Dead capital

Property investment and dead capital

I was recently introduced to a relatively simple idea. The idea was nothing new, it was just something I hadn't thought about before.

Safe property investment Stategy

I have mentioned in previous articles that I eventually want to invest in property. My strategy was a very safe one. I was going to buy my first property and push my finances to pay the mortgage off as quickly as possible. Once paid off I could start to look at an investment property. The only problem with this strategy is that it would take years, decades even, to pay off the first property and then build up a deposit to buy my investment property. The other issue with this investment strategy is the fact that I have "dead capital".

Dead Capital

Dead capital (in this scenario) is equity that I have built up in my property that doesn't generate and marginal (or additional) income.

Let's say that I buy a house with a £40,000 deposit. I take out a mortgage for £160,000 and through tough financial decisions I manage to pay off the whole mortgage in about 15 years. I will then take another couple of years to build up a deposit to put into my investment property. Once again, this will be tough (but not as tough, as I no longer have a mortgage to pay). Then I purchase my investment property, get in a tenant as have them pay off the mortgage over the next 20 years. In the meantime in saving for another deposit for another investment property....and so on and so forth.

If you think about it the above scenario is very inefficient. Once I've paid off my own home I have a lot of equity locked up in my property (£200,000 to be precise, assuming zero house price inflation). Why am I saving up for the next few years for another deposit? Why don't I withdraw some of the equity that I already have in my house ad purchase the investment property today, rather than in 3 years time. The obvious answer seems to be that it means I will continue to pay a mortgage on my own property. 

However, there are many scenarios whereby releasing some of the equity to purchase an investment property would be advantageous. Let's say that after paying for your mortgage for 5 years you manage to build up £30,000 in equity, additionally you manage to build up £20,000 in savings. Between the two vehicles you can put a deposit down on an investment property. Let's say you put 25% down on a £200,000 property (once again assuming no inflation). Now, you still have a mortgage for £120,000 on your home as now have £150,000 mortgage on your investment property. Because I own a decent chunk of both properties, I can get a good mortgage interest rate. Let's say I can achieve 2.5% and 3% respectively. This equates to an annual payment on mortgages of £7,500. However, I now have a tenant paying a yield of 5% on a £200,000 investment property earning a cool £10,000. I'm £2,500 a year better off!

Of course, the above example has lots of assumptions. But it also teaches us a valuable lesson: if you do the maths correctly and choose the right properties then you can benefit from using up existing equity to purchase investment properties. It's a far more effective use of capital, rather than leaving it tied up in your property.

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