitrage opportunity to borrow cheaply and reinvest into the stock market to achieve a return that is over and above the cost of the loan."
Lending rates in the current climate are, "The lowest they have been for quite some time," according to Matthew Hunter, associate director, Relationship Management at RBC Wealth Management in London. “Banks are lending for longer terms and although it should be taken into consideration at the outset, the Bank of England base rate isn't expected to increase again this year, and when it does it will rise very slowly," he says.
2. Look past Brexit and other short-term risks
Brexit negotiations with the EU are unlikely to conclude soon, and there is no indication of what the outcome will look like. This uncertainty may be causing a lot of short-term volatility in the markets, as well as sleepless nights for some investors.
“When it comes to Brexit," Hunter says, "an individual's personal view is likely to influence their tolerance for investment risk. Once a deal is struck, regardless of whether it is good or bad overall, the markets will have certainty."
Waller adds, “A sensible exit scenario will probably see a rise in interest rates, but the increases will be slow — good news for investors borrowing to invest. Similarly, if there is a 'no-deal' Brexit, interest rates will fall. This is an even better scenario to borrow against."
3. Diversify your portfolio
Returns from the stock market are unpredictable. Investors have been extremely optimistic given the past decade's bull market, but how much longer will the rally last?
“If you are looking at a middle-of-the-road risk portfolio, you could see returns of around five to six percent currently, once investment management fees have been taken." Waller says. "It would have been higher in the past because fixed income markets have done better over the last eight years than they will going forward."
“The risk is that investment returns aren't guaranteed but the cost of the debt is something that has to be paid back. A market cycle can last for anything from five to 10 years so you will need to invest for the long term and diversify - the more assets you have the more protected you are from any form of political or economic scenario."
Diversifying a portfolio, not simply by asset type but also by geography can go some way to protect a portfolio against falling markets. “The high-net-worth clients who typically use property as a form of leverage are not always invested solely in the UK and, particularly with Brexit in mind, this global diversification will help protect a portfolio," Hunter says. "When the market falls here, international holdings become more valuable."
4. A recession could lead to over-leveraging
Prior to the 2007 financial crisis, investor confidence was such that borrowing against property to invest wasn't a strong cause for concern. Since investment returns were good due to high demand from tenants and increasing property prices, there appeared to be low risk to borrowing.
The global recession that followed brought the reality of over-leveraging back to the fore and, as a result, loans to value have become much more strict. The risk, however, remains.
“If you borrow a significant sum and a recession hits, you could find yourself in a very poor position," Hunter says. “Property prices will fall, the interest on the loan will become too high and, if the property is let then you also have the risk of losing your tenants."
5. Question your timing
It is also important to look ahead at the state of the economy and question whether we are heading into a recession. Again, personal viewpoints will ultimately dictate an individual's risk appetite, but having already taken a downturn into consideration at the outset could save disappointment further down the line.
“Everything isn't always going to go up and although relatively recent, investors have already forgotten the depths of the recession," says Hunter "What if your portfolio was to fall 20-30 percent? Laying all the risk on the table at the outset often sees an 'adventurous' investor curb their appetite for risk."
It is also possible in some cases for a leverage facility to be agreed and put into place, but not acted upon immediately. This would assist in negating any near term market movements that may cause restrictions on lending.
Waller cautions, “Investment returns aren't guaranteed, so getting advice is paramount before borrowing against a property. We haven't had a recession for 10 years and investors have made great gains — their confidence hasn't been tested."
Borrowing against property has its place
Within a well-balanced portfolio, holdings in real estate make sense for the long term as the asset class offers an element of diversification against, say, equities or fixed income, for example. Prior to the 2007 recession, house prices had risen consistently since the first quarter of 1996, and before that they hadn't experienced a dramatic fall since the 1950s.
For investors today, however, property is not necessarily the all-conquering asset it once was making the ability to borrow low and invest elsewhere more attractive.
“Opportunities going forward are limited, but as long as you have debt with an organisation that will continue to lend at a reasonable price, there is always a place for it on a balance sheet," says Waller.