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Investing in property (pt 2)

This is an article about property investment and how it relates to investing in general, not Orbis Access in particular.

Investing in property

Different routes to property investment

Property is an unusual investment, not least because it’s one you can live in. You can’t make much of a home out of share certificates or bonds. This crucial difference needs to be factored into any financial plans you hatch.

Investing in property doesn’t have to involve your primary residence though, and you can invest in it directly or indirectly. A direct investment would include buy-to-let properties, while indirect investments could involve buying shares in companies that deal in property or investing in property funds.

Residential property (flats and houses) might first spring to mind, but that’s only part of the story. There are plenty of other types, such as commercial property (retail shops, offices) and industrial real estate. Some funds and companies acquire land for development, others specialise in financing property deals and more. So overall, a broad range of property-related investments, both in the UK and abroad, are available.

As an asset, property generates income (in the form of rent charged minus expenses) and a capital gain or loss (depending on whether prices go up or down). If you live in your property, you won’t be generating rent but you will nevertheless have avoided paying rent to someone else. 

Risk and benefits

Investing in shares can also generate income and capital gains, but there are significant differences. For those investing in property directly, certain risks need to be considered more carefully: namely that you may be putting a lot of your eggs in to one basket which you can’t easily sell in a hurry. The sale process can take months and incur significant costs. If you’re a home-owner, it’s likely a large percentage of your wealth is invested in this particular asset class. To ensure your investments are diverse, it could make sense to explore other types of asset.

On the plus side, historically the correlation between property and stock market prices has usually been low in the UK. This means their price swings tend not to be in synch, which is handy if you want to maintain a diversified portfolio. (Nevertheless there have been exceptions, most notably during the financial crisis of 2007-8, when many types of asset fell sharply in value at the same time). Also, property may provide some degree of protection against inflation, with rising prices in the economy potentially triggering higher rents and/or house prices.

A separate topic provides a broad overview of property investment returns. However, when buying or selling any property it is important to recognize that national property price figures may not reflect price movements locally – and for your property specifically – which could be very different.  

Mortgages

The most obvious cost in owning a property is likely to be the mortgage repayments. This is a major financial sector in itself, which we don’t seek to cover in detail.

Suffice it to say that it’s important to shop around and get stuck into the detail, even if there are a thousand other things you’d rather be doing. The difference between a good rate and a shoddy one makes a massive difference.

Over a 25 year mortgage it’s likely at least half, potentially even three-quarters, of your monthly repayments are simply servicing the interest on your debt rather than paying off the initial loan amount.

Using debt, such as a mortgage, will ‘leverage’ your returns (to use the jargon). In other words, it has the effect of amplifying any gains you make if property prices go up, but also amplifying your losses if prices go down.

Buy-to-let

Not everyone lives in the property they own. Over 1.4m people in the UK own buy-to-let property and its total value climbed rapidly in recent years to nudge the £1 trillion mark.*

Historically, property has been associated with its ability to generate regular income, so it comes as little surprise that pensioners might also be attracted to buy-to-let as a way of funding their retirement. The possibilities were further enhanced by changes to pension rules, which now allow for this type of investment as an alternative to an annuity.

Like any big investment though, it’s important to do extensive homework to avoid unpleasant surprises if you’re considering it.

On average, rental income currently amounts to around 5% of the value of a property annually (source: Financial Times). While this represents the national average gross rental yield for buy-to-lets, in practice yields vary greatly. For example, cheaper properties rented to students might typically expect higher yields.

But there are costs to consider too, including:

  • Transactional costs when buying and selling properties: surveyors, solicitors, estate agent fees and tax (stamp duty or Capital Gains Tax).
  • Then there’s ongoing maintenance and replacing fixtures and fittings. Some costs may be relatively trivial, like fixing a broken window, but the longer you own a home, the more likely you are to incur a major cost, like replacing the roof.
  • Ground rent and service charges may apply, especially for flats.
  • To safeguard your asset you need insurance.
  • And fees charged by letting agents, if you don’t do the legwork yourself.
  • If the property falls vacant between lets, there are voids when rental income dries up.
  • Crucially, there is the cost of the mortgage itself to consider, assuming you have one.

Once all these costs are taken into account, you are left with the net yield, which is likely to be significantly lower. As with yields, costs vary greatly, but can routinely reduce the gross yield by 25% (without mortgages costs) and 50% (with). Such figures are of course only basic rules-of-thumb which won’t reflect individual circumstances; get your sums wrong and it is perfectly possible for costs to exceed rental income.

Remember also that rental income, after expenses, counts towards your taxable income (assuming the property is owned by an individual rather than a company).

Of course, such calculations do not take account of any changes in property values. While house price rises can lead to a capital gain, there is no guarantee this will happen and things can get very sticky if rental income isn’t covering costs and the property prices fall. If costs are covered, it is much more likely you can ride out any dips in the market, given the positive cashflow while waiting for a recovery.

Investing in property indirectly

If you want to invest in property but don’t fancy the hassle of actually owning a house, or can’t afford to own one, you can get exposure to the market by investing indirectly. This is achieved by buying shares in companies that deal in property, or by investing in Real Estate Investment Trusts (REITs) or property funds.

There are numerous property companies quoted on the FTSE and other stock exchanges around the world. These can specialise in specific kinds of property, or might be diversified across a range of property-related activity.

Property funds and REITS offer a basketfull of properties to investors. They may, in turn, own and/or manage properties themselves (direct exposure) or buy shares in other funds or property companies (indirect exposure). British Land and Land Securities, for example, are diversified REITS which both feature in the FTSE 100, ranking them among the biggest UK public companies.

If investing directly, the REIT (or fund) managers buy, sell, develop and/or rent a basket of properties on your behalf. These may be residential, but are often commercial (shops, offices, hotels) or industrial. Of course, there are management fees to consider if you choose this route, which will reduce potential returns. On the plus side though, you get some diversification and expertise on your side. While some property funds and REITS may be easily tradable, others are less so, or even include defined lock-in periods during which you can’t sell up. This is because, much like individuals, it’s not easy for them to buy or sell individual properties in their portfolio rapidly. At such times, the market prices of REITs and property funds can fall well below the value of the property assets they own.

Funds and REITS with indirect property exposure are likely to be more readily traded (liquid) and more diversified. However, they are more volatile than direct property investments and tend to perform more like equities, at least over the short term. Also, they add a second layer of management fees, which diminish your potential returns.

*Source: This is Money, The Telegraph

Related links

  • Types of mortgage

    Learn about different kinds of mortgages, from repayment and interest-only to shared equity and buy-to-let.

    Money Advice Service

  • Buy-to-let property investments

    Buy-to-let is pretty much what it sounds like – you buy a property in order to rent it out to tenants. You should consider the property a medium to long-term investment.

    Money Advice Service

  • Value of buy-to-let properties set to smash £1 trillion barrier

    The collective value of property owned by landlords is set to smash through the £1 trillion barrier in 2015 after a boom in both buy-to-let borrowers and house prices, a report suggests.

    This Is Money

  • Rental yield: What is it and how is it calculated?

    The simplest calculation of rental yield involves dividing a property’s price by the yearly rent.

    Landlord Expert, November 2014

  • List of Real Estate Investment Trusts

    REITS can contain commercial and/or residential property. They provide a way for investors to access the risks and rewards of holding property assets without having to buy property directly.

    London Stock Exchange