the best time to invest is when others are fearful

With volatility returning to markets and so much uncertainty we are left scratching our heads as to what we should do. The one area of the market which still attracts many people is buy-to-let. It is a topic we explored in 2015 and one we want to revisit in 2016.

The best time to invest

Nearly 20 years ago we had two properties and were looking to buy a new house. We considered renting the two properties and taking another mortgage on the new house. The challenge was that the rental market was struggling because houses were affordable to the average buyer. Therefore, attracting tenants would be difficult meaning there wouldn’t be a steady income stream, and after six years of falling houses prices there were no guarantees they would go up.

Fast forward to today, and the decision not to rent out the properties was not a wise one. We would have seen significant uplift in the value of the properties and be in a period of high tenant demand. A bad decision perhaps?

We read about buy-to-let being a fantastic investment and the last twenty years being evidence of this, if we then look at the uncertainty in the stock market we can be forgiven for thinking now is the time to invest in property.

The past is no guide to the future?

Take a real example; in 1996 the average house (not inflation adjusted) was £55,169. A 25% deposit would have been £13,792. In 2014 the value of the average house was £189,002. Assuming no change in the initial loan, the capital return on the deposit was £133,833; a 970% return. This doesn’t reflect the rental yield which has the potential to increase this further.

Assuming a property today is worth £200,000 and the same happens, then we would be expecting the house value to be close to £700,000 in twenty years. Assuming rental income of 5% a year (and no increases) this would deliver a return around 17.50% p.a. If the property was funded through borrowing that return would be significantly more (about 55.00% p.a.)

When you place this against the stock market you can quickly see why buy-to-let is attractive. But is there a fundamental flaw to this thinking.

The past will continue into the future

At the moment no-one seems scared, it is seen as a perfect investment. This has to ring alarm bells. There is no doubt that if we had invested in 1996 and been brave then it would have been a good investment but now it is not so clear.

There are several headwinds facing the buy-to-let market where the potential impact is unknown:

  1. A 3% uplift in stamp duty on buy-to-let properties from April 2016
  2. Tax relief on mortgage interest restricted to 20%
  3. Removal of the allowance for wear and tear
  4. Payment of capital gains tax within thirty days of selling the property
  5. Promised further measures to slow the market

The 3% uplift in stamp duty has no doubt caused a mini property bubble as people rush to complete before the change but what happens after April? Those benefiting will be the ones exiting the market (take the recent deal by Fergus and Judith Wilson to sell their 900-property empire), and not those buying.

People are buying at the peak of the market because of what they have seen and there is no guarantee these increases will continue. In fact, it is likely these could flat line or even fall moving forward.

This should add to the concerns.

Take an example of someone buying a property at £200,000 today. Most buy-to-let mortgages are secured at 75% loan to value (LTV) and the cheapest route is via an interest only mortgage. The cheapest mortgage from HSBC would cost £349 a month. With a 5% rental income this gives £484.33 a month to cover other costs.

At the end of the term the mortgage moves to the variable rate which is currently 5%. Assuming with interest rates going up 2% this moves to 7%, then this more than doubles the cost to £875 per month. Even assuming some inflation adjustment on the rent it will not cover the loan and additional costs.

However, at the end of the fixed rate there is usually an option to re-mortgage. But if there has been a correction in the market, and the values have dropped, then this creates a problem. Any downturn in the market means that the owner has to invest more of their own money unless they secure a mortgage above 75% LTV.

Below are some examples based on an initial purchase price of £200,000:

New house price valuation New mortgage loan based on new valuation (assuming 75% loan) Original mortgage to pay down (based on £200,000 purchase price) Amount required to cover shortfall on mortgage (i.e. new mortgage less original)
10% correction £180,000 £135,000 £150,000 £15,000
30% correction £140,000 £105,000 £150,000 £45,000
60% correction £80,000 £60,000 £150,000 £90,000

Some individuals may be able to cover the shortfall in the hope that house prices correct; history shows that after a correction downwards there is a reverse but for those who can’t wait they may be forced to sell.

Taking this a step further. If they sell, what are the returns after a £50,000 investment?

Sale Price Mortgage to pay down Return to investor Profit/loss
10% correction £180,000 £150,000 £30,000 -40.00%
20% correction £140,000 £150,000 -£10,000 -120.00%
60% correction £80,000 £150,000 -£70,000 -240.00%

But what about the yield?

Assuming 5% rental income then this appears attractive but this is gross before day-to-day costs which include:

  1. Mortgage payments
  2. Insurance premiums (between 1% and 4% of the rental income)
  3. Maintenance costs
  4. Ground rent and service charges
  5. Empty periods (‘voids’)
  6. Letting agency fees

And although there is tax relief on some of this there is tax to be paid at the highest marginal rate. Assuming a rental income of £10,000, if we take the mortgage this would be about £4,000 a year and other costs perhaps £2,000 leaving £4,000 profit. Assuming full tax relief for a 40% tax payer (which they wouldn’t get on the mortgage payments) this would leave £2,400. A return of 1.2% p.a.

This doesn’t reflect the initial buying costs which would eat into the profits in the early years.

Of course if there is no mortgage then the return is higher, about 2.4% p.a. for a 40% tax payer. Then there is capital gains to consider if the property is sold and has gone up in value, but there is a question mark as to whether this will happen.

Would you invest in the stock market or a buy-to-let property?

To conclude the best time to invest is when others are fearful, there is no fear with buy-to-let just euphoria but with the stock market it is the opposite.

A fact to consider is if an investor had purchased a property at the peak of the last boom (1989) it would have taken ten years before they broke even. Therefore, before jumping head first into property as an investment it is worth considering whether we are investing because of what has happened in the past or because we believe in future (without influence of everyone around us).

Source: The information for this blog has been sourced from various places. The key sources include; Bank of England Interest Rate Database and Inflation Calculator, Earnings Database, Independent Article ‘Interest Only Mortgages A Million Face Payment Problems Yet Lenders Are Still Pushing Them’, York University Research on Rent, Government Data Statistics on Dwelling Stocks and Private Rental Market Statistics, data on housing market. Telegraph article ‘Buy to let returns beat all other mainstream investments’, indices from Nationwide, article comparing Stocks and Shares to Buy to Let

Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.