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Will resi rise?

Property investment doesn’t appear to be the safe house that it used to be, says Andrea Kirkby, but is it still a better bet than other options?

Andrea Kirkby

Safe house imageAs interest rates head towards their tenth year of record lows, investors are still struggling to get adequate income returns from their investments. That’s something finance houses have certainly noticed, with new types of specialised funds launching to try to give investors a better yield – from leasing finance to wind farms, it seems that anything goes. But as income investors buy up the few remaining pockets of high yield products, returns have been falling and risks have been increasing.

So how does residential property stack up as an investment in terms of income? It certainly produces a far higher running yield than cash. Savings Champion points out that even though Bank of England base rates have held at 0.5 per cent, building society fixes cut their rates by 27 per cent from 2011 to the end of 2015, and banks cut their fixed rates by 11 per cent over the same period. The best three and five year fixes yield just over two per cent, with the best at 2.35 per cent.

Prime regional assets achieve 5.50%, superprime is at 5.15%. In the future a large number of investors will be chasing a shrinking pool of quality stock.

By comparison, finance company Paragon says average rental yields on UK property in the first quarter of 2016 were running at 5.7 per cent, two and a half times more than cash. There’s not a huge amount of variation in yields, apart from a stingy 4.2 per cent in Scotland, which probably reflects the impact of rent controls. Central London comes in lowest at five per cent, with yields rising further out – 5.2 per cent in outer London boroughs and 5.6 per cent in the South East excluding London. The highest yields are, as might be expected, in peripheral areas such as the North West, South West, and Yorkshire and Humber areas, though even here, the highest yield only just makes it over six per cent.

Carter Jonas research points out that with weaker capital growth in most areas of the country, rental income is now the main determinant of total returns. “A growing number of investors are responding to this shift,” the research says, “and focusing their attentions towards property which benefits from higher rental yields.” Growing regional centres have benefited – but increased investor demand could suppress yields.

So geographical diversification can increase yields a little, but not much. Perhaps investors would be better off considering specialised areas of the market, but here again it seems that investor demand has been pushing yields down.

NEW OPTIONS

CBRE’s report on UK student accommodation shows that this has now become a major investment option, with more than £5.5bn of investments changing hands in 2015. But although yields have climbed, they don’t exceed average residential; “Prime regional assets now achieve 5.50 per cent, with super-prime sites at 5.15 per cent,” CBRE says, and the future will see a large number of investors “chasing a shrinking pool of quality stock.”

As ever, HMOs remain a high-yield but high-maintenance niche, yielding 8-9 per cent compared to the standard 5-6 per cent. That suggests there could be an opportunity for lettings agents or developers prepared to service this tricky market – though, of course, their costs would have to come out of that high headline yield. And in some areas, HMOs are now seeing strong competition from purpose-built student accommodation.

GO OVERSEAS

Overseas property might offer a higher return, though research from currency firm World First suggests that locations that appeal to holiday home owners aren’t the best places to look for income generating investments. Edward Hardy, market analyst at World First, says Dutch yields are strongest at 6.57 per cent, with Portugal and Belgium also offering good yields. (The comparable figure he quotes for the UK is 4.28 per cent, so the comparison is more favourable to the Netherlands than it seems.) He says the Netherlands also has relatively affordable property prices. With sterling looking to weaken further, holding euro denominated property might be a useful hedge for some investors, but they will be looking for city centre flats or suburban houses, rather than rural farms or villas – the popular stamping ground for UK estate agents.

COMMERCIAL GAIN

Asset Allocation imageCommercial property has been in the news post-Brexit with a number of property funds having to suspend investor redemptions. Last time they were forced to do so was in the credit crunch, as they simply couldn’t sell property fast enough to meet the demand by investors to take their money out. Since few individual investors have enough money to buy a London office block or a major out-of-town shopping centre, unit trusts are their usual way into this asset class, so this will erode confidence in the sector.

Yields on UK commercial property don’t look particularly good, either. London yields are low – 3.25 per cent in the West End and 4 per cent in the City – while even provincial offices sit at just 5 per cent, according to Savills’ last research report in May. Those yields will have risen, but they don’t beat residential property, and if the economy does stand to suffer from Brexit, there’s a potential risk to investors’ capital.

As with residential, commercial property has seen investors searching for higher yielding alternatives. Cushman & Wakefield research shows that yields on every class of commercial property from offices to industrial stand well below the historical average and are below or at best equal to the lowest recorded yield since the 1950s.

FASHIONABLE CHOICES

Student accommodation, healthcare assets, sustainable energy facilities, hotels, and car dealerships have all been focuses of interest, to the extent that Carter Jonas now sees them as mainstream rather than “alternative” asset classes. But the risk of investing in specialised assets can be much higher than with a relatively standard office or retail investment.

If commercial property doesn’t stack up, what about investing in equities? The headline forecast yield for the FTSE 100 index of leading UK stocks is just four per cent, and that doesn’t look like a done deal; many companies are only just able to pay their dividends out of current earnings, so if the economy suffers, we could see dividends being cut.

Many companies already announced dividend cuts last year, so it’s no longer an unthinkable action for management to take. Besides, the companies that are paying the best yield might not be those you’d want to invest in – banks, miners, and oil companies don’t have the best prospects.

However, there are some bright spots in the market. Infrastructure funds were created specifically to achieve stable longterm income; they include investments in hospitals, schools, and public buildings, as well as a growing subsector of sustainable energy investments. These funds offer yields of 5-8 per cent, many of them beating residential property by some margin and that’s before the costs of maintaining and managing a property are factored in.

Peer-to-peer lending is another area some investors are looking at to boost their returns. Here again, though, rates have fallen as t he sector has matured and investors have flocked to the high yield categories. Zopa, for instance, now offers rates from 3.5 per cent to 6.7 per cent (after making an allowance for losses), which isn’t far above residential property. It should also be noted that P2P platforms aren’t covered by the Financial Services Compensation Scheme, though it is regulated by the Financial Conduct Authority.

STACKING UP

So far, residential property seems to stack up quite well against other areas of income. However, that advantage could disappear for some investors once they start considering their tax position. Equities and commercial property funds, for instance, can be put into a pension fund or an ISA, so that capital gains and income from the funds become taxexempt. While the limits on investments are relatively small (£15,240 a year for an ISA and £40,000 a year for a pension), over time they can add up; there’s a growing number of ‘ISA millionaires.’

The real kicker is the higher capital gains tax that is payable on residential properties compared to other asset classes.

Previously, the geared nature of residential property investment and the fact that interest could be set off in full against tax made it a good bet despite the fact you couldn’t park it in a tax wrapper.

The Chancellor’s changes to buy-to-let tax relief have damaged that attraction. While the gearing effect still remains intact – buying an investment with finance can deliver higher returns than buying for cash – that’s also been diluted by lenders who have no appetite for funding high loan-to-value mortgages. And the kicker is the higher capital gains tax paid on residential properties compared to other asset classes. Sell shares, or an office, or a fund, and you’ll pay 10 per cent or 20 per cent tax on your gains, but if you sell a residential property, you’ll pay 18 per cent or 28 per cent (depending on your marginal rate of tax). That reduces the appeal of buy-to-let against other assets substantially.

Even so, for investors who want a stable income over the long term, residential property does offer substantially better running yields than cash and appears to have an edge over many other mainstream assets.

In fact, its income generating characteristics are likely to come to the fore in the next few years, as most commentators are now expecting relatively weak pricing. In commercial property, Jeremy Gidman, head of investment and asset management at Carter Jonas, said a few months ago that “the party of yield compression is largely over” – yields won’t be forced down much further, but that means capital values are likely to stagnate.

The same appears to be true in the financial markets. If that’s the case, the short term buy-to-let landlord speculating on price rises will be exiting the market – but the longer term investor who prioritises income could be the big beneficiary.

September 3, 2016

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