It’s an area of discussion that is becoming more prevalent in recent years as there are now two million private landlords in the country who own and rent out an estimated five million residential properties to account for 18 per cent of the UK housing market. That figure is only likely to increase further given the change in the pension legislation next April which will allow anyone aged over 55 with a private pension to withdraw the whole sum in cash subject to income tax at the taxpayer’s marginal rate.
Sensible investors can manipulate the tax system to drip feed cash out of their pension pots to part fund the deposit on a buy-to-let property purchase and then draw down further sums from their fund in subsequent years to pay down part of the property loan, or fund even more property purchases. Clearly, buying the right property at the right time in the right place is critical, but if history is any guide then the financial rewards can be significant.
In fact, research commissioned by buy-to-let mortgage specialist Paragon reveals that every £1,000 invested in an average buy-to-let property purchased with a 75 per cent loan-to-value mortgage in the final quarter of 1996 was worth £13,000 by the end of 2013. Around a third of the total return was income (rent less costs) and two thirds represented capital gains. That’s a mightily impressive compound annual growth rate of 16.3 per cent on the investor’s own capital and undoubtedly would have been even higher in the rampant London housing market.
But even if the same buy-to-let investor had funded the property purchase entirely with cash then each £1,000 invested would still have grown to almost £5,000 in the subsequent 17 years, a compound annual growth rate of 9.7 per cent. That beats hands down the return made on an ungeared basis from equities (£3,082), gilts (£2,924) and cash on deposit (£1,949).
Sound dynamics supporting mortgage demand
Clearly, there is greater risk with gearing up any investment, albeit the housing needs of the UK’s rapidly growing population are such that this is fuelling an increase in rents, is highly supportive of tenant demand and reduces the potential for voids in properties where demand is strongest.
So after making a few projections into the future, Paragon calculated that assuming modest capital growth of 4 per cent a year for the next decade, coupled with 2 per cent annual rental growth, and a rise in mortgage rates to 5.75 per cent by 2020, then every £1,000 invested at the end of last year using a 75 per cent buy-to-let mortgage would have grown to almost £3,000 by the end of 2023. That’s a compound annual growth rate of 11.3 per cent. On an ungeared basis, the projected return is more modest at 6.3 per cent, inline with the ungeared return from gilts and equities over the 1996 to 2013 period. Put like that the returns produced from funding a property purchase with a buy-to-let mortgage seem very favourable indeed which helps to explain why 8,400 people took the plunge and borrowed a total of £1bn on buy-to-let mortgages to fund their property purchase in August.
My friends are considering their options and ultimately it can only be their decision to make. But with the government projections predicting that a third of all property will be owned by private landlords within the next 20 years, it’s a fair assumption to make that a not insignificant number of these purchases will be funded in the buy-to-let mortgage market. That’s clearly going to be good news for lenders in this market, the largest being Paragon (PAG: 347p), a FTSE 250 company and one with a market capitalisation in excess of £1bn.
Set fair for property-funded gains
With the UK housing market in recovery mode, it’s hardly surprising that business is good for the company. In fact, ahead of full-year results due out on Tuesday, 25 November, analysts predict that the company’s EPS will rise 10 per cent to around 31p in the 12 months to end September 2014. On that basis the shares are rated on 11 times earnings and trade on a modest premium to the last reported book value of 297p. The consensus is for a repeat earnings performance in the current fiscal year to end September 2015, implying a forward PE ratio of 10. And based on dividend cover of between 3 to 3.5 times post tax earnings, expect a 25 per cent lift in the full-year payout to 9p share, implying a prospective dividend yield of 2.6 per cent. Moreover, with earnings growing in double digits, a dividend north of 10p a share can realistically be expected in the current financial year.
For good measure, Paragon shares look to have based out, having pulled back from a seven-year high of 426p set in April and now appear to have successfully tested the 325p support level. A move above the September high of 361p would be a bullish signal indeed as it would confirm that the correction period is over and raise the likelihood that a return to the spring highs is in the offing. However, I feel it’s better to buy now ahead of the forthcoming results which I believe will act as the catalyst to spark the rerating. My six month fair value price target is 400p. Buy.
Please note that I have written 20 other columns in the past fortnight including one other today, all of which are available on my IC homepage...
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
