Property investment is not to be undertaken lightly. As with all forms of investment, it has its risks. An investment property is much like a small business in itself, and all such ventures require time and effort, as well as bringing a series of legal and moral obligations regarding the condition of the property and the treatment of the tenant. If you have an investment property, you will need to fill out a self-assessment tax form, so you will most likely need professional financial advice. Such are the complexities that an article like this can barely scratch the surface, and if you take one message from this piece, it should be to find out much more before you go into property investment.
Why Invest in Property?
All investments are about making a return on your money, and property is no different. Property is ‘tangible’ – a real bricks and mortar place you can look around – in a way that other investment products, like shares or bonds, are not. We live in houses, we’ve looked for them, so we have a degree of intrinsic understanding about what makes a desirable home. And, the current climate not withstanding, we generally perceive that homes now are worth more than they were 10 years ago. While these are all good reasons as to why property investment is appealing, the real financial reasons for considering property as an investment are hardly alluded to here. To understand property investment more thoroughly requires the introduction of some technical terms.
This is the amount of money that an investment generates against the cost of buying that investment, expressed as an annual percentage. For example, if you buy a flat for £100,000, and rent it out for £500 per month, that’s a rental income of £6000 per year, which is 6% of £100,000. This gives a direct point of comparison with other investment options, from government bonds and stocks and shares, to just putting the money in the bank. Property yields are reasonably easy to forecast, because there are always comparable rental properties available to gauge what tenants will ay for your particular kind of property – but it’s important to recognise that if the property is empty, even for only a few weeks, the actual yield will be lower than it seems. Knowing the rental market, and estimating for periods of vacancy, are important considerations. That said, while bonds and bank accounts may guarantee a low percentage yield, other investments like shares can be even more uncertain than property. You can, after all, influence the desirability or reduce the cost of property to make it attractive to tenants. Unless you are on the board of directors, you’re not likely to affect the performance or dividend payments of a stock-market listed company!
The general perception, that property goes up in value over time, is borne out historically. Britain has had property valuations since the Domesday book, and the general trend is for land to increase in value at around 7% per annum, set against an average inflation rate of between 3% and 4%. In other words, in general property is getting more and more expensive. But there are major caveats to this. In the short term, the property market fluctuates. Falling prices, such as we have seen over the last 18 months, as happened at in the early 1990s, can have a devastating effect on anyone who needs to sell. If you can hold on in a falling market, all the evidence suggests prices will recover… but not everyone can afford to wait for that. Property prices are also affected by local factors which buck the national long-term trends. If you owned farmland around what is now Milton Keynes, you will have seen your property value multiply many times over. If you own a row of terraced houses in a remote mining village in Wales, those buildings might not now be worth anything at all.
But, these warnings not withstanding, the general trend over time is for property values to rise. This contrasts with many other investment products. Take, for example, money in the bank. That £100,000 in a high interest account might produce a yield of 6%, guaranteed year on year. But the value of that £100,000 capital investment is constantly declining in real terms, as general inflation reduces the value of money. If the interest is re-invested at the rate of inflation (say, 3%), suddenly the actual return is only 3%.
With property, the capital value exists independently, and is linked by default to the housing market and the general economy. Property prices follow the market without necessarily having to re-invest the yield. That £100,000 flat will be worth £105,000 if the market goes up by 5%, even if you haven’t spent any of the yield on it. Indeed, capital growth is generally where property investors make their big returns… but it’s a long term strategy, not a get-rich-quick scheme.
This is, perhaps, the most important consideration of all. How much does it cost to buy £100,000 worth of shares? The answer is simple – £100,000 (plus a few fees). Or to put £100,000 in the bank? Same again, but with no fees. But how much actual ‘money down’ does it cost to buy £100,000 of property? Even including expenses, the answer can be as low as £16,000. This is because you can get a mortgage to buy an investment property. And, while no investment ever comes without risks, the fact that banks will lend against the security of a building gives an indication that property is seen as relatively low risk. That intuitive sense, that a building is real, carries a lot of weight with financial institutions. Try borrowing £80,000 to buy shares and see how far you get. But with property, banks will generally lend at least 75%, and sometimes as much as 85% of the purchase price (even in this climate… time was you could borrow even more than that..!)
Borrowing money to multiply the effects of the growth of an investment is called leverage, or ‘gearing’, just as the gears of a car amplify the drive of the pistons into the turn of the wheels. Why does it matter? Because even though you only paid for a fraction of the purchase price, the yields and capital growth are based upon the entire property value. Let’s go back to that £100,000 flat, which we’ve bought with an 80% mortgage. It’s actually cost us £20,000, then. If property values go up 5%, the flat is now worth £105,000. It looks like a 5% capital growth. But.. it we only actually paid out £20,000. So that £5,000 increase is actually a 25% increase on our capital. That’s where the money is!!!
If you borrow money, it comes at a price. The interest rate of your loan shows how much you have to pay each year just for the pleasure of having that money to spend. Bank rates vary with the times, and at any given point there are an array of deals available – hence the importance of talking with an independent financial advisor to find the best and most suitable one. Investment property is treated like a business for tax purposes. The rental income is taxable income, but it can be offset against the interest you pay on the mortgage for that rental property, and it describes the actual cost or return you make from a property.
If the rent pays the interest and nothing else, it is ‘cashflow neutral’. If you have money left over, you have a positive cashflow. The amount of profit you make as a percentage of the actual money you spent is your ‘cash on cash’ return, expressed as an annual percentage. If you need to top up a shortfall, that is ‘negative cashflow’. If you offset those losses against other areas of income to reduce your tax, that’s ‘negative gearing’. And if this hasn’t already convinced you to hire an accountant, then the fact that the tax laws change with every budget really should!
Comparative values of investment
To illustrate why property can be a great investment, consider the table below. To make things as simple as possible, we will ignore any purchase costs, fees, tax, and so on…and let’s assume everything is 5% – the rate of inflation, the growth of the stock market, the share dividends paid, the increase in the property market, the cost of a mortgage. In practice, of course, all of these things are different, so it’s important to stress that the table is purely illustrative, and that financial advice should be sought before making any investment.
In the right hands, and with proper advice, property can be a fantastic investment. Like all investments, it has its risks, and you should seek professional advice, and become as knowledgeable of the factors which can affect the market, and of the legal and tax implications, before you buy. If you want a more detailed consideration of the pros and cons of property investment, do lots and lots of research. The introductory books listed below will give you a starting point. Talking with estate agents, financial advisors and accountants will also help. Good luck!
“Rich Dad, Poor Dad”, by Robert T Kiyosaki and Sharon Lechter, published by Time Warner, 2002.
“Real Estate Riches: How to become Rich using your banker’s money”, by Dolf de Roos. Rich Dad’s advisors series; published by Little, Brown 2002. Various other editions in existence. Available on Amazon.co.uk second hand for 1p.
“Beating the Property Clock: How to Understand and Exploit the Property Clock for Maximum Gain”, by Ajay Ahuja, published by How To Books, 2004.
“Successful Property Letting – How to Make Money in Buy to Let”, by David Lawrenson, published by Right Way Plus, 2008.