Why property investment? This is really where you should begin. Why invest in property, rather than the variety of alternatives on offer?
Put simply, it is my belief that property is a route to long-term wealth generation. Note that I said long-term. If you believe you can get rich quick and give up your day job in 6 months then you have come to the wrong website. Whilst there might be some isolated cases of people doing exactly that, they will either have gotten very lucky or taken extreme risk to do so. As such, they will remain outliers and it is not the experience of myself or the majority of property investors.
With that caveat out of the way, there are 7 key reasons why property is a great investment for your capital. They are:
- The Power of Leverage. This is how you make your capital stretch further and turbo-charge your returns.
- Buying at a Discount. Make money when you buy.
- Forced Appreciation. This is the ability to add value on Day 1, buy undertaking improvements to the property.
- Income and Growth. How you can have your cake and eat it.
- Passive Income. Not my favourite term, but it is close enough. Property investing divorces the need to directly trade time for money.
- High Reward for High Value Tasks. You should be focussing your time where it moves the needle. Property investing allows for this.
- Long Term Buy and Hold is Forgiving. Time is very forgiving to long-term property investing.
Let’s consider each in turn.
The Power of Leverage
Perhaps the biggest advantage property investors have over just about any other asset class, is the ability to use leverage to increase the return on capital employed. This is super-powerful, even at low, sensible levels of leverage.
There are several funding avenues to leverage your own investment capital, depending on what you are trying to achieve. Some examples are:
- Buy-to-let (BTL) mortgages. Used for purchasing properties to let out.
- Bridging or Short Term Loan financing: Used for purchasing properties that require some sort of refurbishment work or development on them, prior to refinancing, retaining and letting out, or selling on at a profit.
- Private Investor financing: Using other individuals to provide financing on either a Joint Venture (JV) arrangement, or on a straight fixed-interest loan basis.
It is important you use the right finance product for the right project.
The amount you can borrow is capped, either as a percentage of the property purchase price (known as the Loan to Value, or LTV), or as a stress test on the achievable rent. If the property is being bought with a BTL financing product, then such lenders will usually lend the lower of the two figures. In expensive parts of the country such as London and the South East, this means you need higher deposits and cannot necessarily mortgage up to the lender’s advertised LTV.
But even low levels of leverage increase your turns significantly. As an example, consider an arbitrary property worth £100,000 that will rent for £600pcm (per calendar month). Let’s assume that after one year, the property value has increased by 5% to £105,000.
To keep it simple, I am going to ignore buying costs, management costs, maintenance costs, voids etc. as these will be the same for both examples, although that does mean the achievable return on capital employed will be less than is stated here. The following example is just for illustration purposes.
If you purchase using cash, then your rental return on capital employed is (12 x £600) / £100,000 = 7.2%.
The growth return on capital employed is (£105,000 – £100,000) / £100,000 = 5%.
So the blended return of income and capital on a £100,000 capital investment is 12.2%.
Not bad, right? Certainly better than having it sat in the bank (although net return will be less due to all the associated costs left out of this example).
Now consider the purchase using just a 50% LTV mortgage, interest only, at a mortgage rate of 4%. This gives rise to annual interest payments of 4% x £50,000 = £2,000. This means you will now need to use just £50,000 of your own capital to buy the property.
Your rental return on capital employed is now (12 x £600) – £2,000 / £50,000 = 10.4%
The growth return on capital employed is now (£105,000 – £100,000) / £50,000 = 10%.
Now the blended return of income and capital on a £50,000 capital investment is 20.4%.
That is some turbo boost to returns at very sensible leverage rates. What’s more, you still have £50,000 left from your capital pot to invest. So, in theory, you could go out and buy another identical property which rents for the same amount, using an identical mortgage product.
You will end up with two rental properties instead of just one, with total returns on your capital employed of 40.8%. Try getting that in the bank, or even in the stock markets!
Take a look at the table below to understand how varying degrees of leverage affect the total returns for our hypothetical example above:
Naturally, there are risks associated with leverage.
Leverage Is a Double Edged Sword
Whilst leverage amplifies the return on capital employed and hence profits, it can also amplify losses.
An empty property or a property with a non-paying tenant will still require you to pay the mortgage on the loan on the property. This will leave you in negative cash flow unless you have sufficient profits from other properties to cover the shortfall.
A downturn in the property market can wipe out your equity if you are relatively highly leveraged. Being very highly leveraged, coupled with a severe enough downturn and drop in property prices (as we had post-2008 in the Financial Crash, see figure 1, below) could you leave you in negative equity, where the outstanding mortgage amount is greater than the market value.
This is problematic for two reasons:
- You are stuck if you need to sell. Any shortfall will need to be covered from other savings.
- You could be compromised by your mortgage. With little or no equity, you cannot remortgage to better terms and may be stuck on an unfavourable mortgage rate, especially once the initial offer period runs out. This will dent your cash flow at the very least, or potentially putting you into negative cash flow if the margins were already tight.
So, with leverage comes responsibility. You must be aware of the risks involved and look at how you can mitigate those risks.
But, it is hopefully clear that sensible leverage is highly beneficial for achieving above average returns. I am not aware of any other investment asset class that benefits from being able to employ leverage at purchase (I am discounting exotic options and derivative trading which is essentially a form of leverage as this is beyond the skills of the average investor).
Making Money When You Buy: Buying at a Discount
Property is not an efficient market. Unlike equity investing, there is little homogeneity amongst properties and within vendor motivations for selling.
This means there are always opportunities to buy well. By this, I mean buying at a discount to market value. There can be many reasons why a property has a suppressed price:
- Motivated vendor: Needing to sell quickly for any reason, e.g. divorce, job relocation, financial difficulties, found dream property etc.
- Property issues: Problems that put most buyers off such as subsidence, very derelict, unmortgageable properties, short leases on flats etc.
This presents the educated property investor with an opportunity to purchase well and lock in a virtual profit at the time of purchase.
Note that this is not an easy task. Such situations are relatively rare, require skill to spot and understand the cost and process of remedy (e.g. subsidence), or require time and money to source (e.g. off-market direct-to-vendor advertising to discover motivated sellers).
But I believe it is your role as a property investor to understand and seek out such opportunities to buy well, as not only does this earn you equity from day one and create a buffer against any market movements, it also makes any future refinancing opportunity to extract out your working capital much easier.
Forced Appreciation: The Ability to Add Value
For similar reasons that allow you to buy well as detailed above, the lack of property homogeneity enables you to force the appreciation of market value once purchased.
Examples of this include:
- Refurbishment: Installing central heating, putting in a new kitchen, bathroom, redecoration and new floor coverings will all enhance a properties value.
- Re-designing layout: Adding an en-suite bathroom to the master bedroom or re-configuring the downstairs layout to have an open plan kitchen / dining room will align the property with modern living expectations.
- Extensions / loft conversions: Adding floor space, particularly in the form of extra bedrooms or large open plan kitchen / dining rooms will add value over and above the cost of the works, whilst also increasing the rental value.
- Planning gain: Getting planning permission for additional dwellings (e.g. in the garden of a large corner plot), or for better use of the property (e.g. residential conversions from other planning use classes such as offices or shops) will add significant value, even without doing the build element.
- Conversion / Development: Continuing the above where planning has been gained, then developing or converting the existing property to realise the planning gain will itself add value.
These all come with a strong caveat: You still need to buy at the right price in order to realise the uplift by adding value! In some cases this is easier than others. For example, in a strong sellers market, it can be difficult to source a standard, non-structural refurbishment project at a price that leaves you with a reasonable profit once the work has been done.
Blended Return of Income and Growth
As a long-term buy and hold strategy, you will make a return on your capital via one, or both, of the following ways:
- Income (in the form of rents)
- Growth (in the form of market value increasing)
The flexibility of property allows you to focus on income-generation strategies such as:
- House in Multiple Occupation (HMO), or renting by the room
- Serviced Accommodation / Holiday Lets
- “Heading North” for higher yields
Equally, you can focus on growth opportunities:
- High demand locations (London and the South East)
- Re-generation opportunities (E.g. certain suburbs of London over the years)
- Infrastructure opportunities (E.g. new rail or road connections such as HS1, HS2 and tunnels / bypasses which makes commuting easier to major employment centres)
It is also possible to blend these strategies to get a balanced income and growth model. An example would be HMO investments in London.
So, depending on your objectives, it is perfectly possible to devise a strategy to suit or indeed follow multiple strategies (an income portfolio and a growth portfolio).
Passive Income (Well, Almost)
Often touted by people with a vested interest in selling you something, property is widely advertised as “passive income”, usually accompanied by photographs of someone sat on an exotic beach drinking a cocktail.
Anyone who has been a landlord for any length of time can tell you that property investing is not passive! Unlike the stock markets you have paying clients (your tenants) to keep happy and a physical asset (your property) which needs maintenance and care. There is also tremendous effort in the beginning to build a portfolio.
That said, I like to define passive income as:
Income that is not directly derived as a 1-to-1 exchange of time for money
What does that mean? Well, a normal job will pay a salary in exchange for you agreeing to do it for 35-40 hours per week. If you are freelance (as I was), then you get paid a daily rate in return for working for the day. You don’t turn up, you don’t get paid.
Property investing is different. The rents are received monthly, whether or not you have to do anything to support your client (the tenant) or the asset (the property).
Think about that for a moment. If you have a good tenant that pays the rent on time every month, with a well-maintained property, then on a general month-by-month basis nothing much happens. But you still get paid. Granted, you will have some months where you need to fix something, but if the property is in good order this should be relatively rare.
This meets my definition of passive income. Now take it a step further and outsource the management of your property and you will be removed from the need to liaise with the tenant to get something fixed.
So, property investing is not zero work (certainly in the beginning) but it provides rewards not directly geared to the time you spend on it.
High Reward for High Value Tasks
Property can pay disproportionately well compared to other investment vehicles or even your day job.
As a simple example, let’s imagine you have the skills and knowledge to source a property which has scope for conversion into flats. You will have the legwork of finding, negotiating, funding and gaining planning to contend with. All this will entail visits to the property, conversations and considerable admin.
But the results could be a significant uplift, just from achieving the planning permission itself (known as the planning gain). This could be in the tens or hundreds of thousand pounds. Whilst this may have taken you tens of hours to get through, your effective hourly rate will nevertheless be huge.
Long Term Buy and Hold is Forgiving
Buying property as an investment vehicle for long term wealth generation is a relatively forgiving asset class, when you consider amortising any mistakes over the holding period.
This is why you shouldn’t wait for the perfect deal to come along. Not only because it rarely does, but because over the time period we are looking at (an absolute minimum of 5 years, in my opinion and preferably 10+), any overspends become small beer.
So, if you find yourself overpaying by 5%, or the refurbishment budget overspent by £5,000, or the rent achieved is £600pcm instead of your anticipated £650pcm … this isn’t really a big deal.
As long as you bought well, forced appreciation and leveraged sensibly, then these errors should be easily absorbed when considered over the lifetime of the investment.
In 10 years time, when the property price has (hopefully) increased significantly, the initial overspend will seem meaningless. A £5,000 overspend over a 10 year holding period is a cost of £500 per year. Tiny in terms of property prices.
Similarly, when you are collecting £1,000pcm rent due to natural rent inflation over the years, the fact that you only got £600pcm at the start will be forgotten.
Note this doesn’t apply to any Buy-to-Sell (BTS) strategies. You need to be much more accurate with your purchase price, holding costs, development costs and planned selling price, otherwise you will find yourself making a loss. This is because such strategies are executed over a much shorter holding period (typically 6-18 months) and so any price inflation is largely irrelevant and any overspend becomes more significant.
Alternatives to Property Investing
No guide to property investment would be complete without considering the investment alternatives.
You will have a fixed capital pot allocated for investment and each pound can only be spent once, so you need to be mindful how you spend it and allocate it efficiently.
Alternatives can be grouped as:
- Investing via a pension
- Investing via an ISA
- Other investment classes such as classic cars, fine wine and art.
Both investing via a pension and investing via an ISA are essentially the same thing. Ultimately, they are tax wrappers with certain conditions attached. The money allocated to them is eventually invested into a combination of capital market products such as investment funds, index trackers, individual equities and bonds.
Which tax wrapper you choose depends on your aims and objectives, but the underlying principles are the same.
With a pension you get tax relief on the way in, which is considerable for a higher rate tax payer. However, the amount you can pay in per tax year is capped and you cannot access the capital or take an income from it until you reach 55 as a minimum.
With an ISA, any income generated or capital gain realised is free from tax, but there is no tax relief on the way in. The upside is that you can derive an income or withdraw capital at any time, although the amount you can invest in any tax year is also capped and at a much lower level than a pension.
What both lack, however, is:
- The ability to invest in property (except in the case of a SIPP or SASS which can invest in purely commercial property).
- The ability to leverage, which as we have seen is uber-powerful.
This is a big subject and I have written much more about the comparative advantages and disadvantages here.
Caution: Property is a Business!
Naturally I am biased, but I don’t want to paint a picture of property being all plain sailing. In many ways, it has never been more difficult. Some recent changes have seen:
- Increasing regulatory oversight, particularly over HMO amenity standards, licensing and requirements for terminating a tenancy agreement under a Section 21 notice.
- Introduction of Section 24, which means the full mortgage interest amount can no longer be offset as an expense, which has implications if you are a higher-rate taxpayer or if property income will push you into the higher tax band.
- Introduction of a surcharge on Stamp Duty, whereby purchasing extra properties as an investment attracts a surcharge of 3%.
These are all increasing barriers to entry and the regulatory changes alone will mean landlords will need to take a much more professional approach going forwards.
This means treating it as a business and not simply as an investment alongside (or instead of) pensions, ISA’s and so on. This has always been the case to a certain extent as a property and it’s tenants must be actively managed.
You should expect to become well-versed with your obligations as a landlord (some of which constitute a criminal offence for failure to do so) and approach it with a business mindset as a result. If this doesn’t appeal or sounds like too much hard work, then property isn’t for you.
On the plus side, I am probably one of the few landlords actually welcoming change. Having spent a corporate career working in the financial services industry for heavily-regulated businesses such as investment banking, wealth management and insurance, property investors have it easy in comparison!
Anything that dissuades the rogue operators letting out substandard or unsafe property, or makes amateurs think twice about entering the fray is a good thing in my book. Less competition in any market is usually a good thing for any existing business!
This has turned into quite a long article! If you are still with me, you should now know there are a variety of reasons you should consider property investment as a core plank to any long-term pension or wealth generation / preservation strategy.
The main reasons outlined above are not the only ones, but they are key considerations to bear in mind.
For me, the biggest two are:
- Buying well (i.e. negotiate a discount) and:
- Forcing appreciation (adding value via a refurbishment, for example).
If you can do this consistently, then you will be trimming your investment sails correctly and setting yourself up for success.