Private investors are understandably wary about the outlook for the property market. The same is true of banks, which remain reluctant to provide mortgage financing. Investing in property became popular because of fast rising prices and easy access to credit. It was a global phenomena and, although the trend was most extreme in the US, leading to the infamous sub-prime mortgage bubble that triggered the financial crisis, home-owners in the UK were also encouraged to overextend themselves with many investors putting large sums of money into the booming buy-to-let market.
Are prices rising or falling?
If demand at the bottom end of the housing market is now as low as is suggested, prices as a whole would be expected to stutter. But are they? According to Nationwide, the price of the average house rose 1.4 per cent in the 12 months to October to £164,381 – still 11.6 per cent below its £186,044 peak of October 2007. Halifax, which uses a similar method to calculate average house prices using its database of mortgage offers, reveals a similar story – 1.2 per cent annual growth to £164,919.
A slightly more attractive picture is painted by the Land Registry which tracks completed sales. Its house price index reports annual growth of 3.4 per cent to £165,505 – although it fell 0.8 per cent in the final month. But all data on house prices is notoriously unreliable when so few deals are being made, as is the case today. According to the British Bankers' Association, the number of mortgage approvals fell to 31,104 in September 2010 – its lowest level for 18 months. Estate agents admit it is not unusual for houses to be marketed for a year or more with owners reluctant to sell at a discount and suffer a capital loss.
Many experts believe this reluctance to sell at the rate demanded by the market means the data is flattering prices. Reports from surveyors paint a sober picture. Research issued by surveyor trade body the Royal Institution of Chartered Surveyors (Rics) in November revealed that demand was continuing to fall, with 55 per cent of surveyors reporting prices falling and only 4 per cent saying they were rising over the previous three months. Rics reported that new buyer enquiries were falling and that newly agreed sales had declined sharply.
Geography is playing its part, too, with prices in London and the south-east pulling up the average for the country as a whole. That is partly thanks to the weak pound, which has encouraged foreign investors to snap up flagship properties in Central London, but the recovery of the City has also played a key role. However, with widespread cuts to the public sector planned, the UK's economy as a whole rests on a knife edge.
Jonathan Davis's view is a stark warning for would-be investors in the housing market and certainly most experts would echo the view that prices are very unlikely to go up in the short term. "We do not believe that there is likely to be any great increase [in prices] going forward for the time being," says Rob Thomas, senior policy adviser for the Council of Mortgage Lenders. "You could not rule out some falls over the next few years or so."
But despite the murky outlook for house prices and the economy as a whole, experienced property investors believe the market offers a unique opportunity for those with the resources, and courage, to take advantage.
A blossoming rental market
While capital values are falling and are unlikely to recover soon, rents are growing. First-time buyers who are unable to get a mortgage still need a roof over their heads, and the demand for rental properties is soaring. According to website Rentright.co.uk, the average rental property commanded £1,105 a month in November 2010, compared with just £787 two years earlier: an impressive 40 per cent rise. And according to Rics, in the three months to October 2010, demand for lettings rose at its fastest rate since the fourth quarter of 2008.
Professional landlords often focus on the yield of a property – the annual rent it commands as a percentage of its capital value. As values have fallen and rents have risen, yields have soared. While landlords put up with yields of 3 per cent or less at the top of the market, now they are spying returns of 6 per cent to 8 per cent. A survey of landlords by buy-to-let mortgage provider Paragon reported average yields had risen to 6.1 per cent by the end of September.
Spicerhaart Residential Lettings has revealed to us that a cross-section of its rental properties are attracting yields of 4.5 per cent to 8.5 per cent across the country. "We are seeing a significant uplift in rental values compared with a year ago," says Andrew Berry, managing director of Spicerhaart Residential Lettings.
"It is very buoyant – there is tremendous demand, with first-time buyers struggling to get mortgages." Mr Berry believes demand is strongest within the M25, but there are plenty of other hot spots. Property investor Ian Clark of Midas Estates also sees Cheltenham, Bath, Bristol, Cornwall and Plymouth as attractive areas, but would steer clear of Birmingham, Manchester and Leeds.
He believes that investors who do their homework and focus on properties in areas with university towns or good transport links will do well if they have a 10-year investment horizon. With an uncertain outlook for capital values, the focus for investors should be on income – not growth. And that means investors looking to buy must focus on areas of strong tenant demand where yields look the most attractive.
After the adrenalin rush of 2006-07 when it seemed everyone was trying to get into the buy-to-let market, seasoned property investors believe normality has been restored, with a proper focus on stable income streams and modest capital appreciation over a long period. "What we have is very strong levels of tenant demand; some of the strongest I have ever seen," says Nigel Terrington, chief executive of buy-to-let mortgage provider Paragon. He believes that 6 per cent income plus modest capital growth should provide an attractive compound return to investors, comparing favourably with the higher volatility that investors would experience from equities. "You also have the ability to add value to it which you cannot do with an equity," he says.
And while the current difficulties for first-time buyers may not continue indefinitely, Mr Terrington believes demographic changes with people renting longer as they start their families later, plus an increasing population will fuel the demand for rental properties. The government predicts the population will increase by 4.3m by 2018, reaching 71.6m by 2013.
Financial adviser Jonathan Davis was one of the experts warning clients about the overheating housing market way before the 2008 financial crisis, and he is just as anxious today. Mr Davis predicts an extra 1m unemployed in the UK over the next three years and believes the housing market is set to fall again. "The house prices we saw in 2007 will probably not be seen again in real terms for years if not decades," he says. Mr Davis has been urging clients who have been holding onto properties, reluctant to drop their price, to sell up, anticipating a further 30 per cent fall over the next three years. He believes that many who bought near the top of the market are already into negative equity or very close to it, yet he urges those thinking about selling to "accept 20 per cent less and cut your losses".
Weighing up the pros and cons
But despite the demand for lettings; is now a good time to expand a portfolio or even hold onto existing investment properties? In Paragon's survey of landlords, the average number of properties per landlord rose to 12.5 from 12 in the previous quarter, suggesting modest growth, but anecdotal information suggests that many professional landlords are thinking twice about expanding their portfolios. This is partly due to the lack of attractive mortgages, but mostly down to the uncertain outlook for house prices which is encouraging them to delay buying.
But it is not just house prices that are uncertain, interest rates are, too. Although currently at historic lows, interest rates could rise next year with CPI inflation at 3.1 per cent – well above the Bank of England's 2 per cent target. Base rates have been at 0.5 per cent for 20 months, despite GDP growth coming in ahead of forecast for the third quarter of 2010 at 0.8. per cent.
A sharp rise in interest rates is a very real danger for property investors, with the risk that gains made from rental income are eroded or wiped out by soaring mortgage costs. A range of two-year tracker mortgages are currently available for buy-tolet investors offering variable rates of 4.29 per cent to 4.85 per cent: that’s 3.79 to 4.35 per cent above base rates. A 1 per cent increase in base rates over 12 months would put the interest cost of a £120,000 mortgage at 4.5 per cent up by £100 a month to £550, severely denting rental profits. And with deposits of 30 per cent to 40 per cent demanded by most buy-tolet mortgage providers, the category of investor who really stands to gain most from the rental demand is the cash-rich investor.
Taking a real example provided by Spicerhaart Residential, an outright purchase of a ground floor flat in Stevenage for £100,000 would return £575 a month, a yield of 6.9 per cent. There is an important list of costs to be considered, however, which will have a huge impact – particularly in the first year.
An estimated £5,000 of costs can be expected with the house purchase (stamp duty, legal fees, surveys etc). Lettings agencies can charge 11 per cent for finding the tenants, and another 8 per cent for ongoing management. Ongoing maintenance costs could be reasonably assumed at £1,000 a year and initial set-up costs for lettings (gas safety certificate, tenancy agreement, inventory etc) normally means a further £500 minimum. Making the typical assumption that only 11 months of the year are occupied, that would leave a net loss of £1,187 for the first year in this example, but an income of £4,313 a year thereafter – or a net annual return pre-tax of 4.3 per cent – and with the added potential of capital gains and rent reviews.
That compares well with equities; the FTSE 100 is down over 10 years and flat over five years. It also offers a higher return than government bonds which are yielding 3.7 per cent a year, although this is an ultra-low risk investment. If the same investor were to borrow £200,000 at a 4.8 per cent variable rate to buy a one bedroom flat in Canary Wharf for £300,000 in Spicerhaart's example, the 6.33 per cent gross yield would mean a £1,482.32 loss in year one, using the same assumptions as above, and a return of £4,018 a year thereafter. But this investor faces the risk of rising interest rates. In addition, property experts warn against committing all available cash to a property, recommending a reserve of 20 per cent be kept back to tackle challenges such as periods of higher interest rates or major maintenance work.
Before the financial crisis, investing in residential property was all about capital gains; now it is about income. But although the demand for lettings makes it likely rents will continue to rise, significant obstacles are in the way of would-be property investors in the form of mortgage costs and the uncertain outlook for house prices. Those with the cash to spare are best placed to take advantage of the shortfall in supply of rental properties, but those who commit to a purchase should be under no illusions about the costs, particularly in the short term. Given the difficulty and cost of selling, investors with existing rental properties will be in no hurry to sell up unless they fear another dramatic fall in prices is imminent. In the short term, rents should provide a healthy income and rent reviews should be conducted regularly. With the outlook for other forms of investment such as equities as uncertain as it is for house prices, inertia for many investors will be inevitable. But for those with substantial sums to invest who are prepared to commit for 10 years or more, the growing demand for lettings in the UK could be a persuasive argument.
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