Mortgages Exposed - How to Become a Millionaire

This section is designed to encourage those who feel confident enough with the principles of gearing and of buy-to-let to make a major investment in the commercial mortgage sector.

If you would like to have a million pounds in say 25 or 30 years time, it essentially depends on what growth rate you can achieve from a reasonably small starting capital.

Growth Rate to achieve £1M	Starting capital needed for 30 year’s growth	Starting capital needed for 25 year’s growth
10% pa	£57,309 (17.4)	£92,296 (10.8)
15% pa	£15,103 (66.2)	£30,378 (32.9)
20% pa	£4,213 (237)	£10,483 (95.4)
25% pa	£1,238 (808)	£3,778 (265)

The table above shows that it is possible with high growth rates and smallish capital or visa versa. The longer the term, the better: the extra 5 years makes a lot of difference. The growth factor is shown in brackets – multiply any starting sum by the factor to see the end result. A million pounds may sound a tidy sum and it has that lovely sound to it, until you look at what inflation can do: -

Inflation rate	Value of £1M in 25 years	Value of £1M in 30 years
2% pa	£609,500	£552,000
4% pa	£375,100	£308,300
6% pa	£233,000	£174,100
8% pa	£146,000	£99,400

It’s probably safe to assume that the purchasing power of £1,000,000 might well fall by 50% in twenty-five years time. Investing £1M for income, a 10% annual return can then produce £100,000 gross annual income – say £50,000 in real terms at today’s prices. But it’s possible to live quite well on that income, regardless of any other income you might have.

We have seen from the section on buy-to-let that it is possible to achieve good returns on both residential and commercial property, provided you are prepared to face up to the gearing risks. Let me restate the argument, but now using a good quality commercial property as a simple example, yielding say 9% pa. Suppose you have £50,000 cash available, or you can raise it with a remortgage on your own home.

Now follow down the line of figures hereunder to understand how you could gear up to achieve a return in excess of 25% pa.

Costs and expenses are ignored although commercial leases are usually fully repairing and insuring, and are far less trouble than residential shortholds. But let us say the gross yield reduced to only say 25%, and you could achieve this every year, your million pounds would be reached in less than fourteen years. In 25 years £50,000 could then be worth £13,000,000. It only takes seventeen years at 20% pa return to reach a million.

Tax
There is also tax to consider. But fortunately, mortgage interest and other management expenses can be offset against rental income for income tax purposes. Also, no capital gains tax is payable until you sell the property. So, if you arrange for the mortgage interest plus expenses to equal the rental income there is no income tax to pay. You can do this by picking a lower yielding but higher growth potential property and maximising your mortgage by raising a re-mortgage on your own property just after you have arranged the commercial mortgage. Although the extra mortgage is secured on a private residence, the taxman looks at how the money was used, not where it came from: if it was a commercial venture, it can generally be offset for tax.

Capital gains tax now enjoys taper relief. After 10 years the tax is down to just 20%, and then only when you sell the asset and is only payable on the gain less buying and selling expenses. But why sell? If you have picked a good asset, you simply increase the borrowing as it rises in value and rents are reviewed, and use such extra loans to purchase additional property.

Save the surplus
Any surplus rent, after charges, could also be saved up as deposit towards the next purchase. The best way of doing that is to enjoy the best short term return possible – a current account mortgage or a flexible repayment mortgage on your own home as described earlier is an excellent, safe short term investment, and is perfect for parking rental income.

You may think that using the surplus rent to repay part of capital owed on the commercial mortgage might be as good. But you are enjoying tax relief on that mortgage - it is as if MIRAS applies on the full loan and at the full rate. 8% pa gross interest only actually costs 5.6% net of 30% tax, or 4.8% at 40% tax. So the commercial loan is only worth repaying if you cannot achieve the same net interest rate return elsewhere. A flexible residential mortgage at say 7% offers an investment return of 7% - net of tax.

Continuing the example, after 30% tax, the rental income surplus of £6,000 pa reduces to £4,200. Invested over five years at 7% pa produces £24,153.

Five years later
Let us continue with the example above and look at the position five years later. If the property grows at say 5% pa it will have increased from £200,000 to £255,000, a £55,000 increase. The more valuable property is now eligible for an increase in mortgage. The reviewed rent could now be increased to say £22,000 pa , so the situation after five years is as follows:

£65,000 is now a sufficient deposit to purchase another £260,000 property, assuming another 75% mortgage, and you double your assets.

Assuming yields were roughly the same, in another five years the exercise can be repeated again, only you can now buy two more new properties bringing the total to four.

In Ten Years Time
If you sold up all four properties after ten years you could have about £328,000 after repaying the loans and before capital gains: all from an initial investment of £50,000. This represents a return of about 20% pa after 30% income tax on the surplus rent. Capital gains tax need not apply if you simply keep the property and re-gear to buy a further four properties.

In Twenty Years time
Repeating this exercise for another five years gives you eight properties in total, and sixteen properties in another five years. Ten more years in total at 20% pa would bring up the free capital in now sixteen properties to about £2M. It has taken just twenty years in total to do it. The rental income less the mortgage interest, if now simply taken as income, would be around £250,000 pa before income tax, assuming the 12% pa running investment yield is sustained. Again there is no need to sell the property: one could happily live on that income thereafter, enjoying regular rent reviews to combat inflation. If your children inherit the portfolio on your death there is no capital gains tax to pay. As a business asset there are also opportunities to mitigate inheritance tax, but you need separate advice for that.

I have not included several important items for the sake of simplicity, but they must be included in a real scenario. There is the question of stamp duty on a purchase, which can take as much as 3.5% of the property value, and also legal and mortgage valuation fees which can take another 2%. This could take out the entire first year’s growth of the property, so one should allow for that in growth projections. One way is to simply knock one year off the growth term and project at the expected growth full rate. Another way is to project at a lower growth rate. For example, 5% pa over four years produces roughly the same end value as 4% pa over five years.

Interest-only, fixed rate mortgage
The mortgages have each been assumed to be interest only to enhance the yield. Lenders are usually quite happy to do this provided there is a sufficient term left on the lease. There is no point in repaying any capital while the gearing is making money – indeed, in theory, there is never any need to repay any loan whilst the overall growth (running income plus capital growth) exceeds the mortgage interest.

A fixed interest loan is quite appropriate for a portfolio of this nature to at least minimise the downside risks. Commercial rents are usually pretty stable and so an equally stable mortgage payment produces a stable surplus.

Remember the risks
Now while all the above has been very simplified, the object is to hint at what is possible. An 8% mortgage rate may be a bit on the high side, but then I have ignored buying costs. I have ignored time differences when gross income is invested and tax is actually paid a year or more later. Obviously the property could grow faster or slower than 5%; it could even fall leaving you with a net loss. But these are the inevitable risks that need to be taken to achieve rewards of this magnitude. There is safety in numbers – better a larger number of smaller properties than the other way round, unless a really solid covenant is available from a larger property.

Spreadsheet tool
A spreadsheet is included called “Property Portfolio” and will enable you to play with various scenarios. The aim is more to develop the principles of the business model, rather than as an accurate plan. The end result is very sensitive to the LTV selected, and the property growth rate is important too. In real life, yields and growth rates vary from year to year: but since property is a real asset, it is linked to the inflationary process and therefore compensates to an extent for unpredicted inflation.

I also suggest you become familiar with the “Investment Property Return” spreadsheet, which enables all the costs to be entered for a specific property transaction in order to calculate the possible return on capital (expressed as an IRR).

Summary
In short, a carefully selected, geared portfolio of good quality commercial property, such as warehouses could produce a sizable profit over the medium to long term, and provide a good source of income thereafter. £1M is fairly easily possible before you retire provided you get cracking in your early 40’s at the latest.

I have used an example of £50,000 to achieve £2M in twenty years. In theory you could scale down with a lower starting capital, but good commercial property requires a sizable commitment and even a £200,000 property is somewhat light. One way to build up to this deposit is your own home and a remortgage at the right time. A house costing just £100,000 today would grow to about £160,000 in ten years at 5% per annum. That’s a £60,000 increase for a start.

Finding and selecting the commercial properties themselves is clearly crucial. You will need to bone up on the intricacies of commercial property and perhaps take on a professional commercial mortgage broker and a buying agent to guide you. It is worth explaining your amateur status to start with since on the whole, people in the professional sector are very helpful to beginners who may become substantial clients in the future.