Episode 11 How investments work – Property

In this session we’re going to look at property and at the end I’ll cover off the work of another good cause. There are two main classifications – residential and commercial. However there is a cross over when you look at “buy-to-let” property which is a residential building but rented out in a commercial venture.

If you own your own home you have not only a place to live but also an asset which has a value. Over the years I have heard many people describe their house as an investment or their “pension pot”. They intend to down-size later in life and release the value that has accumulated in their property. But in many cases that never happens. The reason is emotional attachment – their house is also their home and is associated with memories of the family growing up together. Selling it is not always that easy. Added to that is that in order to downsize you need to move to a cheaper property. In turn that means a smaller property or moving to a cheaper area or even both. After thirty years of being accustomed to the space in a larger home, moving to a smaller one may not be that easy. Moving to a cheaper area is even harder; it will almost certainly involve moving away from close contact with friends. So it is probably not wise to assume you can downsize at will and it is certainly something which needs very careful consideration.

When you buy a property you can reasonably assume that it will go up in value in the long term, all other things being equal, because it should be inflation proofed. What I mean by that is that as prices rise in general, the prices of land, building materials and so on also rise. That should lead to an increase in property prices. But there are other factors at play. Supply and demand is a big one. Population growth and net immigration increase demand for residential properties. If supply, in other words new building developments, doesn’t keep pace, then prices go up. Affordability is another key driver. Interest rates have fallen to historic lows in the last ten years. Lower interest rates mean cheaper mortgages and that means houses are easier to afford pushing up prices. For more on this check out https://housing.com/news/top-5-factors-make-property-prices-appreciate/

In the last thirty years people have been seduced into believing that you cannot lose money by buying a house. This is simply not true. In the late 80’3 and early 90’s we went through a property crash. Property prices fell by up to 50% almost overnight. When I married in 1989 my wife owned a flat in Brighton valued at £65,000. We had to move for my job a year later it sold for… £34,000. Could that happen again? It has in Aberdeen in the last five years. Property is currently very highly valued so be careful.

Moving on from residential property let’s look at buy to let.

“Landlords grow rich in their sleep without working, risking or economising.” John Stuart Mill, English philosopher and economist. No wonder people want to become landlords!

Buy to let is where someone owns a property and lets it out to one or more people in exchange for rent. Usually there is a loan or mortgage attached to the property and the owner is hoping to bring in enough rent allowing for expenses and tax to cover the borrowing costs and provide an income. Over time you would expect your rent to increase and further improve your returns. Clearly there are risks attached. If interest rates go up, that will affect the net return. Occasionally people default on their rent and it may take months to evict them. Tax changes can and have in recent years had a major impact. If you decide it is not for you after investing you need to be aware that property is not a liquid asset and that means it can take time to sell and the price can be a long way from your expectations.

One issue overlooked by many property investors is diversification. Let’s say they have a main residence worth £350,000 and a couple of buy to let properties worth £500,000 together. That is £850,000 in one asset type. If property crashes in value (as I mentioned a couple of minutes ago) that could cause a loss on paper of £425,000 overnight. That is not a problem if you can wait indefinitely for the market to recover but after the 1980’s crash it took ten years for them to recover in real terms (see graph).

Should you need to sell sooner you will crystallise a loss. But surely that is a one off? It couldn’t happen again? In 2007 at the time of the credit crunch property crashed again and in some parts of the UK it still hasn’t recovered today…

Image result for uk regional house prices historical graph

What about commercial property? Commercial property includes office blocks, shopping malls, warehouses, hotels and residences (nursing/care homes, student accommodation). Generally these will cost a lot more than the average investor can afford. Even if you can afford one you will suffer from lack of diversification because you won’t be able to spread your risk over different types of property or different geographical areas.

As an investment commercial property generates rental income which is usually predictable because the leases used are longer term, typically 5-15 years, than those for residential property. The rent reviews are upwards but occasionally tenants may ask for a period of rent reduction during unusually difficult trading periods. In addition to the rental income you would expect property values to go up over the long term. As a very broad rule of thumb about two thirds of the returns from commercial property are from rent and one third from capital growth.

Just like residential properties commercial properties are illiquid and in fact are even more illiquid because they take longer to sell. Because of this, commercial property needs to be a very long term investment. In turn you need to be thinking a long way ahead if you are putting a property portfolio together. For proof look no further than the average high street. Shops are struggling to compete with online retailers and many large firms have asked for rent reductions from their landlords. It is difficult to see what will reverse this trend and as such the attraction of retail high street premises is diminishing.

It is beyond the wildest dreams of most investors to own a portfolio of property that is sufficiently well diversified to avoid this sort of risk but it can be done through investment funds. An investment fund is something we will spend more time on in the near future. For now it is enough to say you would be adding your money to thousands of other investors with a professional fund manager making the investment decisions about which property to buy or sell. You will obviously want to know what your share of the fund is worth on a regular basis so the manager needs to value the underlying properties.

Commercial property is not normally valued using a surveyor but an index. If you have a large fund investing in dozens  or properties, you can’t really have a team of surveyors popping round every week to come up with the latest values. So an index is used which gives a value based on the rental yield of the property. So if a property has a rental income of £100,000 a year and the index says that the yield for that type of property is 5% then the property will be valued at £2,000,000 because 5% of £2m is £100,000. As an investor you get what are called units to identify your share of the fund and the unit has a price which changes with the ups and downs of the underlying investments.

So far all well and good but…there is more to it than that. Let’s say the fund has £1bn, and of that, £20m is in cash for expenses, paying out people who want to cash in and new purchases of properties in the future and suddenly… lots of investors want their money back. Let’s say the total withdrawal requests are £50m in a week. Where will the fund get the cash to pay them? It cannot sell the properties quickly enough to meet the demand, there aren’t too many buyers out there looking for office blocks or warehouses who want to buy them right away. Even if there were a ready buyer they would know the fund needed the cash and the fund would be likely to get a very poor offer. Instead, managers of property funds reserve the right to restrict withdrawals from property funds – usually by refusing to pay out for a period of time. This gives them a breathing space to raise the cash needed. Although it can seem harsh to investors who are trying to exit it protects those who remain invested. The Financial Conduct Authority (FCA) has been looking at this issue following suspensions of dealings applying after the Brexit Referendum in 2016.

Now for the latest good cause. It is https://uk.charitywater.org/?utm_medium=ppc&utm_source=adwords&utm_campaign=uk_brand&utm_content=adwords_2&gclid=Cj0KCQjw3JXtBRC8ARIsAEBHg4mZpiyhKdarJC4iX8JmzJjOH8XJb58QW_Su5KEA4USxDud34NydRKUaAu6gEALw_wcB

Charity Water is funded by private donors for its running costs so all of the donations received go to the cause. They have funded over 40,000 projects providing clean water to 10 million peoplein developing countries  in just 13 years. You can volunteer, raise money or donate at their website.

That’s it for this episode. I hope you enjoyed it and as always if your did – tell your friends, family and colleagues…and if not then tell me through the contact page at Poundsshillingsandsense.com

Till next time – thanks for listening.

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