4 Apr 2012, 5:05pm
personal finance:
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  • The Buy to Let conundrum

    Monevator posted a great article summarising the amount Brits have stashed in tax-exempt ISAs, questioning why there’s so little in there. The highest cluster of ISA saved amounts are in the £20k-50k range.

    He’s got a point. Why so little? Well, whenever I hear middle-aged people talking about how to store wealth, there is one strategy that they focus on, that wouldn’t appear in the ISA tally.  It stands head and shoulders above anything to do with shares, gold, or setting up a business, which is kind of strange for a country that has made finance its engine of growth in a post-industrial era.

    I come across it time and time again, so often that it must either be a sure-fire winner, or there must be something else unusual about this radiant flame that is circled by an endless number of moths.

    Most of these folk have had regular salaried jobs for a while, that pay a steady income, month in, month out. Until, that is, that fateful day when the backdraft of downsizing comes its way, or they come to pick up their carriage clock and sign out of the office for the last time.

    So what they really, really, want is an income like that job, or that’s reliable as they used to remember. They want a steady monthly income. And to many, many people, the first things that springs to mind is a highly unusual investment, that has a typical capital value performance over time that looks like this in real (inflation adjusted) terms.

    It’s residential housing, better known as buy to let. Now the good thing about this capital performance is that it’s generally on the up. The bad thing about it is that you can get slaughtered in it for ten years at a time. I should know, I’ve been there.

    Buying your own house

    Everybody needs to live somewhere, and if you are planning to stay in one place for a long time (> 10 years) then buying the residence you live in is generally a good move.That 10 year condition is a big ask in today’s job environment. If you’re going to move, then it’s best to be able to do it at a time of your choosing, and indeed some BTL owners are accidental landlords who couldn’t sell their house at a price they wanted when they needed to move elsewhere.

    Even if you screw up like I did buying in 1989, after twenty odd years the slow uplift compensates somewhat. If the mortgage and house maintenance you pay is less than the rent you would be paying on the house you get a cumulative benefit from it. However, what you can guarantee with you own property is no occupancy voids, and hopefully the residents don’t trash the place either ;)

    Even buying your own house isn’t risk-free, however – as well as market risk it is such a large undertaking that you can end up out of pocket if you fall on financial misfortune and become a forced seller or worse still a repossession.

    You’re already highly exposed to the graph above through the value of your own house, though it isn’t as bad as it looks because once you own a decent amount of your house if you are selling at a low point you are buying at a low point too, which is what saved my tail in 1998.

    Such a good deal, many people want to do it again!

    So people then extrapolate, and want to own another house for other people to live in. There are two variants of this. Some, looking for somewhere for a store of wealth, simply want to buy and get the rental income. Others want to gear up, borrowing money using a BTL mortgage, using as little of their own money as possible, as advocated here. Your house is normally your largest asset if you own it outright, so doubling up your exposure to the same type of asset is a huge unbalancing of the asset classes you use to store your personal wealth. It so happens that this asset class has done pretty well over the last 20 years, though it’s taken a few hits of late.

    Now there’s nothing fundamentally wrong with this, provided you have asked yourself if this reflects your particular attitude to risk. Maybe you have particular skills working with houses, or tenants, or renting to students. You can use other people’s money, in the form of a mortgage, at low interest rates to gear yourself up. Which is great when house prices rise or there is high inflation, but it’s hell when they fall. I know this from personal experience.

    That was twenty years ago, so a generation has grown up to believe that house prices only ever go up, and those that know otherwise tend to keep schtum. Never underestimate the soulless feeling of paying hundreds of pounds towards a mortgage that is higher than what you sold the house for. At least if you throw tenners on the fire you’d get warm from them!

    What’s so attractive about residential property as an investment, then?

    On the plus side

    • in principle it can give a regular income, voids excepted.
    • profitability is helped by tax breaks on interest payments
    • everybody has familiarity with the product.

    On the downside

    • the capital value is volatile
    • This investment comes in big indivisible chunks
    • There is no geographic diversification
    • it is a high-maintenance operation showing people round and you have to get notice letters exactly right
    • there are a lot of hidden costs like letting agents, repairs

    Some of these downsides would be addressable by residential real-estate investment trusts but I don’t know of any. It is a shame, because it isn’t just prospective buy-to-letters that would be helped with residential REITs.

    Such instruments would allow prospective house purchasers to save their deposits in an asset class which reflected the price of what they were saving for. This would tackle a frequent complaint, which is in the recent past as you save towards a 20% deposit on a house the price races away from you. Residential REITs would lift the value of your deposit as you save. At the moment the only way I know of to simulate this is with spread-betting. Obviously if house prices drop your REIT drops too, but if you are saving for a house that’s not as bad as it seems.

    However, in the absence of residential REITs, which could fix the large lumpiness, intra-UK geographic concentration and maintenance, that’s a lot of downside, particularly when you take the shocking lack of asset class diversification into account, which begs  the question

    What’s wrong with the stock market?

    Or, indeed, any other asset class, even if it’s bonds, oil futures, Apple shares, fine wines or tulip bulbs?

    Two things are primarily wrong with the stock market. Everybody can see or touch a house, and provided they hold buildings insurance they feel it’s solid, reliable and will always hold value. Unlike some shares – in my earlier dotcom forays I held Videologic, Rage software, Ionica and Pace microtech. Rage software and Ionica went bust. You can’t argue with the logic that a house won’t go bust :)

    The second thing people feel is wrong with the stock market is that they can’t see how to get a reliable income out of it. There are various strategies you can use to get an income – a high-yield portfolio, High Income funds, an annuity if you’re old enough and don’t mind your capital eventually disappearing, but none of them offers the comforting constancy of income that a salary or that regular BTL rent cheque does.

    You need to have a much higher, almost entrepreneurial risk appetite to deal with a varying income, and better money management skills, which usually involve having a large float of a couple of years’ worth of essential living expenses. Now that isn’t your typical Brit, who relies on standing in the firehose of income supplemented with a good dollop of consumer credit to smooth out the lumpiness of running costs.

    The sort of people that are looking to BTL as a way of preserving as lump sum can cope with the variable income because they have capital. However, I know personally that it takes a huge wrench to contemplate a variable income if you aren’t used to it. I have several years worth of living expenses in cash and I still bottled it, so I have arranged my affairs so I have a fixed income that keeps the wolf from the door and a variable income that is entertainment and investment budget.

    I’ve got every sympathy for the desire for a fixed income, but sometimes a fixed income comes with a high capital risk, as investors in Keydata know to their cost. BTL is nowhere near that risky, but the steadiness of the income is only steady if you close your eyes to the fact you can lose a big chunk of capital. A diversified HYP has the same sort of risk – the stock market can fall 50% in a bad year, but because you can strategically enter it over a period of about 5 years you’d be unlucky to take such a bath on your total investment, provided you invested in a diversified basket of index funds, or diversified bunch of shares in different sectors and geographies.

    Someone who isn’t used to the principles of sector, temporal and geographical diversification may favour an investment they understand that pays a regular income in a way they can understand. Compared to regular rental income, the uncertain proceeds of a HYP and evaluating how stable that would be is a very big ask. Evaluating how you look at growth and income stocks and derive an annual income also takes a lot of research and understanding, and even then there are no guarantees.

    It’s so much easier to look at your house, which worked well for you over the 25 year term of your mortgage. And think of doing the same again, with BTL.

    Know thyself

    It might well be the right investment for you. But you can only say that once you’ve taken the time out to understand the more accessible alternatives, and what their advantages and disadvantages are compared to BTL. You must have a very good reason to throw out the only free lunch in finance – portfolio diversification. Just knowing that ‘everybody needs to live somewhere’ isn’t good enough. Everybody needs oil, but that didn’t stop people taking a hit on BP a while ago, and nobody needs anything made by Apple, but they made a good investment of late.

    Balancing the opportunity costs is one of the things that makes investing hard. When you buy an asset, you’re also making the decision to not buy a different asset. Diversification derisks this, by stopping you putting all your money in one type of asset.

    BTL is emotive in Britain, carrying the hopes of the ageing baby boomers who tend to have a high cost lifestyle and are distrustful of the financial system because they’ve just seen a huge financial crisis and may not have been lifestyle profiling their investments. And conversely carrying the unrealised aspirations of the Gen Y/echo boomers who want to buy houses around now, and who are finding prices running away from them and mortgage funding harder to find.

    It’s difficult to believe that BTL is right for so many people, with its toxic mix of illiquidity, gearing, lack of geographical and sector diversification and hard to quantify risks and opportunities. If I said I was going to take out a mortgage to invest on the stock market most people would say I’m nuts. It’s not that clear to me why the same doesn’t apply to speculating on the housing market. BTL makes sense if it’s 10% of a diversified portfolio. As 100% of someone’s retirement savings it looks like a recipe for disaster to me. It isn’t just the return on capital that matters. The return of capital also matters.

    I think this is another topic we agree on. I would love to see a profit and loss account of someone who was doing a buy to let. The draw of a buy to let is that the ticket numbers look good and that ‘you are safe with a bricks and mortar investment’.

    Houses can be overvalued, Japan suffices as a lesson in houses being a safe investment. For starters, houses can never be worth more than a single person earns in their lifetime after taxes and living expenses. The idea of houses as an asset that will increase in value beyond inflation is a circular argument. People want houses as an investment increasing the demand and hence value of houses. That said houses do remain the ultimate hedge against rising incomes. If your memory of being young is hazy then that’s an important consideration.

    I’m heavily sceptical about buy to let. I’d love to be a property manager driving an Aston, but I think once you projected for likely downtime, damage, non-payment, managing costs, etc I’m sceptical that you’d earn much more than a fixed term savings account; that said rents are criminal where I am and students are often daft enough to pay whatever you quote.

    With the rises house prices have seen, right now I think they make sense as that hedge against rising income and as a place to live, but I’m sceptical about there being much call beyond fully owning your own house. Fully own your own house and no matter what happens, you’ve still got a place to live.

    what happens when interest rates normalise?

    even if you aren’t a geared buyer, the value of your asset is determined by those that are….

    anyone seriously interested in btl might be better off looking at the German market. Ten year fixed borrowing is 3.7% and yields are 8-9% – (now i brace myself for the litany of ‘yes butters’)

    when i entered btl in the uk, you could hundreds of uk houses at auction yielding 20%-25%, nobody would lend on btl, hence the cheapness – the art was creatively putting together the finance

    the lesson is that it is all about % rates and finance terms and inlfation – houses are not an investment really are they?

    @Trevor — Yes but Germany is a very different market.

    Barely any capital growth for 20 years (not a bad thing if it’s coming in the future in my book) but more importantly very different laws for tenants, how much you can increase rents, taxes, and so forth.

    I’m not saying it’s a bad investment but it’s not UK BTL with sauerkraut.

    Regarding a UK residential REIT, it’s true there’s none, but there are a couple of quoted companies with very large residential portfolios: Grainger and the much smaller Mountview.

    They deal in regulated tenancies, which basically involves buying a house and – not to put too fine a point on it – waiting for someone to die. They then do it up and sell it.

    So there are different kinds of risks here, but you do get exposure to UK residential property. I currently own some Grainger shares, and I’ve done nicely from Mountview in the past.

    4 Apr 2012, 6:22pm
    by ermine


    @Rob though it’s a US perspective, and houses are cheaper (and trashily built IMO, the advantages of less rain) Mr Money Mustache did one.

    There’s a somewhat egalitarian assumption behind

    houses can never be worth more than a single person earns in their lifetime after taxes and living expenses

    though it took some reflection to get it. You’re not allowing for the considerable spread in incomes, in in the past this was a lot higher, and it was usual for most property to belong to a very small section of society. We have many remnants of this – the pattern of land ownership in the UK is highly concentrated, for instance. I would venture that the postwar to 1990s period was anomalous in having such a large amount of owner-occupation, and with the slow death of the middle class the proportion will drop in future.

    Agreed than many people underestimate the costs. Even as an owner-occupier you want to be putting by 1-2% of the value of the house towards wear and tear, and the outgoings are very lumpy and infrequent, playing merry hell with the way many people run their finances. As a landlord you can expect that to be higher, both because regulation and certification costs and because tenants are a bit harder on the fabric of a dwelling than most owner occupiers are. I know I was ;)

    Owning the dwelling you live in is always a special case. You can usually guarantee 0% voids, for a start, and don’t need letting agents etc, so the case is better.

    @Trevor, this is more about the imbalance/diversification issues. BTL is the go-to assumption for most of the people I know when they think about investment, both because it is familiar, they generally bought their first houses in the early eighties, and their kids are paying today’s rents.

    The main problem is that for many people it would be a dominant part of their portfolio. I would do BTL if it were a 10% part of my invetment capital, largely on the grounds of diversification. But I can’t, because of the large lumpiness, it would be madness. I could buy another house, cash, but I couldn’t buy two. If residential REITs existed (and there was enough to provide a competitive market) I’d happily consider a 10% weighting.

    So I wasn’t making the case that BTL is fundamentally a bad investment. But I do think it’s a bad investment for someone if it is > 80% of your total investment portfolio. You could say the same about any asset sector. BTL is odd in the British psyche and seems to far too often pick up the default ‘this is how to do investing’ meme ;)

    4 Apr 2012, 6:35pm
    by ermine


    @Monevator, thanks for the heads up, I’ll research those two. Presumably those tenants are still the beneficiaries of the Rent Acts so these are quite specific, so not a proxy for the UK housing market as a whole.

    I’m not making any killing on my rental property but it has appreciated about 60% since I bought it. My tenants never want to move and take care of my place when I’m away. In return, I keep their rent on reasonable terms. they pay a substantial discount to the market. However, they don’t want to move, so this gives me a certain degree of security. Equity is still increasing marginally and, if I can pay it off in 5 years, I’ll have a small monthly form of income that’s probably dependable for the foreseeable future. Initially, I bought it to supply a small amount of additional income and to sell it at a reasonable profit in a few years but now i think it’s better to hold on to it and use it as reliable income source for the future. I have a special situation. i don’t know if I’d do it again.

    5 Apr 2012, 9:31am
    by frugalscot


    Good post, but….

    I’m surprised you didn’t make more of

    “Others want to gear up, borrowing money using a BTL mortgage, using as little of their own money as possible” and “Rage software and Ionica went bust. You can’t argue with the logic that a house won’t go bust ”

    The latter may be true if you own your BTL outright, but with say a 20% deposit it can be not only wiped out, but can turn into a 20% of purchase price debt. Ask many 2007 purchasers of 2-bed city centre flats about the joys of leveraging.

    @ermine – Yes. The stock of suitable properties for these firms to buy up and sit on is running low. Grainger also does reverse mortgages, too, which you may or may not be comfortable with.

    (I am happy with people using their assets while they’re alive, but some prefer to bank on an inheritance, and therefore seem to think it’s immoral…)

    I thought about BTL in the mid-90s. A 1 bed flat in our area could be bought for about £60k. However, this would have wiped out all my capital except for a small EF and I did not take the plunge.

    In retrospect it would have been a good investment, with similar flats now selling for about £200k, even discounting all rent towards maintenance and general hassle. No regrets, though.

    @g you’ve done well. If the property itself is in north America then prices are more reasonable relative to incomes, which probably help the case all round!

    @frugalscot, your right, after all I know this from personal experience on my own house! Most of the people I’ve heard this idea talked up are trying to stash a lump sum, so think in terms of outright purchase. Hwoever, to actually build a sizable portfolio and get some diversity they’d have to gear up.

    @Monevator – I’ve taken a read of Grainger’s AR and it’s a fascinating firm. Indeed, with its SE and London emphasis etc it is doing exactly what I think I’d like to do, which begs the question of why the TSR is so poor over the recent past compared to their FTSE350 brethren. It’s valuation looks attractive to me, but I struggle to overcome the feeling that UK residential property is toxic, and will shift to the rental model over time as people become unable to earn the price of a house over a working lifetime.

    @SG – that’s the lumpiness problem again – going 90% into one asset class just isn’t clever. If that flat had been £15k it may have been a good move. It’s the sort of disproportionality that makes me wince when I hear prospective BTLetters think in terms of flattening their investment capital

    Interestingly, the Grainger annual review seemed to indicate that Government legislation was going to permit residential REITs in 2012, so perhaps Britian’s army of prospective BTLers and its band of wannable buyers saving to a deposit can both get a slice of the action in better balance with their capital assets ;)

    BTL to me is a no brainer. I would advise anyone to do it from a young age, or get a parent to guarentee a mortgage and get living in the house with all your mates paying off the mortgage. By the time you come to late 20′s you will owe a lot of house.

    The key is to buy at the right price and understand what it will rent for. I have just bought my 8th B2L at a return of 12.5% gross. I haden’t bought any other house since 2005 – the figures just didnt stack up.

    Look for INCOME and forget about capital appreciation. Over time the annual CA is about 2-3% (bonus). If you can secure an annual 10-15% return you are laughing.

    The key to getting these returns is in the more deprerssed areas however, but if the market does implode due to a spike in interest rates the good areas will also be offering 10-15% and the worse area will then be offering 20-25%. You will then have more choices to go for lower annual returns, but higher CA over time, or much bigger annual returns.

    Keep costs down by learning how to do the work yourself. This is a key part of making money this way. Plus you develop skills to be used on your own house and it is very satisfying.

    Remember, how much it costs to physically build a house. Many houses out there are well under actual replacement cost and with inflation will just get cheaper (i am based in the north by the way). This can be useful to work out whether something is good value, but the key is to simply use Cost of prop + all fees and renovation costs / annual rent. Aim for 12% or higher.

    correction: rent / cost + renovation x 100 gives the gross % return

    Hi ermine,

    Something I’ve been thinking about recently is also the morality of land ownership, and by extension, buy to let.

    I believe that some of the problems in the world, for example inequality, are a result of the archaic ideas that we take for granted. Land ownership is one of the biggest inequality-creators.

    If you haven’t already, check out Henry George’s ideas on land tax. There’s also some good blog ideas here:

    http://embraceunity.com/economics/the-only-economic-reform-worth-talking-about/

    (not mine by the way).

    Don’t misunderstand my intention – I’m the last person to criticise others or tell them they are wrong – but I think we can make the world a better place by considering others and realising we have enough to go around.

    I agree that buying your own home is generally a great investment, but buying two or more houses pushes the price of all housing up and takes away the opportunity for someone else to also buy their own place. Taken the to logical extreme, I’m sure we can all agree that if there was a law allowing only one house per person, house prices would be lower and people would have more expendable income for other things.

    @Colin, I’m genuinely surprised that it’s possible to get such a ROI on UK property. I am thinking in terms of SE prices, so things may be a lot more tractable up north. The concept of a house being sold below replacement cost is awesome. Round here a Victorian terraced 2 up 2 down seems to go for 110k, I’d be surprised if it cost more than 30k to rebuild!

    @James, we’d probably have to agree to disagree on some things. I’m with the principle that only the primary residence should be CGT free and that either everybody gets to charge mortgage interest to tax or nobody does. And indeed that land ownership in Britain is very patchy for historical reasons, we haven’t had the cleansing effect of a decent revolution in the 18th century. However, that’s about as far as I go.

    > but buying two or more houses pushes the price of all housing up and takes away the opportunity for someone else to also buy their own place.

    Not everybody, at every stage of their life, wants to own a house. I rented as a young adult, which is just as well as I moved city three times. There is a place in the market for landlords. I would like to see more professional landlords – my experience of amateur landlords was poor. One of them ran the electric shower off the lighting circuit, FFS!

    But legislating against people owning more than one house goes that little bit too far. I think removing the favourable tax treatment on capital gains and the mortgage interest from individuals would go far enough to lose some of the amateurs. So would totally repealing Thatcher’s right to buy and blocking it in perpetuity.

    If someone wants to buy a house, go right ahead and do it in the open market. If they’re too poor to do that, we have social housing paid for from the people around them for a reasonable rent, but they shouldn’t then demand to buy it at a discount depriving future tenants too poor to buy themselves for their personal gain.

    Council housing was widespread and used by a much wider range of society when I was a child than the people that live in ‘social housing’ now. It generally worked, then.

    As for the whole LVT argument, silver bullets are rare and often fail to hit their target IMO.

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