It is difficult to argue against the fact that buy-to-let investing has produced a tremendous return for investors over the past few decades.
Assuming the average buy-to-let investor has been able to achieve a rental yield of 5% on their properties, as well as capital growth of 4% to 5% every year, it is easy to see how property investors have been able to achieve a high single to double-digit return from their properties, before including items such as mortgage costs, maintenance, and estate agent fees.
Unfortunately, these costs are part of investing and cannot be avoided, and when they are included, the returns from buy-to-let investing look a lot less attractive.
Indeed, the average estate agent demands around 10% of your rent in management fees every year, and depending on how much you borrow, mortgage costs could consume the vast majority of the remaining income.
With so many costs and bills to consider, it is no surprise that studies show the average buy-to-let investor does not make any money at all from rental income. Most property investors make their money from capital growth, with rental income just covering costs and the mortgage.
Still, even with rental income being consumed by property costs, buy-to-let investing remains attractive. With your tenant paying off the mortgage, they are essentially buying the property for you, so even though you might not be making a profit on rental income, as the price of the property grows, and the value of the mortgage decreases, the investor’s overall equity in the property will steadily improve.
However, even in the best case scenario, the returns from buy-to-let are unlikely to surpass the returns available from the FTSE 250, which is why I believe this mid-cap stock index is a much better investment than a rental property.
A better buy
One of the most significant drawbacks with buy-to-let property is the lack of diversification offered.
The FTSE 250 is an index of 250 of the largest companies in the UK, with no overweight exposure to any sector or industry. These companies also have operations around the world, so if the UK economy suffers after Brexit, constituents should be able to weather the storm.
Many of the index’s constituencies are also highly profitable, and certainly much more profitable than buy-to-let investing. Around a quarter of the companies in the FTSE 250 have an operating profit margin of 20% or more, substantially more than you would ever be able to achieve from a buy-to-let investment. These companies can reinvest profits back into operations or return cash to shareholders.
As these companies have grown, shareholders have been well rewarded. Over the past 10 years, the FTSE 250 has produced a return of around 12% per annum for investors.
The bottom line
So, those are the reasons why I believe the FTSE 250 will always beat buy-to-let. The index is broadly diversified across sectors and industries, has historically generated much higher returns than buy-to-let and an investment in the index costs significantly less to manage (it is even tax-free if you hold the investment inside an ISA wrapper).
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.