Advanced Financial Advice Coursework Submission

Possibilities in Property

A discussion of the various approaches to investing in property

By Matt Gray

Property, the ever-popular asset class, has been the making of many wealthy investors, but

conversely it has also been the undoing of many, particularly in recent years.

What is it about property investing in general that has brought it such popularity? In part this

must be due to the familiarity that most people feel with it, almost every potential investor will

live in some form of property, whether by renting or purchasing, and in doing so they will

gain a basic understanding of many aspects of the residential property market. Those who

own their residence will already have invested and for many their property will be the most

valuable thing they own.

This necessary everyday involvement with property means that banks and lenders are

generally more comfortable lending to the public via mortgages on property than providing

loans backed by any other asset class. Likewise people are much more comfortable taking

large loans to fund property investments than with other asset types – just imagine trying to

explain to friends and family that you were planning to borrow a few hundred thousand

pounds to invest in equities!

This is where the effects of gearing come into play. By borrowing money to increase an

investment one can significantly increase any gains or indeed any losses. An extreme, but

not unrealistic example is shown in calculation 1.

Calculation 1

Suppose someone with ten thousand pounds was to take a ninety percent loan to value

mortgage and purchase a house for one hundred thousand pounds. If the value of the house

plus any rent collected was to increase by ten percent over the course of the investment

(after costs and interest), then the investor’s original ten thousand pounds would have

brought him a return of one hundred percent. Similarly however, should the value of the

house plus rent collected fall by ten percent then the investor would have lost one hundred

percent of his initial investment.

Historically UK house prices have tended to rise faster than mortgage interest rates in the

long term, therefore people tend to encounter the benefits of gearing more often and so see

this opportunity as an added incentive to choose property as an investment medium.

Gearing like this also carries significant exposure to interest rate risk. If interest rates

increase the effect is proportionate to the size of the loan, highly geared properties can fall

into negative monthly cash flow if mortgage payments outstrip the rent collected.

Another slightly simpler reason why people may prefer to invest in property is a

psychological one based on the fact that property is a much more tangible asset than many

other forms of investment– they can physically see, judge and even use what they have

bought, it is large in size and possibly also attractive and desirable. People’s psychology

around investment varies hugely but this is one factor that seems to widely encourage

people and increase their faith in property. It also allows skill to play a part; because people

generally have greater understanding and access to a property they plan to buy, they have

the potential to judge good and bad properties with greater skill than say equities for

example. Let’s say they can identify an undervalued property in an up and coming area with

increasing rental demand. They would then have the potential to significantly beat the

returns of the average UK residential property.

Skill can play a part in other ways too, for example a skilled tradesman or project manager

can carry out work to increase the value of properties in a profitable way. However at some

point one must make a distinction between an investment and a business and for the

purposes of this article I will consider any major renovation or redevelopment activities to be

the latter and look instead at the options most viable to the ordinary investor.

Of course another key part of the popularity of property, as with any investment, is based on

its track record. UK property has historically performed well- similarly to UK equities as

shown in Chart 1 below, however in recent years investors have been reminded of what was

for some a forgotten fact – that property prices can fall.

Chart 1

Source: Morningstar Adviser Workstation, July 2014

Another factor in property’s favour is that it has historically demonstrated a relatively low

correlation to most other asset types as shown in Table 1 below. This gives it the added

benefit of bringing significant diversification to a portfolio, thereby enhancing portfolio

performance and reducing an investor’s exposure to non-systemic risk – the collapse of any

one particular industry, asset type or sector.

Table 1

(www.hearthstone.co.uk )

Residential Property

This is the largest sector of the property market as shown below in chart 2. Investors in

residential property fall into a range of different categories.

Chart 2 - Value of UK Residential Sector

(www.bpf.org.uk)

Home Ownership

Of course much of this market will consist of people who may not even consider themselves

to be investors- those who simply own their home. There is a prevailing culture in the UK to

do so. The idea of one day owning one’s home unencumbered is seen as a staple of

financial security. The reality is however that making the decision to buy rather than rent a

home is indeed an investment and carries with it potential risks as well as rewards.

There are of course those who are highly aware of the investment nature of home ownership

and who even do so strategically for this purpose. This method of property investing has a

number of advantages:

- Mortgages are significantly cheaper for owner-occupiers and a wider range are

available. They also tend to accept smaller deposits than would be required for say a

buy to let mortgage.

- Although no rent is earned, by living in the house one can offset the rent one would

have had to pay elsewhere. In this way there is guaranteed occupancy of the

property with none of the management fees or risk of getting a bad tenant.

- Repairs and improvements can be carried out on the house over a long period of

time and paid out of earnings if savings aren’t sufficient. The hope is then that the

resale value will be increased by more than the cost of the improvements, adding to

the returns made on the investment.

Some of the disadvantages to consider would include:

- The purchase cannot be considered purely from an investment point of view; it will be

necessary to choose a property that meets the buyer’s needs and is desirable

enough for them to live in – this may rule out some of the most profitable investment

properties.

- The need to live in the property may also mean that the chosen purchase is of higher

value than would otherwise be invested – increasing the risk and stretching finances.

- Along the same lines as above, a buyer might also make compromises in the

standard of the property that they might not have done were it purely for living in. As

well as this any ongoing renovations and improvements can be extremely disruptive

especially if carried out over a long period of time.

- When owning a residence one sacrifices the flexibility of renting- there are greater

costs associated with moving. Similarly as an investment it is illiquid, taking time and

money to sell.

- Maintenance and other costs will be the responsibility of an owner-occupier where

they would not have been that of a tenant.

- Investing such a large amount in a single asset class leaves one highly exposed to

risk of property sector collapse.

Tax Treatment

There are a few tax advantages to investing in property as a home owner:

- There is currently no Capital Gains Tax payable on a primary residence. Consider

the example in calculation 2 below:

Calculation 2

lf an investor who is already a higher rate tax payer, were to sell a property that they did not

live in for £150,000 having bought it five years earlier for £90,000 and spent £10,000 on the

costs of buying and selling the property they would have made a capital gain of £50,000.

Everyone has an annual tax free capital gain allowance of £11,000, leaving a taxable capital

gain of £39,000 to be taxed at 28%. This would result in a tax liability of £10,980 – a

considerable sum and a sum which would not have been due had the property been the

investor’s primary residence.

- As previously discussed, by living in a house an investor could consider that they are

offsetting the rent they would have been paying elsewhere. So this rent saving is

effectively part of the yield from the investment, however there is no requirement to

declare it and no tax payable on the saving. Were the investor to be renting the

house out instead, and charging the same amount of rent as would have been offset,

this would then be taxable income taxed at the applicable rate band(s) based on the

investor’s other earnings.

- The converse of the above is that any expenses for repair and maintenance on an

owner-occupied residence are not deductable against any other taxable income.

- Stamp Duty would still be charged at the applicable rate. Rates are shown in Table 2

below.

Table 2

Rate of SDLT (percentage of the total purchase price)

Up to £150,000 - annual rent is less than £1,000 Zero

Up to £150,000 - annual rent is £1,000 or more 1%

Over £150,000 to £250,000 1%

Over £250,000 to £500,000 3%

Over £500,000 4%

(www.gov.uk)

- The government’s rent a room scheme could be used to provide tax-free income by

renting spare rooms in the owner’s primary residence.

“The Rent a Room Scheme lets you earn up to a threshold of £4,250 per year tax-free from

letting out furnished accommodation in your home. This is halved if you share the income

with your partner or someone else.”

(www.gov.uk)

Buy to Let

This type of investor seeks to rent out the property to provide a regular income. Beyond this

there are a number of different strategies. Some may seek to simply cover their interest-only

mortgage payments and maintenance with the rental income and expect to profit solely from

the capital growth. Others put the focus much more on the rental income by purchasing low

price houses and renting them out to low earners or those in receipt of housing benefit.

These low cost houses typically offer the best yield as the rental value does not decrease as

steeply as the price of the houses toward the bottom of the price range.

Another strategy to maximise rental income is to offer a house of multiple occupancy or

HMO where each tenant agrees a separate lease for renting a specific room and sharing

other facilities. The total of the rent from all tenants in an HMO will usually be considerably

higher than if the house were rented out entirely in a single lease although this method does

carry the extra hassle of arranging multiple leases, also building requirements, particularly

around safety features, are more stringent so bringing older houses up to standard can be

costly. This strategy is normally targeted at students or young professional tenants but

alternatively, specialist accommodation for the elderly can also attract higher rent. Each type

of tenant will bring about different costs and challenges associated with the investment.

Lastly, another option for maximising rental income is to purchase a property with more

desirable location and/or features and market this for short-term holiday lets. Typically these

lets are a week or two at a time but can be as little as a weekend or a few days. Prices are

several times higher than typical residential lets however the level under-occupancy is likely

to be much higher particularly during off-peak times. This method of buy to let is once again

leaning more toward being a business in itself rather than simply an investment. Demands

on the owner in terms of time and/or costs will vary depending on the specific set up but are

likely to be significantly higher than with longer term residential lets. Marketing may be

required, which means time and money spent researching, creating and publicising your

ads. Cleaning, maintenance and redecorating will be required much more frequently. Also, to

justify higher prices, guests will expect a higher standard of internal decoration and

furnishing. One of the key benefits with this type of investment is of course that if they can

afford the time the investor and their friends/family can make use of the property when it’s

unoccupied – not many investments offer free holiday accommodation as part of the return!

Management companies are an option available to the buy to let investor – they take on the

work involved in finding and managing tenants and property maintenance in return for fees

and a percentage of the rent. Using a good management company to find tenants should

reduce the risk of ending up with a bad one. They carry out interviews, check references etc.

to vet tenants thoroughly before signing them up. With ongoing management they can

simplify issues by dealing with tenant queries, repairs, etc. but the monthly charges will eat

into cash flow which may already be tight. Also when arranging any maintenance work on

the investor’s behalf they are unlikely to be as discerning on price as the investor

themselves.

Tax Treatment

There are not many tax advantages to investing in property as a buy to let. In general the tax

treatment is as follows:

- Stamp Duty will apply to purchases at the normal rates.

- Capital Gains tax will be chargeable on gains from the sale of any property that is

not the owner’s primary residence. (Where the gains made in that year exceed the

individual’s £11,000 annual allowance)

- Rental properties owned will form part of a person’s estate for inheritance tax

purposes.

- Income tax will be payable on profits from rental income each year. There are

allowable expenses that can be offset against rental income. These are described

as follows:

“Allowable expenses are things you need to spend money on in the day-to-day running of

the property, like:

letting agents’ fees legal fees for lets of a year or less, or for renewing a lease for less than 50 years accountants’ fees buildings and contents insurance interest on property loans maintenance and repairs to the property (but not improvements) utility bills, like gas, water and electricity rent, ground rent, service charges Council Tax services you pay for, like cleaning or gardening other direct costs of letting the property, like phone calls, stationery and advertising

Allowable expenses don’t include ‘capital expenditure’ - like buying a property or renovating

it beyond repairs to wear and tear.”

(www.gov.uk)

Commercial Property

“During times of economic uncertainty investors often look for an investment diversifier, that

helps to spread risk away from traditional asset classes and can provide an attractive and

stable level of income above inflation. UK commercial property, with its attractive yield profile

and low correlation to traditional asset classes, such as equities and bonds, continues to

provide investors with solid levels of rental income and steady returns.”

(www.henderson.com)

In general commercial property offers a few key advantages over residential property. These

stem from the nature of the tenants - generally established businesses needing secure, long

term premises in which to invest and build a customer base. The results are longer leases,

higher yields and less work to do as a landlord because tenants generally look after the

internal furnishing, decorating, maintenance and repair of the building. Only the structure

and exterior of the building is usually the responsibility of the landlord.

Capital growth in commercial property however has been slower but prices are considered to

be steadier than residential property. Chart 3 below shows how both sectors have performed

over the past 40 years to 2012:

Chart 3

(www.hearthstone.com )

Again the issue of liquidity will arise if purchasing a commercial property, both buying and

selling will take time and cost money, this means that commercial property is also mostly

suitable for long-term investors as part of a large portfolio.

Tax Treatment

Essentially the tax treatment of commercial property is very similar to that of residential

property. Again the rules for stamp duty, income tax, capital gains tax and inheritance tax will

all be applied. There are a few options available with commercial property that would enable

an investor to mitigate some of these:

- Business Property Relief

If the commercial property purchased is used by the investor’s own business (one that he

has a partnership or controlling shares in) it may qualify for business property relief which

can reduce inheritance tax by 50%. The business would need to be actively trading and

making use of the property and the property must have been held for at least two years

before the death of the owner.

- Self Invested Personal Pensions

Commercial property can be held in a self-invested personal pension (SIPP). Investors can

gain income tax relief by investing their income in a SIPP or those with other existing

pensions can transfer pension benefits into a SIPP. By buying property in this way one gains

all the tax advantages of a pension pot i.e. there will be no income tax on rental income

(which must be re-invested in the SIPP), no capital gains tax if the property increases in

value and no inheritance tax if you die – the property should be fully exempt within a SIPP,

an enhancement on the 50% BPR mentioned above. Lastly, if you occupy & rent the

property with your own business the rent you pay to your SIPP is an allowable expense and

helps offset income/corporation tax.

- Stamp Duty Land Tax

The rates of SDLT also differ slightly for commercial property as shown in table 3.

Table 3

Non-residential and mixed-use properties

Purchase price/lease premium or transfer value

Rate of SDLT (percentage of the total purchase price)

Up to £150,000 - annual rent is less than £1,000

0%

Up to £150,000 - annual rent is £1,000 or more

1%

Over £150,000 to £250,000 1%

Over £250,000 to £500,000 3%

Over £500,000 4%

Residential leases - If your residential lease is for more than £125,000, you’ll pay 1% SDLT on the amount above the £125,000 threshold.

(www.gov.uk)

Indirect Property Investments

A popular and potentially less time consuming way to gain exposure to commercial and/or

residential property markets is by investing in pooled investment funds specifically for

property. These take several forms:

“Indirect Property Investments

• real estate investment trusts (REITs)

• shares in listed property companies

• property investment trusts

• insurance company property funds

• property unit trusts

• offshore property companies”

(www.moneyadviceservice.org.uk)

Generally speaking these investments are funds listed on the stock market that invest in

properties. Investors will own shares or units which will reflect the market value of the

underlying properties to some extent, shareholders or unit holders will also receive income

payments called property income distribution (PID) payments and/or dividends based on the

income performance of the underlying portfolio of properties. The funds will usually be run by

managers who apply charges to your investment as payment for their services. This will be

in the form of an annual percentage of the value of your shares, typically 1-2% in the case of

an actively managed fund. There may also be an initial charge on new money invested.

The most common form of these is a real estate investment trust or REIT.

“Reits were established in the UK in 2007 and offer investors a way to own property assets

without buying them directly. Many of the UK’s largest landlords have since converted to Reit

status. The main reason for doing so is that they pay less tax to the government. All the

rental profits and capital gains on rental properties are exempt from corporation tax.

However, there are strings attached: 90% of the rental profits must be paid out in dividends

to shareholders each year, and any profits from property development are subject to normal

rates of corporation tax.”

(www.moneyweek.com)

The benefits of indirect property investments include:

- They give investors exposure to property markets at a much lower minimum

investment, this should allow investors more flexibility in asset allocation as to how

much of their portfolio they wish to invest in property, particularly those with smaller

portfolios who may have had little money remaining to allocate had they purchased

a property in its entirety.

- They allow instant diversification as the investment is spread across a portfolio of

properties held by the fund.

- They generally have better liquidity as prices are usually quoted daily and are much

faster and cheaper to buy and sell than a physical property.

- If an actively managed fund is chosen, portfolios are professionally selected and

managed by property investment experts and so can outperform the market

average.

- Many of these investment funds such as REITs can be held in pensions and ISAs to

significantly reduce tax.

- REITs in particular pay less corporation tax than other companies so can return

more profit to investors.

There are however potential drawbacks as follow:

- Getting low-rate finance or a mortgage to increase an investment through gearing is

unlikely and certainly not widely available compared to mortgages for physical

property. Although as discussed gearing is not always a good thing.

- The Financial Conduct Authority (FCA) does not directly supervise REITS and

many other property funds. This means that an investor cannot take a complaint to

the FCA or claim compensation from the Financial Services Compensation Scheme

(FSCS) if something goes wrong.

- The investor will not have access to or be able to use any of the properties for their

own purposes at any stage.

- Fund charges will reduce investment performance.

Tax Treatment

REITs and their newer alternative property authorised investment funds (PAIFs) benefit from

several tax advantages.

“A REIT has two separate elements for tax purposes: a ring-fenced property letting business

which is exempt from corporation tax; and non-ring-fenced activities like property

management services which is not. If the REIT you invest in does well, you will receive a

distribution of the profits.

Payments from the tax-exempt element are treated as UK property income for the investor

and are paid net of basic rate tax - non-tax payers can re-claim this and if the REIT is held in

an ISA investors receive payments gross.

Payments from the non-exempt element are treated the same as any UK dividend and paid

with a tax credit.”

(www.moneyadviceservice.org.uk)

Conclusion

There are a range of ways to invest in property, each with their own set of pros, cons, risks

and rewards. Compared to other asset classes such as equities and bonds few, if any, carry

the level of emotional attachment and ability to impact so greatly on the daily lives of the

investors that can be brought about by investing in property.

These factors create a unique and perhaps more challenging position for property investors.

The result is that careful consideration and planning are required to ensure that the

investment is suitable, not only for the investor’s budget and attitude to risk but also a range

of other factors such as, time and money available, local knowledge and the desirability and

suitability of the property for its intended purpose.

In comparing property with other asset classes there is no clear overall winner, rather a

diverse range of options which allow investors to find the balance most suited to their own

particular circumstances and investment psychology.

Ultimately however, property has always been a highly popular asset class and has justified

this with historically strong performance and low correlations to other asset classes. This,

combined with the variety of property investment options available, make it a desirable, if not

essential part of the intelligent investor’s portfolio.

Part B

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