One of the earliest scientific dreams was the perpetual motion machine; a theoretically continuous source of energy with no input ever being required.  Perpetual motion is of course physically impossible, although it is easy to design a near utopian machine, which utilises the earth's abundances of free resources such as sun, wind and wave energy.

Our ancestors made particular use of a simple device called the lever.  It enabled almost impossibly large weights to be raised with little effort by using a long pole with a fulcrum near the heavy end.  The same effect can be achieved with pulleys or gears.

Interestingly, it is possible to devise a moneymaking machine that can apparently achieve a greater effect than the effort required and that can also mysteriously double or triple investment returns.  The concept is called gearing or, for American readers, leverage, usually with the "lever" part pronounced to rhyme with "clever".

An easy example of gearing for buy-to-let properties
Say you had £10,000 to invest.  You buy a £100,000 house using a £90,000 mortgage, so your initial £10,000 is the deposit.  Ignore fees and costs for the moment.

Assume the house was let out and the rental income just covered the interest-only mortgage payments, so the ownership cost was zero - again forget maintenance costs for the time being.

Finally, let us say the house was sold for £105,000 a year later, which represented a property growth rate of 5% pa.  After repaying the £90,000 interest-only mortgage, you are therefore left with £15,000. Your profit is £5,000, which is the amount left over after the sale less your original capital investment of £10,000.

Capital growth enhanced
In summary, you have invested £10,000 and after one year received £15,000 - a profit of 50%.  But the underlying asset itself, the house, only appreciated by 5%.  You have achieved an actual return on capital of ten times the underlying asset growth.  The IRR (Internal Rate of Return) of your investment is 50% pa.  Had you bought the house for cash with no mortgage, the IRR would be only 5% pa.  This remarkable result arises as a direct result of gearing.  You have geared up by a multiple of ten to increase a return of 5% to 50%.

Income yield enhanced
Now let us move one stage further.  We first assumed there was no net income since the rent equalled the mortgage interest.  But say the property was actually rented out for £7,300 per annum (about £140 per week) - that's a modest property yield of 7.3% pa and is easily accomplished in many areas of the UK. 

If the £90,000 mortgage interest rate were 7% pa, the interest payable in the year would come to £6,300.  Income £7,300, expenditure £6,300:  the result is a net income of £1,000 per annum.

An income of £1,000 per annum on an initial investment of £10,000 means a running income yield of 10% per annum.  So, not only have you achieved a capital growth of 50% but there is also an income of 10% per annum as well - an IRR of 60% in total in year one!

Is this really true? Surely it is not that easy.  What are the snags?  Well, reality always involves some friction, which also frustrated the perpetual motion machine from realising perfect success.  But despite some setbacks, the results from gearing can still be impressive.

The key to understanding gearing is to base your yield calculations on the actual capital invested, the deposit if you like, and not on the value of the house.  It is only then that your calculations come to life.  The investment yield is the rental income divided by the capital invested expressed as a percentage.  The property yield is the rental income divided by the value of the property only.

Friction reduces returns but does not eliminate them.
In the first example, we ignored costs and the effect of tax.  Taking "friction" (i.e. all the costs) into account will inevitably bring down the eventual return.  Say there is an additional £500 per annum to pay each year to cover maintenance and the general expenses of running the property.  This brings the running income yield down to £500 pa - from 10% pa to 5% pa.

The expenses on the purchase and the sale of the property could well absorb much of the first year's profit, leaving only say £1,000 surplus out of the gross £5,000.  But even £1,000 is 10% of the £10,000 invested. 

After just one year, adding in the running yield of 5% pa, the IRR is now a more humble 15% pa gross, less than the dramatic 60% frictionless return from our first example but still three times bigger than the underlying 5% growth of the asset, so gearing still multiplies the return.

Tax
Income tax must be paid on any revenue profit, which is your rental income less any relevant expenditure.  Mortgage interest counts as relevant expenditure so tax is levied only on your £500 pa profit.  Your net income is the gross income less tax at your marginal tax rate. A top rate 40% taxpayer would pay £200 tax pa, reducing the net income to £300 pa - a 3% pa net-of-tax running yield.

Capital gains tax is also due on the capital profit less acquisition costs and selling costs. If the gain was just £1,000, capital gains tax at the maximum rate of 40% could whittle this gain down to a net £600, although many taxpayers would pay less tax, if any at all, if their total gains are lower than the annual allowance and taper relief is available over time.

With your net income of £200 and the £600 net capital gain, the eventual outcome from your £10,000 investment is £900 in total after all tax and expenses - possibly more if your tax rate is lower.  This is a 9% net-of-everything profit in one year. A 40% taxpayer would be lucky to get 3.6% pa net of tax from a conventional deposit, so gearing has at least doubled, and could possibly triple the underlying growth rate. And we have only considered one year and absorbed all the expenses.

Buying & selling costs
The buying costs should strictly come out of the initial investment and the selling costs from the sale. Realistically, one needs to hold the property for at least two years to produce a return that exceeds that which could be achieved by paying cash, to cover the buying and selling expenses. The “Buy-to-let” spreadsheet included allows you to enter any set of variables.  In particular, it compares the overall return both with and without gearing (i.e. paying cash) to highlight the advantages of gearing when relevant.

Risk of loss
Suppose the property fell in value by 5% instead of increasing in value, producing a £5,000 loss.  You will still have costs to pay as well, so you could lose most of your initial £10,000. 

Similarly, if the mortgage interest increased by more than the rent there could be a negative running yield - even more negative if the tenant leaves or goes into arrears.  Voids in rental income are commonplace and must be expected.

So obviously the downside with gearing of this type is the risk of loss.  As we have identified earlier, higher returns always imply higher risk.  The higher the gearing, the greater the risk of loss but the more exciting the gain if it all works out.  Administration costs could well turn out to be more than expected.

Minimising the risk
The figures in the above example assumed a sale after just a year to keep the figures simple.  In practise one would want to hold the property for a bit longer and in particular resist selling if the market is depressed.  As we have seen earlier, property prices can fluctuate, although the general trend is very likely to be upwards. 

Mortgage interest can fluctuate but fixed interest deals are available as we have seen and are particularly appropriate for the nervous investor. 

A smaller mortgage can reduce the risk as it increases the running income although it reduces the yield since you have to put down more capital.  The ratio of the mortgage loan divided by the property value is known as the LTV (loan-to-value percentage).  The last example assumed a high LTV of 90%.  The higher the LTV, the higher the running yield and the greater the potential capital return, but the higher the risk of both losing the capital and suffering a negative income over time.

Individual investors can therefore address their own perception of the balance between risk and reward by choosing the most appropriate LTV.  In most cases it is down to what deposit is available.  An ideal balance of risk against reward might be an LTV of between 70% and 80% and most lenders would not lend more than 80% anyway as they like to see the rental income covering the mortgage interest by a comfortable margin.  But ultimately it is down to individuals, their cash situation and their attitude to risk. 

The property yield will also affect the choice of LTV. In some areas property can be rented for yields of well over 10%.  The best yields often come from the smaller, cheaper properties costing well under £100,000 and not situated in up-market areas.  But higher yielding properties often grow by less and visa versa.  The careful investor who chooses well could achieve a geared return well into double figures and 20% pa is quite possible.

Safety in numbers
For the serious, professional investor, it can be worthwhile buying a portfolio of properties. There is always an advantage in the economy of scale, since expenses can be distributed and the risk is spread.  There is less likelihood of a void (ie no tenant) being so serious when you have a few other performing properties to bolster the income.

If you had £100,000 available to invest, you could buy one property for £100,000 for cash and enjoy a good rental income with low risk but a modest capital gain.  Or you could buy ten similar properties with high gearing and achieve two or three times the return and with a higher running income than if you paid cash. But the risk, albeit on the higher side, is significantly lessened with the "safety in numbers" strategy.

A successful example of buy-to-let
A colleague of mine manages a portfolio of 35 flats in the West Country distributed over seven separate properties with five or six flats in each.  Each flat fetches from £70 to £90 per week producing around £100,000 per annum gross income, allowing for 10% voids - so 3 or 4 flats may be unoccupied at any point in time.  He is using some surplus income to refurbish some of the flats in order to improve chance of earning a higher future rent.

He invested initially about £200,000 and borrowed £500,000 from the Nationwide Building Society to buy the £700,000 portfolio, which initially yielded around 15% pa running income, based on the property values alone. The average LTV was just over 70%. 

After mortgage interest, maintenance, refurbishment and management costs, he enjoys around £40,000 per annum income before tax, which represents 20% pa running yield on the £200,000 investment.  The portfolio now, about 15 months later, is probably worth at least £800,000, which represents a capital profit, when sold, of £100,000 on an investment of just £200,000 - 50% in 15 months.  Not bad!

Clearly he bought well and at a good time and luckily had a decent chunk of capital to start with.  But it demonstrates the sort of exciting returns that are possible, in spite of "friction".

Commercial property
Many would-be landlords baulk at the prospect of finding and managing even one tenant let alone several dozen.  There are many Agencies who will, for a fee, take on the burden for you. But for the investor with a sizable deposit of more than £100,000 and who wants to minimise the hassle, there is another alternative - the commercial property.

I am talking about offices, warehouses or even factories, let on a commercial tenancy basis.  The concept of gearing described for buy-to-let residential properties is still equally valid.  The difference is that commercial rents are usually for a longer period (5 to 10 years or more as opposed to a 6 month shortholds) and the tenant is usually responsible for repairs and insurance.  Moreover, a good quality commercial tenant is far less likely to default and the rent usually rolls in every quarter with little aggravation.

Quality covenants
Like residential tenants, the quality of the tenant, in terms of their likelihood of paying the rent regularly, is critical.  In commercial terms, it is referred to as the "strength of the covenant".  A good quality covenant may mean a blue chip public listed company like a bank or an insurance company, or a well known high street store like Boots or Woolworths, or one of the numerous government bodies.  They are very unlikely to default and they also like the comfort of a long term contract.

The downside is that the property yield for such good quality tenants may be lower than that for the less illustrious occupant.  Nevertheless it is possible to obtain property yields of 8% to 9% pa from first class covenants that provides a solid income stream. 

There are many lenders willing to provide loans for commercial property.  They will base their offer of mortgage primarily on the tenant's ability to pay the rent rather than just the landlord.  Moreover, the better the tenant, and the longer the tenancy term, the lower the interest rate you can negotiate.  There is no ‘standard’ rate: some commercial lenders set a fixed margin over a defined independent base rate such as LIBOR.  Payments are usually collected quarterly to match the rents, which are also normally paid quarterly.  So although you might receive a lower rent with a higher quality tenant, you may pay a lower interest rate and management costs are lower.  The gearing advantage therefore remains intact but the better the tenant the lower the risk element.  In short, it makes sense to seek out the best possible tenants.

Syndicated purchases
Unfortunately, prime tenants normally like to inhabit expensive property.  If you like this sort of investment property, you may have to join a syndicate of like-minded investors if your cash is insufficient to provide the deposit for a single property investment.  There are a few specialist companies who deal in syndicated commercial property transactions, some even organising the mortgage on behalf of the syndicate. 

It is also possible to build your own commercial investment by developing a commercial unit in a particularly desirable location, sometimes pre-let to a good tenant.  Again, specialist syndicates are available and you are now very much in the professional sector.