FOOL'S EYE VIEW
'Buy To Let' For Retirement

By James Carlisle
October 16, 2002

'Buy to let' investment in property has been getting a bad press recently. House prices have been racing along at unsustainable levels and, we're told, a lot of that is down to the 'buy to let bubble'. That however, doesn't stack up. After all, the reason that people want to buy their homes is that it's marginally cheaper, taken over the long term, than renting them (although it involves taking on a bit of risk). The risk and return of homeowning is kept in balance by the supply and demand for housing generally, regardless of how much of it is occupied by its owner.

You can look at it another way. If everyone decided to buy two homes and rent one out, then rents would quickly fall to a point where it was more attractive for people to rent instead of buying. In the same way, if everyone decided to rent instead of buy, then rents would be pushed up to the point where buying was much more attractive. Property prices and rents are joined at the hip and the number of people that own the house in which they live doesn't make a whole heap of difference to the price of potatoes (just look at Paris or Brussels, where the majority of homes aren't owner-occupied, for more evidence).

Having said all that, the property market might indeed be set for trouble in the short-term -- I wouldn't know. Just as I wouldn't claim to be able to predict the short-term direction of the stock market, I wouldn't claim to be able to predict the short-term direction of the property market. The reason for investing in any asset is that, as an asset type, it has the qualities to achieve what you need it to, within the parameters of risk that your prepared to accept and as part of your overall balance of investments. Property is no different, so you shouldn't think about it in terms of whether now is a good or a bad time to be buying it. If you go for it, then it's something to be doing for several decades, so the important thing is whether it does for you what you need it to.

Providing income

On the face of it, property makes for an excellent generator of income. At the moment, the rent you can get from a property (its rental yield) amounts to around 5%-6% of its value (depending on what the Wise people expect to happen to property prices in that area). That's more than the safest assets, like cash and gilts, but then it needs to be. As a landlord, you have certain costs to cover, like wear and tear and, in fact, fees to a letting agent (if you don't want to spend time managing the property yourself).

There is also the problem of 'voids', which are periods of time when you're inbetween tenants and not receiving rent. If you expected to change tenants only once every couple of years and have a gap of just two months, then it would take nearly 10% off your rental income.

These things would take your 'yield' down towards 4%, or maybe even a little less, which would be below what you might get from cash in the bank. The difference is that, other things being equal, you'd expect your rent to increase, over the long term, alongside growth in average earnings. At the moment, average earnings growth is running along at 4% or so a year and, after a while, you'd expect your rental income to leave things like cash and gilts standing.

One problem with rental income is that it's taxable, even though you don't get any tax relief on the money you used to buy the property. With pensions, you at least get tax relief on the money going in and, with an ISA, you at least get tax relief on the money coming out. With 'buy to let' investments, you're taxable on the way in and the way out.

Providing growth

The link between property rents (and therefore prices) and average earnings is also an advantage in terms of building up your assets over the long term. Shares are the other well-known type of long-term investment and they provide a dividend yield that you'd expect to grow in line with average earnings over the long term. Property is not much different -- you get the rental yield growing alongside average earnings. The rental yield on property is slightly higher than the dividend yield on shares, which covers the costs of letting out a property as well as voids. When you've taken these away, you'd probably reckon that there's not so much difference between the long-term returns to be expected from shares and property -- after all, both are 'yielding assets' linked to the real economy.

Stick to quality

There are, however, one or two major differences between shares and property. First of all, it's harder to diversify with property than it is with shares. An individual property probably isn't as risky as an individual share, after all they don't go bust, but there are areas in the country that have gone from thriving communities to deserted backwaters in a few years, leaving houses worth a few hundred quid and unrentable. If they'd been your buy to let investment, then your retirement savings would have disappeared down the Suwannee.

It therefore makes sense to stick to quality properties that are less likely to suffer voids. That means buying in areas that are pretty uncontroversial -- where you can't imagine that people would not want to live (e.g. near the nice, old, central, restauranty parts of big cities) -- and buying properties that are also uncontroversial (stick to the basic small house or flat and avoid the quirky thing with turrets and hard-to-maintain garden). All this would tend to reduce the rental yield of the property (since voids are less likely), but it's probably worth it to reduce the risks -- especially if you only have the one investment property.

Of course, another way to reduce risks, if you can, is to go for several small and relatively cheap properties, if you can, rather than one big one. Even better if they're in different areas, although this would have to be balanced against the extra costs of managing them.

Gearing

The other big difference between property and shares is that banks will lend you money to buy them. In fact, without a 'buy to let' mortgage, you wouldn't be able to gradually build up your assets in this way at all. But the mortgage brings gearing and that increases both your risks and your potential returns.

It pays to be respectful of the risks that come with borrowing money. You're taking on an obligation to pay a defined amount of interest (though it can move up or down), which you aim to cover with an undefined income (the rent). If the income falls, or worse disappears altogether, then you'll find yourself in deep trouble -- just ask Marconi (LSE: MONI)! If you're struggling for rent, and/or interest rates move higher, then it will also, most likely, be the very worst time to sell your property to pay back the loan (remember the perils of negative equity?). So make sure you stay well within yourself and stick to the 'quality' properties that are less likely to suffer voids.

Tread carefully

All in all, 'buy to let' investment property can provide an interesting alternative to the traditional methods of saving up for retirement, despite a relatively unfavourable tax treatment. But you have to tread very carefully. The basic point is that you have to be rich enough to absorb the risks. If you haven't the resources to pay the mortgage on two homes for a few years without any rent coming in, then you shouldn't even be thinking about it.