Cashflow is King in Buy-to-Let

Running out of cash is what kills most business ventures. Understanding the cash flow is a crucial first step.

Over the long term, interest rates tend to rise and fall in relation to inflation, so that real rates of interest (ie net of inflation) are far less variable than the headline

rate. Consequently a fixed-rate loan increases vulnerability to lower inflation, because the interest charges will not come down as inflation falls, resulting in a higher real rate of interest. Borrowing at a fixed rate becomes a gamble that inflation will rise, when rising inflation is not in itself a problem.

Most buy-to-let investors would be happy to accept this level of cash flow risk. They might well be prepared to inject a little more cash into the scheme to make up for any shortfall in the early years so long as they were confident it would be profitable in the medium or longer term.
The best way to quantify the cash flow risk is to calculate on the basis that all gains and losses are retained in the investment, so that gains add to a cumulative balance, and losses reduce it. We can then forecast how long it will take for the investment to break even and what the peak debt will be. This should take full account of tax liabilities, but need not make any provision for interest on the landlord’s own cash invested.
With a 25 year repayment mortgage the project would not break even until the loan was paid off, and the peak debt would rise to £161,000, double the initial deposit. Banks might be reluctant to lend on these terms because the rental cover would be only 115% ie the gross rent would be 15% above the loan service costs. Lenders generally want to see rental cover of 125% or more. With an interest only loan it would be 160%.

Inflation 1% higher at 3% would not cause a problem in itself, although raising the long term interest rate by the same amount would begin to have an impact, resulting in three years during which additional investment would be required. Reducing inflation by 1% has a similar effect to raising the interest rate, since it increases the real rate of interest. In this example the cash flow is partially protected during the initial three years at the lower fixed rate of interest, so neither of these changes causes an increase in the peak debt.

How crucial cash flow is to the viability of the scheme depends on how deep your pockets are. Cash flow problems can accelerate very rapidly, which is why it should be the first concern of anyone contemplating a buy-to-let investment.