The Complete Guide to Investing in Property
Over the past 3 decades, Brits investing in buy-to-let property has become almost as much of a cultural fixture as an annual holiday to the Spanish or Greek resorts. It’s simply what we do, or at least what many of us do. Of course, the UK is not unique in its affinity to bricks and mortar as an investment. To a greater or lesser extent, often dependent upon tax regimes and regulations such as rent caps, investors the world over have an innate trust in property as a store of wealth.
Despite the fact that property market cycles of boom and bust have not historically been all that different to those of equities markets, empirical evidence suggests investors are largely inclined to feel a greater sense of security in property ownership when compared to less tangible paper assets.
“Prices might drop but they always come back stronger than before. And I still have a rental income”.
Buy-to-Let to REITs via Crowdfunding
It could be argued that the same holds true of a diversified equities portfolio but our job here is not to compare property investment with stock market investment. Both have their merits and shortcomings and, as we will see, can also cross over in the form of REITs, and property-focused funds and ETFs.
Property investment is hugely popular in the UK with an estimated circa. 2 million landlords owning circa. 5 million buy-to-let residential properties. As an asset class, residential property had become so popular with investors that the investment cash flowing in to the market led to serious concern it was driving up prices to an extent that first time buyers were being priced out of the market.
The response to these concerns was a raft of significant changes to the tax rules around buy-to-let properties aimed at reducing their investment appeal to at least some extent. Some of these changes came into effect earlier this year and some will have a staged introduction over the next few years.
The response to these changes and impending changes to the tax rules around buy-to-let has been reported as many landlords reassessing the attractiveness of the market. The changes will have a particularly significant impact on higher income tax bracket landlords with larger buy-to-let portfolios, though in most cases there will still be some negative influence on smaller buy-to-let landlords further down the food chain.
However, buy-to-let, while no longer the close to no-brainer investment it perhaps once was, still has plenty of attractions. And there are many other ways that UK-based investors can gain exposure to the property market outside of classic buy-to-let.
In this guide, we’ll cover the main investment vehicles that are entirely or heavily exposed to the property market and their advantages and disadvantages.
Bricks and Mortar – Buy-to-Let
Let’s start with the most direct investment play in the property market: classic buy-to-let. Buy-to-let is buying a residential property which is subsequently rented out. Investors look at buy-to-let as a double opportunity for investment returns.
The first, what more experienced investors generally consider as the core investment case, is as a generator of regular income through rental returns. In the UK, gross returns from rental income to purchase price normally fall between 2% and 8%, though there may be occasional outliers above and below this range.
The lower end of this range would be expected to be higher value properties in the most expensive parts of London and the South-East. The usual rules of investment apply here with the lower rental ROI considered to come with very low risk. London and South-East property prices tend to fall by less and recover more quickly than in the rest of the UK during property market downturns. Occupancy rates are also highest. Sales values in these geographies have also historically shown the highest growth and capital gains on the sale of a property in these areas have tended to be very healthy over the past few decades.
Rental returns towards the higher end of this range are mainly found in regions of the country where property prices are lower than average, often in towns and cities where the overall economic environment is less healthy than in London and the South-East. Higher returns can also be achieved by guessing right and buying in formerly down-at-the-heel areas that are in the earlier stages of ‘gentrification’ or redevelopment, such as former industrial zones. Investing in a property that requires significant renovation or can be extended into a larger or additional property can also lead to better rental ROI being achievable.
We can again go back to the fundamental investment maxim of risk to reward. Areas where property prices are lower and offer better rental returns also tend to suffer more and recover more slowly during market downturns. Occupancy rates will also often be generally poorer and more cyclical.
The second opportunity for returns on buy-to-let property is from capital gains. The price of the average residential property in London was £79,000 in 1996. Now it’s £488,908, a 518% gain, or average 25% a year. That’s a phenomenal return on investment in anyone’s book. While house prices in the rest of the country have not seen quite as spectacular growth, they have also been huge over the same period.
Tax changes that start to come into force this year have made mortgage-supported buy-to-let investment less attractive. Until this year buy-to-let investors were able to deduct mortgage interest from taxable rental income. Many bought buy-to-let investments on interest only mortgages, with the interest deductible against rent, leaving the remainder as a nice source of income and hoping for capital gains on the property’s eventual sale. Others paid down their mortgage with rent generated with the aim that, excluding the original deposit, which could be as low as 10%-20%, after 20 years they would be left with a fully-owned property acquired with a modest down payment.
That tax break is now being phased out by 25% a year over the next 4 years and replaced with a new, significantly smaller relief on the first 20% of rental income only. Buy-to-let investors must now be very careful that the sums add up if an existing buy-to-let property still has a significant outstanding mortgage or a new investment is being considered. The main impact will be felt by buy-to-let investors in higher income tax brackets, who will be hit with 40% or 45% tax on rental income. There is also a danger for investors that could be pushed into a higher income tax bracket when their rental income, no longer benefiting from deductible mortgage interest, is added to other income, such as from employment.
40% or 45% of rental income being lost to income tax obviously makes a serious dent in the investment case for buy-to-let property. Another change is that buy-to-let landlords could previously automatically deduct 10% of taxable rental income for notional wear and tear. Now only actual expenses for replacing furnishings and appliance or repairs can be deducted and must be supported with receipts.
There are mechanisms that buy-to-let investors can employ to get around some of the new tax changes, such as holding properties in a company. However, this also comes with some tax disadvantages and probably only makes sense for those with larger portfolios.
All of this is not to say that buy-to-let is no longer an attractive investment but new and existing investors will certainly face greater challenges when it comes to finding investment properties for which the math adds up. There is expected to be a natural movement towards a reduction in buy-to-let investments and future landlords will likely be those that can afford to pay a higher percentage of the initial purchase price of a property upfront.
Buy-to-let advantages: Income generating. Under the right circumstances buy-to-let investments have the potential for solid return on investment from rental income. Historically, capital gains have been very good, outperforming most other asset classes. Historically, house prices have always recovered from market downturns to reach new heights. Demographic influences of a growing population and the finite resource of housing stock are in the favour of home owners and investors. Strong legal framework and political stability in the UK protects ownership rights and make property a low risk investment.
Buy-to-let disadvantages: Even with a mortgage, buy-to-let investment has a relatively high barrier to entry with a 20%+ deposit normally required. Changes to the tax regime mean minus a 20% allowance, rental returns are taxed as personal income. A buy-to-let investment is a time commitment if rental and ongoing service to tenants is managed personally. Using a 3rd party service provider to fully manage a buy-to-let rental property can eat significantly into rental income. Risk of vacancy periods that could damage rental returns and mean mortgage payments must be covered from other income sources. Property is an illiquid asset and even in a strong market would be expected to take 2-3 months to convert into cash.
Bricks and Mortar – Commercial Property
Many buy-to-let investors are said to be switching their focus away from residential property to commercial. The commercial property classification approximately covers any piece of real estate the primary purpose of which is not residential. Garages, shops, offices, clinics, warehouses etc.
Commercial property advantages: one major advantage of commercial property is that it can be held within a SIPP, protecting rental income and eventual capital gains from all tax. This can be achieved by either using funds already held in a SIPP to purchase a commercial property, or if the value of the property is up to the £40,000 annual SIPP allowance, plus any unused allowance from the previous three tax years. The disadvantage to this is that SIPP assets are locked up until the holder is 55. A commercial property held within a SIPP can be sold at any time but the cash can’t be accessed until the age of 55.
Commercial property returns are generally higher than those from residential property and lease periods longer. Tenants are also generally responsible for repairs and renovations etc.
Commercial property disadvantages: the downside is that untenanted periods will also often be longer and the commercial property market is much more strongly influenced by the general economic environment making it more volatile than residential property. Choosing a commercial property investment well also requires more specialist knowledge than is the case with residential property.
Alternative Bricks and Mortar – Unit Offers
An alternative to classic property ownership of a residential or commercial property is alternative property investment schemes that sell individual units such as student ‘pods’, care home rooms or even parking spaces.
Final pricing is usually modest, with student pods sold by companies offering this kind of scheme starting from around £40,000. A rental guarantee of up to 8% or 9% is also often offered for several years following the unit’s purchase. ‘Full management’ when it comes to finding a tenant, collecting rent, and keeping the building the unit is part of operating smoothly is also usually part of the deal. Sounds perfect!
However, there are also numerous drawbacks investors should be aware of when considering this form of property investment. Firstly, a mortgage is very difficult to secure on this kind of unit as they are generally not considered to be individual properties in the traditional sense, so cash will have to be paid in most cases. The rental ‘guarantee’ is often not as watertight as promoted in the sales pitch and the suspicion is that this is often at least partly financed by a premium per square foot being paid for the unit. While the overall price of this kind of property unit is often attractive, when looked at on a square foot basis they can be priced at a huge premium. There are numerous reports of the ‘guaranteed’ rental period quickly being reneged upon and new agreements being put in place at more realistic market rates, which are much lower.
A resale market is also highly dubious and investors in this kind of individual unit may have very limited opportunities if they wish to cash it in. Overall a property investment fraught with risk and best avoided!
Indirect Property Market Investment
For investors who decide not to buy an entire buy-to-let residential or commercial property there are still a number of investment options available which provide exposure to the property market. Let’s take a look at the property investment alternatives to direct ownership:
Buying shares in stock market-listed home builders or construction companies is one way to gain exposure to the property market. The share prices of home builders are heavily influenced by the property market and tend to go up when prices are rising and the market is healthy and down during housing price downturns. However, house prices are not the only factor influencing the share price of a home builder. The company’s profitability, land bank and good management are also strong influences.
Knowledge, or access to knowledge, in how to evaluate share price value of a residential construction company is important if equities is the chosen route to property market investment.
The advantage of investing in home builder or construction company shares is that entry levels are low and investors can buy as many or as few shares as they wish. It is also a very liquid investment and can be cashed in almost immediately at any given moment.
The disadvantage is that as well as the property market, share prices are also influenced by how well the company is run and the current strength of the wider stock market.
A REIT (Real Estate Investment Trust) is a specialist form of fund the units of which are normally traded on the stock exchange. Public non-listed and private REITs also exist. REITs own a property portfolio, which is usually commercial but can also be residential or mixed, and must generate most of their income from rental returns. To qualify as a REIT, the trust’s assets must be at least 75% property and 75% of gross income must be generated by rental income. 90% of the trust’s taxable income must also be paid out to the REIT’s investors in the form of dividends. While shares in construction companies are a play on the land price and construction costs to sales price ratio, buying units in a REIT is a play on the strength of rental yields.
Different REITs have different focuses, from offices, to retail and shopping malls, through to hospitals or industrial properties such as warehouses or factories. When a REIT’s investment merits are being assessed it is important to pay close attention to the nature of its property holdings and judge the current and future rental market prospects for this kind of property. Again, at least in the case of listed-REITs, this is a liquid investment that can easily be sold and should provide a solid income via dividends as long as the REIT’s property portfolio is performing well in terms of rental income generated.
In the case of exchange-listed REITs, one disadvantage to this kind of property investment is that a stock market downturn can lead to a drop in the REIT’s unit value even if its portfolio is performing well.
Property-focused investment funds can be listed or non-listed and are similar to REITs but without the same restrictions around having to derive 75% of income from rental returns. Property funds can generate income from rental and management of property assets but can also generate income from buying and selling advantageously with greater freedom than REITs. They are also not obliged to distribute 90% of income to shareholders in the form of dividends each year.
ETFs (Exchange Traded Funds) are a good way to achieve diversity in property-focused funds, REITs and individual company shares. A property-focused ETF will have holdings in a diverse range of property construction companies and REITs, though different ETFs will have different focuses in terms of the kinds of companies and REITs shares of are held and geographical exposure. Property ETFs also tend to pay out dividends and as exchange traded instruments are also a liquid investment.
Listed and private corporate bonds are another way to invest indirectly in property. A property-focused company may sell bonds to raise construction or acquisition finance as an alternative to bank financing. Bonds pay a fixed rate of interest over several years and often pay an attractive return.
Private bond placements are not uncommon as a means of raising alternative finance for a construction project or to acquire a piece of property. This kind of property bond often provides for a very good rate of return but also carries a higher level of risk of the bond issuer defaulting if the project is not successful.
Property crowdfunding is a relatively new option when it comes to property investment. There are now several property crowdfunding companies on the market. The idea is that several to many investors pool their resources to buy a property. How this is structured can vary but normally the property is held by a company with its shares split between the investors relative to the size of their investments. The crowdfunding company also usually then acts as the property manager and takes a cut of rental income. A percentage on the acquisition price is also often taken or on the profit when the property is sold.
Different companies have different models when it comes to investors exiting the investment. Some hold the property for a fixed number of years at which point it is sold, and the cash distributed among investors, regardless of market conditions. There may be a mechanism to allow investors to vote to hold the property if they don’t think it is a good time to sell. Others have slightly different exit mechanisms and some have launched ‘resale’ exchanges where investors can sell or buy shares in existing crowdfunded properties.
The risk with the crowdfunding investment approach is that there is little history so far to demonstrate success or failure of the model. How easy it is to dispose of shares in a crowdfunded property is the major concern and should be looked into carefully by anyone considering this route.