This is a very well known and openly shared property investment strategy. The basic premise is that you buy a property with a plan to refurbish it and that the refurb adds significant value to the property. When the refurbishment is finished you let the property out and then refinance which essentially pays back all the money you invested so you can move on to the next project and keep building your portfolio until you reach financial freedom.
Clearly lending plays a large role as you may want funding to buy the property and will certainly need a lender for the refinancing.
There are specialist lenders in this sector and I will provide some guidance and information on how the lenders approach these projects and some issues to be aware of that may help you.
Firstly you need to buy the property. The lender will want to know your plan for the deal and the fact you intend to refurbish the property changes the game. In this case the value of the property will decrease before it increases during the refurbishment process. As such the lender will expect that you use a short term loan for the purchase and refurbishment stage as this is in itself a short term project.
Short term property loans are also known as a bridge loans. The interest rate is higher as well as the lending fees. However the loan can be serviced ‘fully rolled up’ this means the interest charged is deducted from the loan at the start so that you do not have to make monthly payments and can focus on the project. There are further options of fully serviced – meaning you pay the interest monthly or part rollup and part serviced. Some lenders charge you an exit fee and some don’t. You always need a plan to exit a bridge and in this case it’s a refinance, where the exit plan is a sale, please bear in mind the time to sell and complete the conveyancing will be time you are paying interest. In most cases where the interest is rolled up the lender charges for the agreed period say 12 months and if the loan is redeemed early the unused interest is rebated.
The bridge loan market has become very competitive with some lenders trying to get their share of the market by being inventive with the product – offering higher loan to value or offering a loan based on the end value so they can lend more on the refurbishment costs. Each of these products comes with different levels of risk and therefore different levels of finance costs and rates.
So lets use a typical example which we will continue with through the process to the end. Lets say you are buying a house at full market value for £100k, you intend to spend £25k or less on the refurbishment and you expect the property to revalue at £150k or more at the end, and no longer than 6 months refurbishment period.
Most lenders offer 75% of the purchase price on either short term or long term funding. However short term lenders will also offer an additional 10% of the purchase price to help fund the refurbishment. Please be aware that the lender will expect to see that you have the remaining 15% deposit in funds as well as the £25k refurbishment funds so £40k in cash in your bank to do this deal. This is not a no money down deal scenario.
Lets say you have the £40k and want to borrow the rest. Here is an example of the lending finance:
85% LTV = £85,000 gross loan.
6 months interest @0.8% pcm – £680pcm x 6 months = £4,080 (deducted from loan)
Lender fee circa 2% – £1700 (added to loan)
Broker fee circa 1% – £850 (deducted from loan)
Valuation Fee circa £320 (paid up front not from loan)
Legal Fees circa £650 (deducted from loan)
This provides a net loan, i.e. the amount of money to draw down into your bank of circa £79,420
Please note the interest is deducted from the loan so if you redeem the loan after say, 3 months, there will be 3 months interest rebated so you will get back £2040. This incentivises you to complete the project as quickly as possible.
So you can see from these numbers that you need £125k for project less the net advance of £79,420 is £45580 in your own funds. You can identify the finance costs here have added £5580 to your project. For some clients this is too much but for others – its justified to enable the project to go ahead. You need to decide so please base your decision on being aware of all the costs.
Ok so lets move forward and using the above example say you took the loan and completed the refurbishment in 6 months. You can now apply for refinance. Lets have a look at the numbers for this and see what your left with.
Property Value now £150,000
Loan to value 75% = £112,500
Lender fee circa 0% – £0
Broker fee circa 0% – £0
Legal fee circa £350
Revaluation Fee £135
Net advance £112,150.
Payment of bridge £85,000
Cash returned to bank = £27,150
So at this point you have finished the project and you are left with:
- A property worth £150k and equity of £37,500
- An income estimated at circa £750 pcm in rent less 10% management fees / 10% maintenance fund = £600 pcm net.
- An interest only mortgage servicing at circa £400pcm or less.
- A bank balance of £45000 reduced to £27,150.
- An appreciating asset.
Its fair to say in this example you have not been able to pull all your money out in the refinance but you have been able to restrict your own cash investment to £17,850 bearing in mind you now have £2400 per annum income you have a 13% + annual return on your investment plus the equity in the property starting at £37.5k and increasing year on year potentially. Where else do you get these levels of return?
Lots of people simply look at the purchase price, refurb cost and end value just like you see on homes under the hammer to assess a good property deal. In this case the basic profit was £25k in 6 months and if that’s not enough for you personally you either don’t do it or do more projects. Professional landlords and property investors look at all aspects and contributing factors both positive and negative to assess the deal and will look at the return on investment over time coupled with the asset appreciation to make the decision on a property deal or BRRR deal.