Investing
in real estate has received its fair share of bad publicity in the past decade.
An unprecedented rise in prices at the beginning of the millennium was followed
by the much-spoken about crash in prices around five years ago. Ignoring the
hype that surrounds boom and bust cycles, property should be viewed as a valid
investment class in its own right. As Mark Twain once remarked, “buy land,
they’re not making it anymore.”
This
document will seek to provide objective and accessible advice for those
considering investment in property. It should be noted from the outset that
where property is concerned in particular, objective advice is rather short on
the ground. Potential investors should be wary of advice from mortgage vendors,
so-called construction industry experts, real estate agents and others, all of
whom benefit from sales in the property market.
These
stakeholders in the property industry will provide information about where the
price of property was three years ago and how it has grown in successive years
to today’s price. This is largely irrelevant to the intelligent property
investor. No property is bought today at the price offered three years ago. Far
more relevant is where the price is going in the future (be that three years or
more). In ascertaining this value, property should be analysed from several
aspects. This document is an overview of this anlysis.
An overview of the
characteristics of property investments
At
the outset, it is useful to note some characteristics of property as an
investment. These characteristics provide a check-list that applies to any
property, regardless of its profile (housing, office, commercial), location (UK
or abroad) or tax properties (more of which later). Most individuals who get
burned when investing in property lose sight of these characteristics,
preferring instead to listen to real-estate agents promising unrealistic
short-term returns.
The
cardinal rule of property investing is that it is an illiquid investment. If
you buy a share on the London Stock Exchange today, in all likelihood, you can
sell that share again moments later; similarly with bonds. This does not apply
to investing in property, however. Properties have been known to sit on the
market for years at a time as their owners wait for the purchase price to be
met. Selling a property two months after putting it on the market is regarded
in the industry as a fast sale.
There
are several factors behind this illiquidity with the main one being that every
property is unique in nature. That is to say, no two properties are exactly the
same. Even a residential complex with standardized apartments has otherwise
identical apartments on different floors (about as close to identical as properties
can get). The difference between each property creates asymmetry of
information, where buyers need to spend more time searching to be informed
about what’s available.´
A
second factor behind the illiquidity of the property market is the price
required for purchasing property. According to the House Price Index provided
by the Land Registry website, a useful resource for investing in property, the
average house price in England and Wales as of June 2014 was £172,011 (www.landregisry.co.uk/public/house-prices-and-sales). Given that this amount is
considerably more than the average UK salary, it becomes additionally clear why
the sale can be a drawn out process.
 |
| Signs of an overheating property market |
Illiquidity
isn’t necessarily a drawback to investing in property; rather it means that
investors need to set an appropriate timeframe. Property can be “flipped” at
times – particularly when prices seem to be quickly departing intrinsic values
– but for the most part, property should be viewed as a long-term investment
(much like a pension). Adjusting to this mind set means that illiquidity isn’t
a drawback in itself – rather a characteristic particular to this type of
investment.
Aligned
to illiquidity, is the fact that property prices are inefficient. Efficiency of
prices is a theory which came to prominence in the financial literature in the
latter half of the 20th century (Fama, 1970). The theory essentially
states that where there is asymmetry of information (as is the case with
property), prices cannot reach a perfect equilibrium. In terms of investing,
this means that invariably one side gains and one side loses. The message for
investors here is clear: be informed before investing.
In
fact, this point deserves special attention. Under no circumstances should
anyone invest in the property market on the basis of reading an article which
says house prices are rising and expected to continue rising. Newspapers are
full of such articles and they should be taken with a pinch of salt. It is
unrealistic to assume that a first time investor will ever get close to the
amount of information that existing participants in the markets possess, but
that should be the ultimate goal: Understand the property in the context of its
immediate surroundings and the larger macro environment, both of which will
affect its investment return.
In
terms of information, transaction costs in particular are an area in which many
participants in the property are under-informed. Prices quoted for properties
are gross. That is to say that they don’t consider the (sometimes considerable)
commission of real estate agents, legal costs, maintenance costs, tenant search
costs and tax. Understanding how all of these costs will affect an investment
of a property over its lifetime is essential to making a return on the
investment.
To
begin with, the cost of real estate agents; A 2013 Guardian article (Stewart,
September 11, 2013) stated that there is a record number of real estate agents operating
in the UK. The article noted that 77,000 people had begun working in the
industry in the previous 12 months alone, bringing the total amount to 562,000.
Someone has to pay all of them and regrettably for property investors,
ultimately they are the ones picking up the tab.
If
we assume that the average real-estate agent makes £35,000 annually, this
implies that the total cost of real estate agents in the UK for one year is
£19.67 billion. It is a massive price for investors to pay for agents whose function
has effectively been superseded by that of the internet. Nevertheless, the real
estate agent is ubiquitous and given their relative position of power, it is
better to be on their side rather than against them. Their fees are usually in
the region of 2.5% of the property price.
In
addition to the fees of real estate agents, investors in property face legal
fees. In the UK, these fees are generally between 0.5% and 1.0% of the gross
property price. These fees cover land registry fees, searches and conveyance
costs. Given its relatively low cost, the legal aspect is especially important
when purchasing property and should not be economized on. Acquiring full title
to a property in a transaction without any complications is essential to adding
long-term value.
The
maintenance costs of a property vary, depending on various factors. Properties
near the sea incur more wear and tear than those further inland, for example.
Likewise, properties aimed at the high end of the rental market need to be
refurbished and/or redecorated more often than those aimed at the student
market. Regardless of which end of the market a property is aimed at,
maintenance costs will amount to at least a few thousand pounds a year.
Maintenance
costs have an almost symbiotic relationship with tenant search costs. Good
tenants will not only pay rent on time and provide a constant income stream for
the property, but as a general rule, properties with reliable tenants incur
less maintenance costs. It follows that when experienced property owners
recognize this value that good tenants can bring, they often give them
discounts on rent or raise the rents more slowly than they would otherwise be
inclined to.
A
final consideration in terms of expenses is the tax treatment of property
investments in the form of capital gains tax. The distinction of “investment”
here is important. In the UK, capital gains tax is paid on property or land
outside of the investor’s primary home. As soon as the property is disposed of
(through selling, giving it away, transferring it to someone else, exchanging
it for something else), capital gains tax is paid by the investor.
Establishing
the cost of capital gains tax is essential when investing in property, as it
will materially affect the value of the investment. In those cases where a sale
price hasn’t been recorded (when the property has been given away for example),
the market price should be used for calculating capital gains tax. Calculating
this value need not be complex if viewed, as with every valuations, as simply
being a few individual steps:
i)
Costs
incurred by improving the property can be deducted. These costs include the
legal and real estate fees discussed in the previous paragraphs, stamp duty,
land tax and any costs incurred by extending the property.
ii)
Calculate
the net income provided by the sale (calculated by the sale minus the initial
purchase price and any extension costs).
iii)
If
the overall net gains in the year are below the annual tax-free allowance,
there is no capital gains tax to pay. If capital gains tax apply, they are
charged at 18% or 28% for higher rate tax payers.
Buy-to-let
investments do not compare favourably in terms of their tax treatment compared
to other investments. For example, the return from investing in funds, shares
or another investment trust will incur taxes of 10% on their income earned and
zero capital growth tax (that is, investors pay on dividends but not on the
growth in share price, should there be growth)(Lambert, July 29, 2014). This
form of investing is also less cumbersome that that of property investing when
one considers the time involved in setting up.
A
further consideration when investing in real estate is stamp duty, charged on
all land and property transactions made in the UK. There are various pricing
thresholds involved here and contingencies based on whether the property is
being purchased with a new lease or not. However, HMRC (see: http://www.hmrc.gov.uk/sdlt/intro/rates-thresholds.htm) provide a breakdown of the
thresholds which serves as a good opening guide to the application of stamp
duty (see below)
Purchase
Price or Transfer Value
|
SDLT
Rate
|
Up to £125,000
|
0%
|
£125,000 - £250,000
|
1%
|
£250,000 - £500,000
|
3%
|
£500,000 - £1 million
|
4%
|
£1 million - £2 million
|
5%
|
Over £2 million
|
7%
|
Benefits of property
investing
The
previous pages outline some of the characteristics of property that should
private investors should be aware of. That is not to say that investors should
be scared off investing in property (as long as it suits their investment
profile). Rather, it is important to have a well-developed picture of what the
investment profile for property is. Certainly, there are illiquidity issues and
costs to be considered, but there are also benefits associated with property
investing that many other assets cannot provide.
In
an interesting introduction to a piece on property investing, Assetz Property
Management CEO Stuart Law (Law, d/u), states, “in reality, we believe that the
family home is actually a liability until sold, with there being council tax,
utility bills and upkeep costs that create negative cash flow during most of
the period of ownership.” This is a distinction that should be made from the
outset with a property for investment – unlike the family home, the investment
property will be an asset rather than a liability.
As
well as being an asset, property has no fixed maturity. While purchasing
property does incur the previously outlined transaction costs, these costs can
be written off over the life of the property (which if maintained, can be an
indefinite period of time). A point to consider is that investing in shares and
bonds also incurs transaction costs (trader fees, etc.), but that these costs
have to be written off over a much shorter period of time than those of real
estate agent costs.
The
extreme case of the Duke of Wellington and his family’s property estate in
London shows that a good property portfolio (or in this case, an unrivalled
property portfolio), can yield returns far beyond the life of a 20-year
treasury bond (to take one example from a traditional asset class). This
characteristic of a long timeframe for yielding income to its owners should be
a consideration for those planning estates for children and grandchildren.
Property
investing is, in its nature, tangible. That gives the investor a degree of
control over the asset that isn’t easily available with other asset classes.
That is to say, an investor can make improvements to a property investment
through extensions or redecorations and effectively change its return profile.
The same cannot easily be done with companies, unless the investor is a major
shareholder, and even then it can be a challenging task.
Perhaps
the greatest benefit of property investing is that it provides relatively
consistent total returns. These returns are composed of rental income and the
eventual capital growth (which ultimately depends on how well made the initial
investment has been). While shares can pay an annual dividend to the tune of a
few percentage points of the total value of the share, a typical rental
property should yield its owner between 7% and 10% gross income annually: a
healthy return.
The
rental yield should be at the forefront of the mind of the investor when
calculating the purchase price of the property. Regardless of whether a
property market is rising, falling, heating up or cooling down, rental prices
(the income yielded by the asset) should be the primary concern. The property
to rental ratio is the property investors P/E ratio (price to equity). When the
ratio becomes too high, property investors need to move with caution and ask if
they’re receiving value for their investment.
Types of Property
Investing
There
are a range of property investment types available to investors. When making
the investment decision purely on the basis of total returns, all the options
should be considered. Property investing can be divided into office, retail,
industrial and leased residential. As stated previously in this document, the
more information the investor holds about the property market on a macro level,
the better the returns to the investment will be. On this basis, in theory, all
types of property should be considered.
A
note of caution should be sounded here, however. Rental yields can only tell
investors so much about a property. Outside of residential property, markets
become more specific. That is to say, industrial properties are no longer just
warehouse sheds but often complex logistics operations in their own right.
Similarly, retail premises have changed profile considerably over the years,
from city centres to out-of-town box complexes and from smaller units to huge
department stores. Investors should be wise to these dynamics.
The
benefits that these types of property hold over residential property, however,
are lease agreements which guarantee income streams for longer periods into the
future. Whereas tenants in an apartment purchased as an investment typically
sign a new lease every 12-months, it is not unusual for a commercial tenant to
lease an office or warehouse space for 20 years, considerably removing the risk
of the investment for the investor and possibly even allowing some flexibility
in mortgage terms from the lender.
Another
type of investment which can be considered investing in property is investment
in real estate funds. These are essentially securitized groups of real estate
(meaning that they can be purchased as shares and their income becomes the
dividend) which can be traded freely on share indices. Although much of the
advice above can be discarded as issues like management and maintenance fees
are taken out of the investor’s hands, this method of investing in property
should be considered on its merits.
In
terms of the benefits to investors, real estate funds are essentially a hybrid
of direct property investments and shares. Because investors are purchasing
shares, the threshold price for entry is much lower than that of regular
property investing. The liquidity issue is also broadly removed, as shares have
far more liquidity and are exempt from corporation tax (IPF, 2007). Management
fees are also lower, but it can be difficult to guarantee the quality of the
real estate being purchased, which can hurt dividend yields in the long term.
Summary
This
document has attempted to provide an overview of property investing for
individuals in the UK in as objective and informative manner as possible.
Property investments demand considerable capital and should be made on the
basis of solid, well-researched information and to match the investment profile
of the investor in question. It is not this document’s purpose to encourage
property investing, rather to inform potential investors about its
characteristics.
Property
investing offers a wide field of opportunities for an existing investment
portfolio. Through residential and commercial properties, properties in the UK
and abroad and real estate funds, the investment universe of property is vast
and far larger than most real estate agents and commentators would have you
believe. On this basis, it should be considered something worth investigating,
using prudent financial advice and as part of an overall investment strategy.
Bibliography
Academic
Papers
Fama,
E., (1970). “Efficient Capital Markets: A Review of Theory and Empirical Work.”
The Journal of Finance, Volume 25, No. 2, pp. 383-417.
Online
articles
IPF
(Investment Property Forum)(2007), “Understanding Commercial Property
Investment: A Guide for Financial Advisers, 2007 edition.” Available online at:
http://www.bpf.org.uk/en/files/bpf_documents/finance/Understanding_Commercial_Property_Investment.pdf
Lambert,
S., (July 29, 2014). “Ten tips for buy-to-let: the essential advice for
property investors and pick of the top for mortgage rates.,” thisismoney.co.uk.
Available online at: http://www.thisismoney.co.uk/money/mortgageshome/article-1596759/Ten-tips-buy-let.html
(accessed:
July 29, 2014)
Stewart,
H., Wintour, P., (September 11, 2013). “Record number of estate agents signals
UK house price bubble,” The Guardian. Available online at: http://www.theguardian.com/society/2013/sep/11/record-number-estate-agents-housing
(accessed
July 26, 2014).
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