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Understanding why property investors borrow

Published on September 5, 2016

If you are going to invest in commercial property debt whether Peer to Peer or not, it is important to understand why property investors take on debt.

 

For most individuals our relationship with property debt is a mortgage on our personal home. The reason being is that we are unable to purchase the property outright on day 1, so we put down a deposit, borrow the balance and over a matter of 20 plus years pay down the outstanding mortgage, until it is us and not the mortgage lender who actually owns and controls the property. Until the mortgage is paid off, our name may be on the title deeds but the mortgage lender sits ahead of us and if we want to sell or refinance the property, they are first in line for money. Mortgage lenders, residential or commercial, sit in the safest part of the capital structure.

 

In the commercial investment world, however debt plays a different role, not only does it reduce the capital requirement but it also drives the returns on investor capital much higher than they would otherwise be. The amount of debt, or leverage available, can drive the decision whether the investment should be made or not.

 

To illustrate the effect of debt within a property investment let’s look at 4 different investment scenarios:

Why borrowers borrow table

 

 

Although this is a slightly simplistic overview of the numbers, it is clear to see across the different investment scenarios, the impact of adding debt or leverage and how it can increase the return on the investors capital by between 50-75% per annum. Unlike residential property where debt (a mortgage) is used to enable the purchase of a property, in commercial property investment, debt is used to actively leverage the potential returns on investor capital.

 

Whilst debt can be used by the property investors to increase returns, the greater the debt the greater the returns on capital. Commercial property debt investors (the lenders) need to ensure that the level of debt taken out by the property investor is both affordable and provides enough of a cushion to cope with day to day volatility in the underlying value of the property and should the borrower default on the loan, that the sale of the property will cover the outstanding loan.

 

Debt is an implicit part of commercial property investment and in the current long term low interest rate environment, investing in commercial property debt, can offer investors the opportunity to earn attractive rates of risk adjusted fixed income returns.