Personal Finance 8: Residential Property
by George Hatjoullis
There is always a need for residential services. Everyone needs a secure and healthy place to live, that is convenient for their place of work and other social needs. Need however does not constitute demand. Need plus the means to pay constitutes demand in a market economy. Residential services warrant a high priority in the household budget so that need usually constitutes demand. Moreover the social safety net acknowledges residential services as a social need and often makes some provision where private means fall short. There is thus a consistent demand for basic residential services. Supply is variable and in particular varies by location. Population movements, changes in household sizes and patterns will all impact regional supply, and indeed, demand. Residential property is a major issue in personal finance for two distinct but related reasons. Should you rent or buy? Should you invest in the business of providing residential services?
First, let us address rent-or-buy. The popular view is that rent is ‘money-down-the-drain’. If you rent then at the end of the period you have nothing to show for your period of rental. This is an odd view given that you are consuming residential services much like you might consume any other services. The implication is that by purchasing a residential property you do not consume and pay for residential services. This is nonsense and conflates consumption of residential services with investment in the provision of investment services.
Assume you have a handy £30k of savings and are employed in a secure career. A mortgage lender is happy to advance you £70k to purchase a flat worth £100k and you are living in a flat and paying a rent of £5k p.a. (inclusive of property taxes). The owner puts the flat up for sale at £100k and you are certain the new owner will continue to let the flat and at that the rent will remain at £5k p.a. Do you buy the flat or continuing renting? Assume in addition that the identical neighbouring flat is also available to purchase at the same price and is in the same condition and will be let at the same rent. You thus have three choices: a) continue renting and leave your £30k of saving invested as before; b) continue renting and use your savings plus a mortgage to make a leveraged investment in the neighbouring flat; c) use your saving plus a mortgage to purchase the flat that you are currently renting. In the case of option b) you are still paying rent but you have switched your unleveraged £30k of saving from whatever you were invested in before into a leveraged investment in a flat identical to the one in which you are living. It is obvious that option c), buying the flat in which you are living, is the same as option b) except that you now pay rent to yourself. It is buy-to-let-to-yourself. Logically, you are still paying rent and purchasing residential services.
In order to grasp the rent-or-buy decision one needs to compare options a) and b) and then add the specific aspects of option c) that apply in your jurisdiction. The most important issue is that, in going from a) to b), you have gone from a unleveraged to a leveraged investment. Assume your £30k was invested in equities. Why did you not have a leveraged £30k in equities? It is possible to borrow to invest in equities though perhaps the loan-to-value ratio is lower than 70%. However, there are ways of replicating a 70% leveraged investment in equities and you did not choose to do this before. Yet you are quite content to leverage up and buy the flat next door as an investment?
The investment in the flat is undiversified. One of the interesting differences between investing in equities and investing in buy-to-let is the difficulty of diversification across types of property and location unless you have a very large portfolio. In contrast one can invest in a global equity portfolio with very little and certainly with £30k. Another important difference is cost. A property needs maintenance and incurs material legal and management costs both in the purchase and letting. There may also be fallow periods in which the property is empty and no rent is earned. The cost of maintaining a global equity portfolio is modest by comparison and there is never a fallow period if you are diversified. Dividends always accrue. Finally, there is the question of liquidity. It is always possible to liquidate a diversified equity portfolio. Residential property often appears not to fall in price by very much but the market may become very illiquid and it may take a long time to sell and only then at a heavily discounted price. The price stability is an illusion and largely reflects a non-trading bias (i.e old and unrealistic asking prices). A more accurate comparison of the decision to buy a single flat as a leveraged buy-to-let investment would be with a leveraged investment in a single stock or sector, perhaps even the housebuilding sector!
In the UK, a buy-to-let mortgage is classed as a business loan and thus expenses and interest can be offset against some tax liabilities arising from return on the investment. It is also easier to repossess a property secured on a non-performing buy-to-let mortgage. UK tax also privileges option c) above and explains why ownership may be so popular. If you buy-to-let-to-yourself then fallow periods are not a problem. Moreover you are not liable for tax on rent that you pay to yourself or any capital gains tax on the sale of the main residence. There will not be any ugly disputes between yourself and the landlord over maintenance and no legal bills or managing agent bills after purchase. The loss of opportunity to offset costs and interest against tax is irrelevant as there are no tax liabilities arising from buy-to-let-to-yourself. Residential mortgages are not business loans and it is harder to repossess.
On the other hand, you are still not very well diversified. If you lose your job and need to relocate, it may be hard to sell your property. You may need to rent in your new location and switch to an option b) arrangement. If you worked for a dominant local employer and your job loss is part of a local problem, you may have problems letting at all or only at a reduced rent. Concentrating your commitment of your human and financial capital to a specific employer that dominates a specific region only makes sense if you are very confident of the employer (e.g. a university). If your region becomes a problem area (flood, subsidence, crime etc) and has no offsetting positive features, sale may never be possible at an acceptable price. Diversification is always a consideration. The high minimum investment involved in buy-to-let makes diversification difficult but, if possible, buy-to-let is always worth considering as part of a well diversified portfolio. The main point of this blog is that if you are an owner occupier with a mortgage then you already have a substantial leveraged buy-to-let investment in the form of buy-to-let-to-yourself. To add to it reduces diversification and should only be done if the specific risk being introduced is worthwhile and well understood.
There are of course alternative ways of gaining residential property exposure. Equity investment in the housebuilding sector provides indirect exposure and is well diversified. From time to time counterparts offer structured products indexed to residential property prices, though one needs to look at the creditworthiness of the counterparty very carefully as well as the costs imbedded in the structured product. Exchanges and spread betting counterparts offer various opportunities to bet on house price changes (falls as well as rises). It is not necessary to make a large leveraged commitment to one property, in one region, in order to gain exposure to house price changes. One can rent and achieve exposure in other ways. Moreover, ownership is buy-to-let-to-yourself and you still pay the rent.
As a postscript it is worth noting a report out this week (27/04/2014) in the UK highlighting the virtues of the buy-to-let versus other investment classes. The Financial Times reports the study in a very misleading manner, reporting the cumulative return from a leveraged buy-to-let investment compared to a unleveraged equity investment (http://on.ft.com/1lVQBXU). The Daily Telegraph reports both the unleveraged and leveraged buy-to-let returns (http://bit.ly/1fl0ZFE). There is a big difference as one might expect. The table from the Daily Telegraph is reproduced above. The study was sponsored by a not disinterested party, Paragon Mortgages. Details of the return calculations are not available in the press reports but one suspects costs, taxes and fallow periods may not be fully accounted. Moreover, it is typical of the usual buy-once-and-hold investment comparison so beloved of journalists. Is buy-once-and-hold really the investment process? As always the start date is not immaterial to the outcome. The moral of the story is do not make investment decisions based on press reports of such ‘research’. Do your homework or do not invest. The success of buy-once-to-let rather depends on in which region of the UK you located your investment. To get some sense of the variation look at this website (http://bit.ly/1khLgq0).