If we are potentially reaching that peak then going forward the returns from property could be very different.
Residential property appears a good investment, as highlighted by the much quoted research from Wrigglesworth which shows that between 1996 and 2014 buy-to-let properties returned over 1,200% for investors. Compared to other asset classes this seems outstanding.
In this blog we go behind the headlines and delve a little deeper.
Comparing other asset classes
The same research showed that £1,000 in UK Shares would have grown over the same period to £3,119, UK Government Bonds £3,329 and cash £1,959.
So why the difference?
The research by Wrigglesworth appears to ignore inflation. If we take the ‘real’ house price inflation adjusted increase over the same period the actual growth is 104.36%. Which means £1,000 would have grown to £2,043.60.
However, to ensure a fair comparison to other asset classes these should also reflect inflation.
This being the case (and using the Bank of England Inflation Calculator), £1,000 in UK Shares would have grown to £2,617.70, UK Government Bonds £2,825.00 and cash £1,455.00 in inflation adjusted terms.
But a drop of 1,200% to 104.36% seems extreme.
Wrigglesworth show that investing £1,000 in property would have grown to £14,897 (the survey assumes 32% of the return comes from income less costs and 68% capital gains). Hence the 1,200% return.
The main difference is gearing, it is assumed that 75% loan-to-value mortgage is in place which increases the potential return.
Take a real example; in 1996 the average house (not inflation adjusted) was £55,169. A 25% deposit would have been £13,792. In 2014 the value of the average house was £189,002. Assuming no change in the initial loan, the capital return on the deposit is £133,833; which is a 970% return. This doesn’t reflect the rental yield which has the potential to increase this further.
If however we use the ‘real’ house price (which reflects inflation), the average house price was £91,867. A 25% deposit would have been £22,966.75. In 2014 the value of the average house was £188,296. Assuming no change in the initial loan, the capital return on the deposit is £96,429 which is a 420% return.
So effectively the Wrigglesworth figures are comparing apples and pears!!!! If we look at their data, it shows that without gearing the investment would have grown to £5,071 but this isn’t inflation adjusted. Once this is built in, it drops to £2,043.60 (excluding any rental income).
The power of borrowing in increasing potential returns shouldn’t be ignored but you need to be careful how you compare asset classes because it can be misleading.
Property carries an attractive yield (rental income). Assuming an average yield of 5% p.a. then this can be added to the total return.
Well not exactly:
- Mortgage payments
- Insurance premiums (between 1% and 4% of the rental income)
- Maintenance costs
- Ground rent and service charges
- Empty periods (‘voids’)
- Letting agency fees
And of course there is tax to pay on rental income. With so many variables it is difficult to calculate the ‘actual’ return from the yield, and therefore it maybe more realistic to exclude from the calculation.
Safe as houses
Another strong argument for investment in residential property is the perceived low risk nature of the investment – it tends to go in one direction (up) and there is very little volatility.
Below are the yearly returns of real house prices vs the FTSE All Share from 31 December 1996 to 31 December 2014
During this period (from the trough of 1996 to today) residential property delivered 104.96% inflation adjusted returns. Inflation adjusted the FTSE All Share Index would have returned 162.30%.
Between 2000 and 2002 property would have made a great investment compared to shares but from 2008 to 2012 the reverse was true. In fact these figures show that shares delivered five negative periods and property four. The truth is that property can be as volatile as shares.
According to Nationwide it is estimated that there are close to 2 million private landlords in the UK today. It is expected that by 2032 a third of all houses in the UK will be owned by private landlords.
In our next blog we question the direction of the housing market as interest rates rise, and whether we are reaching the top of the cycle. If we are potentially reaching that peak then going forward the returns from property could be very different.
Between the peak and trough of the last correction in the housing market (1989 – 1996) house prices dropped 60%. The correction happened at a time of rising interest rates and stopped when interest rates declined (and the availability of credit became easier).
Take an example of someone buying a property at £200,000 today. Most buy-to-let mortgages are secured at 75% loan to value (LTV) and the cheapest route is via an interest only mortgage. The cheapest mortgage from HSBC would cost £349 a month. With a 5% yield this gives £484.33 a month to cover other costs.
At the end of the term the mortgage moves to the variable rate which is currently 5%, assuming with interest rates going up 2% this moves to 7%, then this more than doubles the cost to £875 per month. Even assuming some inflation adjustment on the rent it will not cover the loan and additional costs.
However, at the end of the fixed rate there is usually an option to re-mortgage but if there has been a correction in the market, and the values have dropped, then this creates a problem. Any downturn in the market means that the owner has to invest more of their own money unless they secure a mortgage above 75% LTV.
Below are some examples:
Some individuals may be able to cover the shortfall in the hope that house prices correct; history shows that after a correction downwards there is a reverse but for those who can’t wait may be forced to sell.
Taking this a step further. If they sell, what are the returns after a £50,000 investment?
Taking a headline figure without delving deeper can be dangerous. For cash buyers or long term investors in property it can be a good investment but it shouldn’t be forgotten that property can fall in value and corrections happen (it is not always an upward curve).
Often the best time to avoid the market is when there is ‘speculation’ and ‘froth’. As we highlight in the next blog we could be coming to that point in the market.
Source: The information for this blog has been sourced from various places. The key sources include; Bank of England Interest Rate Database and Inflation Calculator, MeasuringWorth.com Earnings Database, Independent Article ‘Interest Only Mortgages A Million Face Payment Problems Yet Lenders Are Still Pushing Them’, York University Research on Rent, Government Data Statistics on Dwelling Stocks and Private Rental Market Statistics, EconomicsHelp.com data on housing market. Telegraph article ‘Buy to let returns beat all other mainstream investments’, HousePriceCrash.co.uk indices from Nationwide, Nationwide.co.uk article comparing Stocks and Shares to Buy to Let
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.