How to earn double-digit returns from Polish property

As readers of my articles might recall we have, for many years, been earning double-digit returns from our property investments in Poland. There are many factors which have contributed to this success but, in a low-interest-rate environment, a key component of delivering such returns has been the use of leverage. 

The overuse of leverage was the main cause of the boom that ended in the bust of 2008. Since then leverage has been shunned by many investors – to their own detriment. Interest rates have been at record lows for many years now (in negative territory in the eurozone) and unlikely to increase dramatically. So, when buying properties yielding 7.5% or more per annum (which we have been consistently able to do for over ten years), leverage serves to magnify the income returns earned by investors. 

Indeed, in markets such as Poland, the prudent use of debt to finance properties not only boosts returns but can help to reduce risk. There are several reasons for this but the main one is that it reduces the amount of equity required and, with the double-digit returns which leveraged investments produce, allows investors to accelerate the repayment of their equity, often within a five-year period or less. An investor’s position can therefore be de-risked within fairly short order without relying on market liquidity. This is in stark contrast to the payback period associated with investing in, for example, prime London property on yields of around 4% per annum – which is roughly 25 years and very much subject to market liquidity!

But debt must be treated carefully for the risk of its use to be mitigated. Here are the six rules which I always follow:

1. The correct quantum of debt to apply to a given property depends primarily on the amount of sustainable income the property generates and the longevity of this income. Properties must yield enough income to comfortably pay interest on debt secured against them, other operational costs (including taxes) and a respectable amount of annual debt repayments. During the life of a loan, the property must be able to generate enough income to reduce the amount of that loan to a level where it should easily be refinanced and would not therefore force a sale of the property (a potential cause of stress) – whether or not the original intention is to sell the property at the time of the loan expiry.
2. It is not sensible to adopt a fixed loan-to-value (LTV) policy when investing. The key to determine the correct LTV for a given property is dependent on the income profile of that property. Often, because of the higher yields available, good secondary properties are better subjects for leverage than prime property. I have heard of prime property, leveraged at 30% LTV, becoming stressed. Yet, at First Property Group, we have direct experience of applying higher levels of debt to higher-yielding secondary properties that have continued to perform well throughout the credit crunch. Prime properties are typically low-yielding and do not generate sufficient income to sustain and repay significant loans.
3. For a long-term investor, capital value movements in a leveraged property prior to its sale are only relevant to the extent that these might cause an LTV loan-covenant breach. The apparent accentuated movements in capital value, as a percentage of invested equity, created by the use of leverage make no difference to the actual amount by which the value of an investment rises or falls. In purely commercial terms, as long as an LTV covenant cannot be used against a borrower, it makes more sense to risk the debt provider’s capital than your own. If only suitable assets are leveraged (that is, assets with adequate, sustainable income streams), the higher income streams should dampen the effects of capital-value movements. Furthermore, as debt is paid down, the apparent volatility should, in any event, reduce.
4. LTV loan covenants have to be managed carefully. This is possible. Ideally one should try to avoid entering into such covenants. If a covenant must be entered into, the borrower should achieve some, or all, of the following:
   1. an LTV covenant set at a level above the actual initial LTV
   1. a loan amortisation rate that affords the borrower protection from the covenant (the need for income is self-evident)
   1. agreeing less punitive consequences for a breach (a cash-trap is far more preferable to an acceleration of the loan; and if the income level is suitably high, the cash-trap should rectify the LTV breach within a reasonable period).
5. Property is illiquid. Therefore, loans should be for as long as possible. This enables the borrower to pick the moment to sell the property while also allowing enough time and accrual of income to reduce the actual amount of loan outstanding. Short-term funding of illiquid assets is a notorious recipe for disaster. Generally, one should seek the longest loan periods available, even if the business plan for a property assumes an earlier sale. The longer loan period provides protection.
6. Interest rates need to be hedged, at least for the earlier years of an investment (before income has had an opportunity to reduce the amount of loan outstanding) to ensure that the cash-flow projections made at the time of purchase can be more accurately determined. Interest rate caps are generally a better way to hedge interest rates than fixing rates of interest, because their cost is certain and, unlike fixed rates, they do not introduce rigidity into the investment structure. However, with long-term interest rates lower than I have ever known them, at close to zero, the partial use of fixed rates, perhaps in conjunction with interest rate caps, does make sense.

The use of an appropriate amount of leverage, in association with suitably high-yielding investments, affords a purchaser the ability to fund the purchase of a property with that property’s own cash flow. It is a tremendous way to acquire property. 

As mentioned, interest rates are historically low and property prices, at least in Poland, are also generally low. This is, therefore, a good time to consider using leverage to boost rates of return earned from sustainable income streams. If the loose monetary policy of Western central banks does eventually result in demand-led inflation, the use of long-term leverage, with appropriately structured LTV covenants and hedged interest rates, to acquire income-producing hard assets should continue to prove to be a superb way to invest.  

Leverage is, in itself, neither ‘good’ nor ‘bad’, and should not be described in moral terms – something which became fashionable in the immediate aftermath of the credit crunch. Used poorly it can cause problems. Used well it can be a financial tool to boost rates of return and acquire properties. The key is to pick the target assets carefully, treat the leverage with respect and structure it carefully.