A Coastal Folly
One thing has, after all, led to another. Against many years of better judgement, Mrs FvL and I have taken the plunge and bought a second home on the UK’s south coast. Our Coastal Folly.
This blog post tells the story of how I’ve paid for the Coastal Folly. I’ve surprised even myself with how it’s happened.
The Coastal Folly is expensive. Well over £2m of property. It is not a little 2 bed cottage 20 minutes drive from the sea. It is a premium piece of real estate, with uninterruptible sea views.
As a second home, it attracts additional stamp duty (the property transaction tax payable in cash to the government at completion) – for this value of property my stamp duty is well over 10%. A lot of people I know froth at the mouth at this level of stamp duty. Not me. My portfolio has benefited from low investment taxes. And most of what I spend my money on incurs 20% VAT. So having to shell out 12-13% purchase tax on a discretionary purchase, using money that has been taxed at 0% or 20%, doesn’t feel unreasonable at all to me.
Rustling up £3m
So I’ve had to find, for argument’s sake, about £3m. This is before any furnishing / renovation / upgrade work.
When I made my offer it was a ‘cash offer’ – I said I was not using any mortgage finance. This enabled me to move quickly and be in control of the process, which I think was to my advantage.
My vague plan when I put my offer in was that I would fund the property through three means:
- Some spare ‘windfall’ cash I had received recently and had not put to work
- Selling down a small portion of my invested portfolio, drawing on unsheltered accounts.
- Borrowing money via my margin loan – i.e. enlarging my existing margin loan(s)/portfolio finance arrangements.
I was able to pay the 10% initial deposit out of ‘windfall’ cash, and that gave me a little bit of time to get organised around finding the remaining funds. Apart from a wobble in which my private bank thought that I couldn’t use their margin loans to buy property, until they relented, I have gone ahead very much in line with my vague plan.
What I had not taken into account was capital gains tax. Once I realised that selling down unsheltered assets would involve realising significant gains – and thus becoming liable for significant capital gains tax – I became a bit more aggressive about borrowing the money, rather than selling down assets.
As a result I have adjusted my target asset allocation. I am now aiming for a loan amounting to 25% of my total investment portfolio (net, which is equivalent to 20% of the Gross value – i.e. if the portfolio is £12.5m Gross, with a £2.5m loan, then the net total is £10m). Initially I will be slightly over levered versus even this new target, so any rebalancing will need to slowly whack that loan mole flat until I reach the 25% point.
This loan is in EUR, GBP and USD – about half in GBP (resulting in quite a high LTV against UK assets), the rest split USA and International in line with my target weightings. I am already finding the EUR margin loan tricky in practice because I don’t have many EUR holdings and don’t like feeling that I am borrowing EUR to buy (even EU-focused) GBP holdings. So I may yet adjust the loan target away from EUR but for now the theory beats the practice.
Alongside that loan adjustment, I am increasing my fixed income target slightly – to reduce the volatility of the leveraged portfolio. I am also increasing my target overseas exposure – largely at the expense of my UK exposure – reflecting my greater disillusionment with the UK FTSE, the increase in my (property) UK assets, and the significant home bias evident even with a reduced UK target.
A free house
I had told myself that raiding my portfolio for funds would set me back 2-3 years, and that if I was financially secure 2 years ago, I would still be financially secure after raiding my portfolio. This assumes I can absorb the extra running costs of an additional home, which in the scheme of things I think are a rounding error.
What I now realise, doing the annual sums, is that if anything my position has been set back only 12 months, not 2-3 years after all. My invested portfolio (which excludes properties and illiquid assets) has ended 2021 worth almost exactly the same as it finished 2020. And that’s despite having funded a c.£3m house purchase. As Mrs FvL put it to me, “we have bought a house for free”! Or putting it another way, if my returns (and windfalls, to be fair) in 2021 had been +0%, I’d be in the same place, but minus the Coastal Folly.
Managing a £3m loan
As you can see from the above graph, the blue Net Total may be in the same place as it was at the end of 2020, but the composition is different – the dashed Gross total is quite a bit higher, and the yellow Margin Loan has grown a lot. By taking out the extra margin loan I haven’t had to sell many holdings at all. However, this leaves my enlarged margin loan at around £3m. This is the biggest it has ever been – somewhat bigger than it was even at its peak just after I bought the Dream Home in early 2016.
When I bought the Dream Home, which was my first serious foray into using margin loans in the physical world, I was significantly leveraged. My loans (orange, in graph below) then were almost half of the value of the accounts they were borrowed against (orange+blue), so a drop in the markets of say 25% would have put me under real pressure. I was aware of the risk, and managing it carefully, but it was a real risk. While I didn’t manage to sell my previous home when I expected, in the end I was fortunate that markets were kind to me (thank you Brexit!), and via a mixture of repayments from windfalls and market gains I had managed to get my leverage to a ‘safe’ level by the end of 2017.
My increased loan exposure, of about £3m, leaves me in some respects no more exposed than the ‘safe’ level I reached by Q4 2017. My total portfolio has grown considerably since 2017, so the new record level of loan is, in proportionate terms, no higher a proportion of my total portfolio than the smaller debt was in 2017.
As it happens I use margin with two brokers – my private bank and Interactive Brokers. Back in 2017 these brokerages had the vast majority of my unsheltered funds (i.e. excluding the black segment in the graph above). But now I have quite a bit invested in other accounts too – the grey portion above – which I could easily move into a margined account but at the time of writing is not available to my lenders. So my lenders only see the orange and blue bits, but not the grey or black bits.
One of the key risk ratios here is the Loan To Value – LTV. This is the orange section, as a % of the orange plus blue section. It has just risen to about 30%. If you took into account my total value, including the grey and black sections, my overall LTV is closer to 20%, but for the purposes of avoiding margin calls the number that matters is what the lenders see and that is around 30%.
In fact what really matters is the LTV on each account. I have different brokers, and multiple subportfolios within the brokers. But the headline three numbers are shown in the line graphs below – the Maroon and the Green lines are Interactive Brokers (personal and via my Ltd company respectively) and the Yellow line is my private bank. You can see my LTV has jumped up into the 30%+ zone, which is a level I haven’t been at since 2017. But it’s not as high as I was at when I bought the Dream Home. These days I consciously run the Ltd company leverage at the highest level of the three, because interest charges are tax deductible for companies (but not for me as an individual).
As to the cost of funds, Interactive Brokers as ever beats my private bank. I’m paying a blended 1.3% to IB, and 2.35% to the private bank (tho I think I could roughly halve this if I consolidated all my funds with them). I’m expecting total annual interest costs of under £50k (and dividend income of at least £70k from the collateral assets). This feels very competitive with a mortgage alternative, but hasn’t required any income disclosure or repayment commitment that would come with a mortgage.
Avoiding Bill Hwang’s mistakes
I need to make sure I don’t inadvertently become the next Bill Hwang – the billionaire whose fund Archegos overextended its margin loan to a level that hurt not just him but some of the biggest banks in the world.
As well as LTV, a ratio that matters a lot is the ‘headroom’ I have left above the amount of collateral I have. With Interactive Brokers (IB), the proxy for collateral is ‘initial margin’, and the headroom is indicated by the ‘Avail funds’ (so called because is the amount I could spend on new investments).
One trap for the unwary is that some stocks are better collateral than others. And as it turns out, I have one sub portfolio which I now realise has more ‘unsuitable’ holdings in it than I knew. This is revealed by my colour coding in the table below (note – numbers are illustrative, not actuals). The ‘Passive’ subportfolio, running at 29% LTV, has only 18% Available Funds – whereas the Active and the Tech subportfolios have 40% headroom despite running at very similar LTVs.
Digging in to this further, I discovered that the culprits are some of my newly acquired Lyxor ETFs such as LCUK and GILI. Whereas for large tech stocks, IB wants only 25% of the value as collateral, for relatively illiquid Lyxor ETFs it wants 100% of the value (i.e. you can’t borrow anything against these securities). My Passive subportfolio, and my Oz subportfolio, have quite a lot of unmarginable ETFs in them. I think from IB’s point of view ETFs on other exchanges are higher risk, so the Oz ETFs I use have always been difficult to margin. But thankfully for the holdings in my Passive subportfolio there are marginable alternatives from Vanguard/iShares – e.g. VUKE not LCUK, and INXG not GILI. I may take a slight hit in higher fees / more concentration risk, but when I need to manage my loan exposure this is a very small price to pay.
In fact even as I wrote this blog post, IB is reducing the margin available against GILS, one of Lyxor’s ETFs:
The red box on my margin dashboard has led to me rotating back out of Lyxor and towards Vanguard/iShares. I will look to rotate the other way in my sheltered accounts, which I can’t margin.
I am still not completely safe here so my portfolio will need attention over the coming months, to ensure I get my leverage levels down to ‘safe’ levels. In the meantime, I am really learning for myself why rich people buy houses differently from the rest of us.