A guide to investing in property

The UK property market
A round-up of what’s going on in the residential and commercial property markets
Buying abroad
How and why to invest in a residential property in another country
Global hotspots
A country-by-country guide to the regions offering the best investment opportunities
Let it right
Make sure you take the right steps to residential property investment

UK property play

The property market offers a whole range of different investment opportunities, as Hilary Osborne explains

We seem to have been saying this for some time now, but it still holds true: property is a hot topic, and not just for investors. The latest house price surveys still make front-page news, programmes about buying, selling and renovating are still on prime-time television, and the number of property funds available is on the increase.

The public appetite for bricks and mortar is still booming, despite predictions that the residential market is heading for a fall. And perhaps this isn’t surprising. In early 2003, two of the best-known housing market commentators, Halifax and Nationwide Building Society, predicted growth of 9–10 per cent for the year, but by the end of the year prices had risen by over 15 per cent.

As 2004 began the prediction for the year was growth of 8-9 per cent; on the 31 December 2004 house prices were 12.7 per cent higher according to Nationwide and 15.1 per cent higher by Halifax’s estimations. This year Nationwide anticipates growth of around 2 per cent, while Halifax expects prices to fall by 2 per cent. But bullish investors may be inclined to take a chance on them being wrong again.

In the commercial property market the Investment Property Databank (IPD) recorded the best performance in 11 years. Total returns from the 11,000 properties monitored by the IPD averaged 18.3 per cent, compared to 10.9 per cent in 2003. Capital values across the sector rose by 11.4 per cent and although rental growth was unspectacular – up by just 2.3 per cent during the year – this compared with rental falls in 2003 and 2002. According to the IPD, commercial property now ranks as the top-performing asset class over the last one, three, five and ten years. So how do investors get exposure to property?

Residential property

Most people invest in the residential property market through a buy-to-let investment. A property is bought and then let to tenants who provide the investor with a rental income. Alongside the income, the landlord benefits from any increase in house prices. “Our customers see house price appreciation as a long-term benefit of investing in property,” says John Heron, managing director of buy-to-let lender Paragon Mortgages. “They tend not to rely on or anticipate the kind of appreciation we have seen recently.”

According to Paragon’s latest landlord survey, in 2004 rental property values increased by an average of £29,372, taking the price of an average investment property from £123,372 to £152,834. Combined with an average rental income of £9,098, this produced an average.

total return of £38,560 – some 31.26 per cent. While landlords may not be relying on capital appreciation, they must be aware that in recent years this has been a key part of their investment return. Had the average price remained at £123,372 and the rental income been the same, the return would have been 7.4 per cent over the year – compared to the 12.8 per cent total return from the FTSE All-Share index. One of the advantages of buy-to-let over many other investments is that it’s expected you will borrow a substantial amount of the money you invest. In fact, interest repayments on a buy-to-let mortgage are subject to tax relief at 10 per cent, so the more you borrow the more tax-efficient your investment. Lenders have developed specific buy-to-let mortgages which have different rates and lending restrictions than normal residential mortgages but have one key advantage – the borrowing can usually be worked out in relation to the expected rental income. Your personal income need not play a part in the calculation of how much you can borrow, which means buy-to-let loans are as readily available to the retired and self-employed as they are to other borrowers.

Borrowing has traditionally been restricted to between 70-85 per cent of a property’s value, but a new three-year fixed-rate mortgage from GMAC is available up to 89 per cent loan to value (LTV). Had that deal been available in December 2003 you could have bought Paragon’s average property with a deposit of just £13,571. The interest rate on the mortgage is 5.85 per cent so your rental income would have been diminished by monthly mortgage repayments of £535 (assuming a mortgage calculated over 25 years). However, your total return for an upfront investment of £13,571 would have been £32,137.

Downside risks

That’s the theory, but in practice as with any investment there is an element of risk. You may experience void periods, that is, times when you do not have a tenant for your property. According to the Association of Residential Letting Agents (ARLA), the average void period is 29 days a year. Even if you manage to limit your void periods to a couple of weeks at a time, if you have a mortgage on the property you will still be paying half of the monthly payment out of your own pocket. This can dramatically reduce the total return from your investment. You may also have to carry out repairs on the property or replace furniture. There are tax breaks on some of the things you may need to do to maintain the property, but you will still be spending money on running your investment.

It’s important to bear these costs in mind when considering a buy-to-let investment – together with the cost of actually buying the property, including conveyancer’s fees and stamp duty alongside the deposit, and the costs you will incur if you want to sell it. Before you invest get an idea of what these costs are and see how they compare with the initial fees and annual management charges on your other investments.

Unlike other investments, unless you employ an agent to manage the property, you will be paying these costs and looking after your investment yourself. “It is much more akin to running a business than buying an investment,” says John Heron. “It requires a great deal of proactivity on the part of the investor.” Anyone who doesn’t want to be actively involved in the investment has two choices – pay an agent or avoid buy-to-let.

Buy-to-let is not a short-term investment. You will probably need to hold the property for several years for the returns to cover your initial costs. You may also be locked into a mortgage – many of the fixed-rate and discount deals available have redemption penalties if you choose to pay back your loan during the special offer period.

Property is also relatively illiquid, says Patrick Connolly, investment manager at IFA John Scott & Partners. “It can take some months to get the right price – sometimes houses take months to sell and you may have a buyer who drops out,” he says. “This can be a real problem if the market starts turning while you are selling.”

Connolly is concerned about the number of people who are considering buy-to-let ahead of other investments. “Most people have residential property in their portfolio already, through owning their own home,” he says. “If you are putting more money into a buy-to-let property before buying other assets all of your portfolio is subject to the vagaries of that one market.” He acknowledges that it would be difficult to convince someone who has made considerable money through buy-to-let over the past few years that they have done the wrong thing, but says diversity is key to long-term success. “When someone has a large portfolio and it’s well diversified – they have fixed-interest investments, equities and cash – that’s when they could consider a buy-to-let property.”

Commercial property

Before making a buy-to-let investment Connolly suggests investors consider commercial property which, despite being based on a bricks-and-mortar investment, offers diversification away from residential property and, at the same time, from the stock market.

“The main difference between commercial and residential property is that on commercial property tenants enter into much longer leases and the only way a company can get out of the lease is to go bust or pay their way out of it,” says Richard Burrell, investment manager of Berrington Fund Management’s Westbury Property Fund. “As a freehold owner that is very reassuring.” Leases are often between ten and 20 years and many are subject to upwards-only rent reviews, so investors can expect a steady increase in income.

“I say to people, would you rather own a Marks & Spencer share with a yield of 2 per cent, or a property let to Marks & Spencer with a yield of 6 or 7 per cent?” says Burrell. “If M&S collapses you would have a share that was worth nothing. If you invest in the property at least you still have the building.”

It is often said that commercial property is a good way to diversify your portfolio because it has little correlation with the stock market. This is perhaps oversimplifying the relationship. “Statistically there is almost a negative correlation in the performance of equities and the stock market,” says Stewart Cowe, property research manager at Scottish Widows Investment Partnership (SWIP). “However, that is more to do with the fact that property lags behind the stock market so it is at a different stage of the cycle.” Following any kind of stock market shock, companies will tend to put decision-making on hold, including any decisions about the property they own or let. Cowe says it can take six to nine months for the commercial property market to feel the effects of any stock market downturn. “There is a direct link, but it is probably a deferred link,” he says.

Joining forces

If you are looking to diversify into commercial property it is unlikely you will be in a position to do so alone. Commercial units can easily cost upwards of £10 million so even with a seriously big mortgage they are out of the reach of most private investors. To get exposure to this market you will need to consider a fund.

There are a number of funds available to UK investors that invest purely in commercial property. Among them is the recently launched Britannic UK Property fund, the Westbury Property fund and SWIP’s UK Balanced Property trust. These funds hold between 14 and 21 properties spread across three sectors: retail, office and industrial.

As of mid-December 2004 SWIP held 54.42 per cent of its fund in retail property, 20.29 per cent in industrial and 25.28 per cent in offices, but this looks set to change as the investment team expects offices to outperform retail in the future. “This is due in part to improving sentiment in the equity and bond markets,” says Stewart Cowe. With many offices, particularly those in the South East, rented by financial services companies, the stock market recovery is expected to drive an expansion and with it demand for office space. In contrast, following three good years and total returns of 20.5 per cent in 2004, according to IPD figures, many expect the retail sector to underperform. Cowe explains: “There have been five interest rate rises and most people expect tax rises to follow the general election – that’s not good news for consumer spending.”

However, Daniel Lockyer, a fund-of-funds manager at iimia Investment Group, says the type of retail exposure most funds offer means investors should not be hit too hard by any downturn in this part of the market. “Most of the property portfolios only have stronger retail investments – for example, the out-of-town Comets. The ones that are more vulnerable are the high-street shops which are getting pushed out as people go to out-of-town centres,” he says. The managers of Britannic’s fund seem to share this view – they hold 9.8 per cent of the fund in the De Mandeville Retail Park in Enfield. In total 37.3 per cent of the fund is in retail outlets, 30.6 per cent in industrial units and 25.3 per cent in offices; the remaining 6.8 per cent is held in cash.

Paying the price

Despite having cash on its books, Britannic warns investors that its fund is relatively illiquid – investors, it says, may have to wait up to six months to get their money back. Greater liquidity is available if you invest in property via an investment trust or other closed-ended fund. Because the manager does not need to sell assets whenever an investor wants to cash in their holding, they don’t find themselves holding large amounts of cash or being forced to find a buyer for one of their holdings. As a result, Lockyer says this is the only route iimia would recommend for investors.

At the moment, however, another characteristic of investment trusts is limiting the choice for investors. The popularity of property as an asset class means most of the investment trusts in this sector are trading at a premium – that is to say, their share price is higher than the value of their underlying assets. While you may still get a good yield from these trusts, you are taking a gamble. “The risk to your capital is quite high when you’re buying things at a premium,” says Lockyer. “You could see the premium change to net asset value (NAV) or even a discount without the NAV actually changing purely because sentiment in the market has changed.”

The only investment trust currently trading at a discount – and the only one Lockyer holds in his fund – is one that has even closer links to stock market sentiment, the TR Property Trust. Run by Chris Turner and Marcus Phayre-Mudge at Thames River Capital, the fund can hold international equities alongside direct UK property; currently around 85 per cent of the portfolio is in shares. Its biggest holdings are Land Securities (11.48 per cent), British Land (7.22 per cent) and Hammerson (5.82 per cent) – the same top three are held in the Aberdeen Property Share unit trust and the New Star Property unit trust. “This isn’t really a pure property play because it is correlated to equities,” says Lockyer. “If the stock market falls it’s likely the TR Property portfolio will fall.”

The fund has a yield of just 2.05 per cent, so Thames River has launched the TR Property Growth & Income fund to cater for income seekers. It targets a yield of over 4.5 per cent. Lockyer rates this fund and says he may replace his existing TR Property holding with it.

The new fund can also invest in a mix of shares and property but the emphasis will be different to reflect its income target. “TR Property focuses on more development-orientated property companies which tend to reinvest their dividends,” says director of sales, Ed Morse. “The new portfolio will have a greater focus on Continental Europe and it will hold more direct UK properties because it is more efficient from a collection-of-income point of view.” Property companies in Europe have an average yield of 4.5 per cent while the corporation tax charged in the UK means companies in the country offer a lower income.

The new TR fund – which is only available via IFAs – is not recognised by the Financial Services Authority (FSA). This is because it is domiciled in Guernsey and listed in the Channel Islands. Several of the other property funds available are also domiciled in Guernsey, but listed on the London Stock Exchange, among them the Westbury Property Fund. This set-up means they do not have to pay capital gains tax (CGT) when they sell a property and they pay no income tax on rents. “This the most tax-efficient way a private investor can hold property,” says Richard Burrell.

To increase the tax efficiency, you can hold some property funds within an individual savings account (ISA). The Westbury Property fund is ISA-able, as is the existing TR Property trust, but the new, income-focused version is not. It can, however, be held within a self-invested personal pension (SIPP).

Hilary Osborne

Editor

Charterhouse Communications

www.whatinvestment.co.uk

close window