Introduction
The following article is designed to give individuals an insight into the different ways we can invest in property. Whether it’s a direct investment into residential or commercial property or putting your faith in one of the many retail funds out there, there are many routes you can choose if you want to get access to this particular asset class. As well as focussing on the various methods of investing, we shall also look at the benefits and drawbacks of putting your money into property, as opposed to different asset classes such as gilts, fixed interest, cash or equities. As this article was written specifically for your accountant’s publication, we shall also have a comprehensive look at the various tax implications of investing in property.
The article will also partly focus on the type of returns that property has provided in the past, so that by the end of this article you should have a much clearer understanding of the nature of investing in property and will be a much better position to decide if this type of investing is for you.
Overview of Property Investing
Investing in property is nothing new to UK investors. The notion of property as an investment really started to take off during the Thatcher years as the Right to Buy scheme encouraged many millions to purchase instead of renting. The new expanding middle class saw the potential for long term growth in rising property prices as opposed to “wasting” money on rent. However it was the Housing Act of 1988 that really provided the background for small investors to plug the housing gap created by the sale of council housing and it afforded tenants a level of protection into the bargain. However, the boom of the years from 1996 to 2007 where house prices rose a staggering 219% (according to Halifax), are a distant memory and common sense has been brought back into the marketplace. The rampant profiteering has given way to a much more cautious approach. There is still good money to be made in investing in property but only if you’re sensible and take good advice.
In the past it almost seemed as if one could not fail to make money out of property. However the reality is, as with all investments, that there are of course risks and in some instances people have lost a lot of money. The last few years have been a large wake up call for those that thought investing in property was an easy ride to fame and fortune. Both Commercial and Private Property have both found the going tough in recent times but investing in these assets is still vital for the diversification and long term growth potential that it brings to a portfolio.
Many of you will think of investing in property simply in terms of buying a property cheap, doing it up and selling it on for a profit, or in terms of Buy-to-let, which is where you buy a property and rent it out as a private landlord. Whilst these are two of the most common ways to invest in property they are by no means the only methods available. In this article we shall take a close look at the many ways we can get exposure to property and also try to analyse the pros and cons of each method we cover. New regulation has made investing in property funds more accessible in recent times and we shall look at the various investment vehicles such as ISAs and pensions and their tax advantages.
We will also look at the potential for growth, income streams, yields and cover the risks associated with property such as defaults and liquidity.
RESIDENTIAL PROPERTY
In this section we will take a look at the various ways of making an asset backed investment in residential property.
Buy To Let
Residential buy-to-let really came to prominence in the1990s and this was due to a number of factors:-
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Buy-to-let mortgages became more obtainable as you could get a loan with as little as a 15% deposit on a property.
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The yields on bonds and equities fell in relative terms making the rental income from property more attractive proposition.
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Strong capital performance during this period also main residential property more appealing.
When entering the buy-to-let market it is very important to do your research and make yourself aware of the potential pitfalls. The popularity of this type of investment meant that many areas of the country (such as parts of London, Manchester and Leeds) led to an over supply of rented properties. This was a big contribution to the price falls of 2008 when the housing market also started to cool. Prices are very heavily affected by supply and demand and economic factors can easily change the demand in different areas. The relative prosperity of an area will go a large way to determining the attractiveness of property investment, as demand will be higher in areas where business is flourishing, local amenities are good and the general demographics mean that people wish to live there.
One of the most important aspects of buying a property to rent out is of course getting tenants in. It is vital to give thought to this when sourcing a property i.e. is this the type of property in the kind of area that will attract tenants paying a decent rate for the rent? Most buy-to-let investors will still have mortgages on the property or properties and these mortgages still have to be paid, even if there is no tenant in the property. When a property is suffering loss of rent this is often referred to as a void period. A void period could also occur when a tenant fails to pay the rent and removing those tenants can prove to be difficult as well as costly. Investors who have borrowed more are most at risk from void periods.
The income (or yield) you can expect to get from a rented property does vary from area to area. Generally though, you will find the more expensive the property, the lower the yield. Rising property prices in the years up to 2007 tended to push down yields. Although property prices have fallen in recent years this has not always meant that yields have increased because rents have also come down in many areas. One feature which has been to the advantage of buy-to-let investors though has been the low interest rates, which in turn have led to lower mortgage rates. This has widened the gap between income and outgoings for many investors resulting in greater yields.
An example of the potential yield on a property can be illustrated as follows:-
A property is advertised at £185,000, with a potential rental income of £850 a month. This means the gross yield would be.
Gross rent = £850 x 12 = 5.51%
Market price £185,000
In reality though, you would incur many costs in purchasing, such as stamp duty, legal fees, survey costs and perhaps the cost of basic furnishings. For the sake of this example let’s say this all comes to £4000. Added to this you will have general management expenses of let’s say around 20%. This will change the above formula to the following:-
Gross rent – expenses = (£850 – £170) x 12 = 4.32%
Market price + cost of buying £185000 + £4000
The above figures do not take into account any void periods which would reduce your yield even further. I have also left out any mortgage expenses which would obviously reduce returns. For example if your mortgage rate on an interest only basis was 4% on borrowings of £138750 (80% of £185000) then you would be paying £462.50 a month which would reduce your yield down to 1.15%. If you were in this situation you really would be relying on capital appreciation to gain out of buy-to-let. If property prices were to fall then you could easily find yourself in a situation of negative equity and struggle to pay off your loan(s).
The reality of the situation just now would tend to suggest that with first time buyers still finding it very difficult to get on the property ladder, demand for rental property still remains high and according to FT.com there are now more than 49 postcodes in the UK achieving more than 6 per cent yield-12 of them in London.
Investing In Your Own Home
Many clients often say to me words to this effect: ‘My house is my pension’. By this, what they really mean is: ‘I’m going to pay off my mortgage as soon as I can and watch my property value grow. Then when I need money when I’m older I’ll just sell my property and move into a smaller home and live off the profits’. Whilst there is nothing inherently wrong with this in theory putting all your eggs in one basket aside), in practice it is often a completely different story. One of the main drawbacks is that when it comes to down sizing, it may not be so easy to give up a family home where there may have been so much emotional investment over many years. Your own property is not just an investment it is also a home and not so easy to dispose of as a result. The introduction of flexible mortgages has made it much easier for people to pay off their debts much quicker by over paying their regular mortgage payments. With many people now paying very low historic rates it should be a very attractive proposition to make over payments. However the other side of the argument might be that if you are paying off debt at rates as low as 2% for example, then that is the return you are getting for your money if property prices are not appreciating. In most parts of the country property prices have in fact been falling. So perhaps just now is not the time to take a short term view on your own property.
In general though, people are attracted to property investment because they see it as a good bet for long term growth. The owner-occupier market has tended to drive forward property prices in the UK and prices have tended to follow the growth in average earnings. However as always past performance is not necessarily a guide to future performance and the sharp fall in house prices in 2008 was a reminder to us all that property is the same as any other asset i.e. it can go down as well as up. Probably the most well known housing bubble of recent times occurred in Japan where house prices tumbled throughout the 90s and have only recently started to move in a positive direction again.
Overall forecasts for the UK housing markets make gloomy reading. According to the National Institute of Economic and Social Research NIESR house prices will fall 4.5 per cent I real terms and an average of 1.5 per cent per annum in the subsequent 4 years.
Land Registry: House prices have been trending down for the past 12 months
This pessimistic forecast tends to be backed up by others such as estate agent Right Move who have predicted a 5 per cent fall this year and Royal Institute of Chartered Surveyors (RICS) predict that prices will fall a minimum of 2% but no more than 5 %.
Rent a Room
Another way to make money from your own property is to let out rooms to lodgers. The main advantage of this is that you will pay no tax as long as you will pay no income tax as long as the rent does not exceed £4250 a year. You will need to live in the property at the same time as your tenant and the property will continue to be exempt from capital gains tax as your principle residence. However if the letting extends beyond the limits set, the part of the gain that is attributable to the part of the property that is let is chargeable to capital gains tax. However there is an exemption of the lesser of:
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£40,000; and
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An amount equal to the exempt gain on the part of he property occupied by the owner
COMMERCIAL PROPERTY INVESTMENT
Investing in commercial property is in many ways just like investing in buy-to-let in so much that you finance the purchase of a building in an area you have researched and put a tenant in to pay you rent. In a market where we have falling house prices it may make sense to go down the commercial route simply to spread your investment risk.
Commercial property is split into three separate sectors;
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Office buildings;
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Industrial properties(factories and warehouses); and
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Retail (shops).
The commercial property element does tend to be more specialised than other areas of the sector. You will find that a very significant proportion is owned by insurance companies and pension funds.
As with residential property selecting the right tenant and the right area are very central to your success. The quality of tenant and their ability to pay is obviously going to play a big part in how successful you become. Remember that you are going to be renting to businesses rather than individuals which can mean that your tenant is more reliable. Commercial property leases are generally longer as this added security does add value to the property (traditionally commercial properties are valued as a multiple of the rent they produce). The average lease term has come down in recent times. Where once it was not uncommon to see 25 year leases the average term has now reduced to less than 10 years. Rent reviews usually take place around every 3-5 years depending on the length of the lease and are designed to allow the landlord and tenant to adjust the rent to an ‘open market value’. Traditionally rent reviews were on an ‘upward only’ basis meaning that they could never come down but this has proved to be contentious in recent times because of the low inflationary environment we find ourselves in just now. There has been political pressure to change to a system where rents are linked to inflation or turnover.
Using a Pension to Invest in Property
In recent times using a pension vehicle such as SIPP (Self Invested Pension Plan) or SSAS (Small Self Administered Scheme) has proven to be a very popular way to invest in commercial property. By far the most common use of a SIPP has been through small businesses using their pension funds to buy their own business premises. Changes to the pension rules in 2006, means that it is now possible to do this, even if the property is already owned by them or someone connected to them. However it should be noted that these types of arrangements are subject to strict criteria must be done on a commercial basis. That is rent paid to a SIPP must be a market rent.
Buying your pension within a SIPP has several tax advantages. The rent you pay to the pension fund can be paid free of tax because it is a deductable business expense. If you sell your property when it is contained within the pension fund then there is no capital gains tax payable. Also, if you die before age 75 and haven’t started taking your pension yet then your property can be paid into your estate free of inheritance tax.
Past performance of Commercial Property
The values of this sector tend to be cyclical in nature. They have often moved in the opposite direction to the residential sector and equities. An example of this is when commercial property showed very little growth from1982 and 1986 when the stock market was booming, but rose sharply in 1987and 88, remaining virtually unscathed by the crash in October 1987. This led to a property bubble, especially in London. However the bubble popped and from 1989 to 1992 the market experienced a major crash. Since then it’s been a bit of a roller coaster ride with good followed by bad spells. The next major crash happened in 2008 when values fell by an average of 26.3% (source: IPD UK Annual Index). The commercial property market has steadily recovered from it’s bottom in 2009 and from June 2010 to June 2011 the FTSE UK all Property Total Return Index (NAV) returned 10.22 % (source: www.ftse.com).
INDIRECT INVESTMENT IN PROPERTY
So we’ve covered investing directly into property but what about an alternative way? Over the last couple of decades investing into funds dealing in property has become a really popular place to put your money. One advantage of investing in this way is it allows you to diversify your portfolio by getting exposure to property, without the expense associated with the previously discussed methods. Here are some of the ways it is possible to invest indirectly into property:
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Property unit trust/OEICS and investment trusts;
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Shares in listed property companies ;
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Real Estate Investment Trusts;
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Student Accommodation Funds
Property Unit trusts and Investment Trusts
This is a convenient way to invest as little as a few hundred or thousand pounds into one of the many regulated property funds out there. They give the investor a wide exposure to property and usually have sufficient liquidity to allow investors to realise their holding when required. Authorised unit trusts are those that are allowed to the general public. They can invest up to 100% directly in property and the fund manager has the power to defer redemption requests by up to 6 months. There are now about 20 UK based unit trusts specializing in property. Performance over the last 12 months has ranged from +6.2 (Close Freehold) to -6.23 (Aviva). Source: www.morningstar.co.uk
The main differences between Unit and Investment Trusts are:
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Unlike Investment Trusts a Unit Trust cannot borrow money to invest.
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In a Unit trust the price of units is directly linked to the value of the investments held by the fund, whilst in an Investment Trust the share price will move independently of the net asset value, depending on level of demand.
The fact that Investment Trusts are permitted to borrow money makes them more risky. Also, it is important to check on the status of investment trusts, as many of them are in fact offshore companies.
UK Property Companies
This is another way to invest in property with much more liquidity, although there can be a lot more leakage in terms of tax. With this you are simply buying shares in one of the 60 or so companies listed on the London Stock Exchange. Different property companies do different things as some can hold property as an investment whilst other are more concerned with development and can be more like construction companies. Many do both. With this comes varying degrees of risk as the development based companies can have erratic sales whilst those who hold on to the property have a secure income form rent. Most of the property companies that could convert to REITs have done so in recent years have done so (more than 80% according to www.bpf.org).
Real Estate Investment Trusts (REITS)
Most of the larger stock-market property investment companies have converted to the REIT format after they were introduced to the UK market in 2007. A REIT has more tax breaks than a normal property company and it must be a closed ended company and listed on a recognised stock exchange and widely available for private investors. REITs are also a good way to get exposure to global property shares which helps with diversification. As far as performance is concerned there are so many REITs out there and they vary so much it is difficult to give a figure for the whole sector, however one of the most popular in the UK is the Skandia Global Securities Fund run by LaSalle, which is down 12.83 per cent this year and that is after a 2 year rally on the back of a 51.46 loss in 2008 (source www.trustnetoffshore.com). This goes some way to exemplifying how volatile certain types of property funds can be.
Student Accommodation Funds
Still a relatively niche sector Student Accommodation has never-the-less been attracting a lot of attention over the last few years so I though it was worth a mention in this article. The main reason for their recent surge in popularity has been some of the performances. The Brandeaux Student Accommodation Fund for example has consistently returned around 10% p.a. since launch in 2007. It should be noted though that there are problems with liquidity as shown by the fund suspension in 2009 for 3 months. It does however seem to be pretty resilient to downturns perhaps due to successive Governments promotion of further education.
TAXATION
This is obviously a vast subject and worthy of whole books on its own given the nature and diversity of property investing, but I’ll touch on what I think are some of the main points of interest on this subject.
Buy To Let
All expenses must be incurred ‘wholly and exclusively’ for business purposes and must also be incurred on an ongoing basis in order to earn income. Non-revenue expenses are regarded as capital expenses and will be deducted from the capital gain when the property is sold.
The following is a list of allowable expenses:-
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Interest and finance payments
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Motor and travel
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Accountancy and legal fees
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Repairs and renewals
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Insurance and service charges
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Training costs
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Advertising and marketing costs
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Office costs
The main difference between the taxation of your own property and any commercial venture, such as buy-to-let, is that you will pay capital gains tax on disposal of any property that is not your main residence.
Commercial Property
As we’ve mentioned above capital gains tax can be a big liability for property investors but there are a few reliefs available:
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Indexation relief (for properties bought before April 1998)
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Taper relief, and
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The annual exemption (currently £7900)
There are other ways to use commercial property as a tax efficient investment such as investing in funds through an ISA. The current limit for individuals is £10680 in any tax year. As we’ve mentioned putting your property within a SIPP has tax advantages such as freeing it up from inheritance tax, it grows free from CGT and the rent you pay to the pension fund is an allowable expense.
As we know tax can be a very complex issue and that is why it’s important that you take professional advice in relation to any aspect of property investment you plan on undertaking.
CONCLUSION
In conclusion we have seen that there are many ways to get exposure to property as an investment and the biggest problem with this asset i.e. liquidity is not as relevant to indirect investment as it is to direct investment. Property can be a very expensive asset to invest in and it is clear that your initial research will be vital in the process. However the attraction of long term growth still exists and I still think that property has a role to play in any properly diversified portfolio.
In contrast to bonds or equities property is a physical asset…you can touch it, feel it, walk around it and that has to be worth something. Just be prepared for a few headaches along the way and remember property is not something simply to be dabbled in.
