FOOL'S EYE VIEW
Buy-To-Let, Buy-To-Regret

By Cliff D'Arcy
May 20, 2003

Since hitting 6,950 on the last day of 1999, the FTSE 100 index - which tracks the value of the UK's 100 biggest listed companies - has fallen over 40%. This fall has destroyed hundreds of billions of pounds of capital and has discouraged many people from investing in shares (never again, for some shell-shocked investors).

The three-year bear market has forced canny investors to look elsewhere for investment opportunities, preferably those with lower levels of risk and volatility. Investors seeking income and relative capital security have turned to bonds, whereas others have increased their exposure to property.

Property is already Britain's biggest asset: the equity in our homes (their value after deducting mortgages) reached a mind-boggling £2 trillion at the end of 2002, about 45% of our entire wealth.

In recent years, property has proved to be an excellent investment: house prices have increased seven years in a row from 1996 to 2002 and are expected to rise again this year. According to data from the Nationwide BS, the UK's biggest building society, property prices have only fallen in four years since 1973. For most home-owners, property has provided an excellent tax-free return.

What's more, with prices rising over a quarter between 2001 and 2002 alone, returns from property have absolutely thrashed the stock market over the last five and ten years. In this scenario, it's not hard to see the relative attractiveness of buy-to-let. However, with house prices rising far faster than earnings, it is unclear how long the housing winning streak will continue.

Of course, most of us own only one house, so our exposure to property is limited to the value of our homes. However, many investors choose to buy property in order to rent it out, aiming for a decent income and, with any luck, capital gains.

However, investing in property is a whole different ball game to merely owning a home, as contributors to our Property Investing – Practical discussion board will confirm! Here's why you should think twice about jumping on the buy-to-let (BTL) bandwagon just as it may be leaving town:

1. Property prices may be peaking

One of the great attractions of BTL is the capital gains one enjoys. With house prices up 87.5% over the last five years, many seasoned BTL investors will have almost doubled their money since 1997. However, this is the best five-year performance since 1989 (in fact, five-year returns were negative in 1993, 1994 and 1995).

Arguably, we are unlikely to see hefty returns over the next five years, since an 87.5% jump from where we are now would take the average house price to almost £220k in 2007 – way beyond the reach of many buyers.

This is especially evident in the capital: in my area of West London, a three-bedroom semi-detached house in a good location typically costs around £450k, which is out of reach for most couples and young families. At the moment, property outside of the South-East of England looks a better bet.

2. Gearing is a double-edged sword

Of course, most BTL investors don't buy properties outright; they usually put down deposits and take out specialised BTL mortgages to cover the remainder. So, on a £100k property, you might put down £15k and borrow the remaining 85%.

If property prices then rise 25%, your equity rises to 125-85=£40k, an increase of £25k or 167% on your original £15k investment. So, thanks to the gearing effect (borrowing a bank's money to invest alongside your own), your returns are magnified.

Conversely, if prices fall just 10% (they fell 10.7% in 1990), your property will be worth £90k and your equity will shrink to just £5k. So, you'll have lost £10k, two-thirds of your original investment.

So, the magnifying effect of gearing makes BTL akin to various financial derivatives, such as options, futures or contracts for difference.

3. Properties and tenants are a hassle to manage

None of my share certificates have ever called me up to complain that the toilet was blocked, but tenants expect you, as their landlord, to sort out every property-related problem they have!

Of course, bad tenants mean bad business: late payment of rent and void (unlet or unpaid) periods will eat into your return. What's more, competition for tenants can be very fierce, especially in Greater London, which often leads to falling rents and reduced yields.

What's more, you need to put aside substantial amounts for the inevitable repairs and damage, servicing and maintenance, insurance, letting agency and accountant's fees and so on. Another downside is that your rent is taxed as income at your marginal rate of tax (up to 40%), after allowances for mortgage interest and other expenses. In addition, any capital gain is liable to Capital Gains Tax, unless you are selling your main home.

Furthermore, you'll also need to spend some considerable time buying, maintaining and selling properties. I can sell a share online in minutes but, in my area, it takes about 18 viewings and seven weeks to sell a typical property, according to hometrack. So, you need to bear in mind that property can be one of the least flexible investments – and even a burden at times.

In the words of one of The Fast Show characters, Archie (the old chap in the pub): "Being a landlord? That's the hardest game in the world, that is. Done it meself, you see. Thirty years, man and boy."

4. High relative prices mean lower yields

Outside of the South East, rental yields are running in the 7% to 10% range. However, latest estimates in the London area suggest BTL property yields have fallen to under 6%. This is largely due to an increase in private landlords (making tenants choosier), which has brought down market rents.

To maximise your rental income, you should only consider prospective properties in areas with good transport links and local amenities. Check out market conditions: talk to local letting agents to establish what areas and properties are in demand, and their prevailing rents. There's no point in being unrealistic and believing you can charge top whack for a so-so property. You may decide to use a letting agent (such as a member of The Association of Residential Letting Agents ) to make life easier.

5. You need to build a portfolio of properties

One of the cornerstones of investing is diversification – spreading your money around to reduce your risk. This is often much more difficult with property than other investments, since you are forced to tie up a large slice of capital in every purchase (unless you remortgage to withdraw equity as prices rise).

Without a portfolio of properties, you could be dangerously exposed to a single property or one geographical area, which may prove very costly if a large local employer goes out of business or has mass lay-offs. Also, damage to your property, whether by tenants or natural causes can be costly. One ex-colleague of mine was forced to return early from travelling abroad after finding out that her tenants had trashed her home and dumped its entire (ruined) contents in her garden!

In summary, I personally believe the BTL boat may have sailed already and existing landlords will get all the cream, but I could easily be wrong!

So, if you want to be a successful BTL investor, you'll need to take a long-term view and invest for at least seven to ten years. When buying, your primary objective should be to find a property in an appealing location that will provide good long-term rental income. In the end, it's just too hard to predict how much you'll stand to gain from short-term movements in house prices in the years to come.

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