Looking back through history at bubbles and their subsequent bursting, it always seems so obvious after the event. After all, the signs are always there, but we as investors can sometimes have a difficult job of successfully interpreting them in advance so as to avoid a possible crash.
Take, for example, the UK residential property market. For many people, it feels like a one-way bet. An investment without any risk and which offers superb long term returns. And, while the reality is very, very different, people can hardly be blamed for thinking that buying an investment property is a great idea right now. After all, prices have risen for the last twenty years (credit crunch aside) and have turned a huge number of people into paper millionaires.
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Why wouldn’t you want to get involved in such a market?
The problem, though, is that the UK property market is all set to disappoint over the medium to long term. Certainly, its past has been incredibly lucrative for many buy-to-let investors but, realistically, the game appears to be well and truly over.
A key reason for this is a tightening of monetary policy or, in other words, rising interest rates. While property investors have enjoyed a boom from historically low rates of just 0.5% for a handful of years, from 2016 onwards interest rates are set to head northwards. Certainly, many buy-to-let investors may argue that even if rates reach 2% or 3% within even a couple of years, mortgages will still be affordable, demand for houses will remain buoyant and house prices will keep going up.
However, the real change with interest rates will not be with regard to their level, but rather in the shift in mind-set that will take place once they start to rise. In other words, potential buyers will begin to factor in a higher rate once their fixed term ends and, as such, are likely to become far more cautious than they are at present. As such, they will question whether their potential purchase offers value for money and may decide to rent until houses become more affordable.
And, while foreign buyers have been attracted by a weak sterling in years gone by, rising interest rates will strengthen the pound and make buying prime London property a lot less appealing, thereby reducing demand even further.
Another key reason why buy-to-let is a bad idea is affordability or, more accurately, a lack of it. For example, since 1983 the Halifax house price index has compared house prices to earnings. In that time there have been two corrections in the housing market: the first in the late 1980s and the second in the late noughties. On those two occasions, the house price to earnings ratio peaked at 4.99 and 5.86 in the UK. Today, the ratio stands at 5.26.
However, this includes regions where house prices have not really recovered since the credit crunch (or have certainly risen at a far slower pace than in the south east of England). As such, the figures are skewed downwards. Focusing solely on Greater London, things look much, much worse for buy-to-let investors. In fact, in the late 80s and late 00s (i.e. just before corrections), the house price to earnings ratio stood at 6.12 and 6.41 respectively. Today, the figure is a whopping 7.84, which is by far and away the highest figure on record.
A further reason why buying a residential property as an investment is a bad idea is changes to taxation. As announced in the Chancellor’s recent budget, landlords will no longer be able to deduct mortgage interest payments from their tax bill. This could mean that landlords end up paying tax even though they have made a loss – especially as interest rates rise and their mortgage rate heads northwards.
For example, at the present time a landlord may receive £1,000 per month in rent, pay £500 in interest costs and have to pay tax on the remaining £500. However, if interest rates treble and his/her interest costs rise to £1,500 then tax will be payable on £1,000 – even though the landlord has made a £500 loss. And, even if interest rates do not rise, profit margins for landlords will in any case be reduced substantially and could push many of them into the red.
Of course, a key feature of bubbles is that they tend to last for longer than expected but, when they burst, lead to a price fall that is a lot faster than anticipated. House prices may continue to perform well in the short run but, in a decade’s time, hindsight may point out that it was so, so obvious at the time.