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Navigating the UK property market: Part 1

Navigating the UK property market: Part 1

Elections, referendums and a host of political developments are making it tough for the aspiring investor looking to put money in the equity market. One of the best investments on a long-term basis is property – but despite the UK’s love of bricks and mortar the asset class is not free from political uncertainty. So here’s our take on what investors should look for and what they should avoid in the potentially difficult months ahead.

Elections, referendums and a host of political developments are making it tough for the aspiring investor looking to put money in the equity market. One of the best investments on a long-term basis is property – but despite the UK’s love of bricks and mortar the asset class is not free from political uncertainty. So here’s our take on what investors should look for and what they should avoid in the potentially difficult months ahead.

Every year, thousands of people in the UK make an investment in property; it’s called buying a house. For most people, this will be the only property investment they ever make. However, for those with more funds to invest, there is a bewildering array of opportunities on offer in what is actually a very diverse sector.

There are some very basic pointers to remember; the key one is timing. It’s quite possible to make a quick profit from investing in property, but you’re more likely to reap the full benefits by taking a longer-term view. The fortunes of property, by nature, tend to follow economic trends. Capital values can slump in a recession, but as long as rental income covers the costs associated with owning a property, it’s more a matter of riding out the storm.

The tricky part comes when rental income fails to cover costs. This is one of the basic mechanics of being a landlord, whether it is for a one-bedroom flat or a 1m sq ft warehouse. Delving a little deeper, however, reveals that the process is far from straightforward. So we’re trying to provide some pointers, especially relevant at the moment, given the uncertainties generated by the UK’s decision to quit the EU. But you must remember that the UK economy is in reasonable shape, so don’t be influenced by suggestions that activity in the property sector won’t return to normal (whatever that is) until after the exit process is complete. That process could take up to 10 years, so let’s get on with investing now.

Key characteristics

Property is a diverse sector, covering residential and commercial, as well as more specialist sectors such as primary healthcare, student property, buy-to-let and build-to-rent. For most aspiring investors, direct investment will be confined to buying shares in a quoted company or one of the many conduits that allow investment in property without all the hard work that comes with being your own landlord.

The two ways through which your investment will deliver returns are capital growth and income – or, if you’re lucky, both. Property companies with a portfolio of offices might be considered vulnerable at the moment because of the uncertainties created ahead of the UK’s exit from the EU. Empty offices or voids are bad news, and if there is an excess of supply over demand the other money maker – asset appreciation – also comes under pressure. The same can be said for retail landlords. Owning a shopping mall can be very attractive, but with consumers increasingly opting to shop online, lower footfall can lead some tenants to leave, and that means another void to cope with.

Capital values can slump in a recession, but as long as rental income covers the costs associated with owning a property, it’s more a matter of riding out the storm”

Currently attracting considerable interest, distribution centres are much in demand as all the big names adapt to the online rush by setting up a grid of distribution centres and ‘last mile’ depots to cater for consumers’ growing preference for shopping in front of the computer or on their mobile phones. The point here is that all these asset classes can and have done very well over the past few years, but any investor must pay attention to changes in the economy and consumer trends to avoid being caught out in a downturn.

It’s also important to check how exposed a real estate company is to unfinished developments. In the good times, building an office block on the assumption that someone will want to rent it is more likely than not to be met with success. But conditions can change quickly, leaving a property company with a development arm soaking up money, with little prospect of securing a tenant. If a company has a development arm, it’s best to check whether current projects are already pre-let or pre-sold, which essentially de-risks the investment.

Real estate companies always talk in terms of yield. This relates to the rental income as a percentage of the cost of buying the asset. So if a property is bought yielding 9 per cent and sold for 5 per cent, it means that the company has made a profit by selling it for more than it paid.

 

The macro and micro factors you need to understand

Property companies, like most other companies, prosper the most in an economic upturn, some more than others. But what happens when the economy is in decline or just ticking over – it takes a lot more than a glance at the pre-tax profit number to see how well a real estate company is performing. That’s because valuation movements always appear on the profit-and-loss account. So in the good times there will usually be a large chunk of money attributed to an upward valuation in the property portfolio, and the opposite applies when assets are devalued as a result of a weak economy. Far more important is the amount of rental income. This should be enough to pay all the expenses and any dividend payout.

Sometimes this is not the case, and property companies will pay a dividend that is not covered by earnings (adjusted to discount valuation variations) but which is paid out of capital. This haemorrhaging of assets clearly has a limited life, and ultimately the dividend will be cut unless rental income recovers. Property companies are also sensitive to any increase in interest rates. It could be said that interest rates are pushed higher to control inflation caused by excess demand pushing prices higher as supply fails to keep up.

This implies a decent rate of economic growth, which in turn generates demand for space, be it for more shops, offices or warehouses. But it also makes it more expensive to borrow, and gearing plays an important part in how property companies operate. It’s important to note the true value of gearing and pay less attention to the loan-to-value ratio. This can be more flattering as it calculates debt as a percentage of book value. This works well when capital values are rising, but looks distinctly unwell when values start to fall.

You’ll also want to take a look at how the share price compares with the value of the properties owned. The net asset value per share provides a theoretical amount that each share would be worth if all the assets were sold off. There are good reasons why the two will vary. Shares trading at a discount to net asset value (NAV) might be undervalued because the company is not performing well or because the company’s potential is not recognised. On the other hand, shares trading at a premium to NAV might simply be overvalued, or it could mean that the company’s property portfolio and income stream is of high quality.

 

Dos and don’ts of buy-to-let

Almost anyone can become a buy-to-let landlord, but the process always falls somewhere between time consuming and a nightmare. If you manage to cover all the right points you will find it time consuming, but failure to do so can be a disaster. The first decision you have to make is how much money to invest, and whether that will be a cash sum or whether you want to top it up with a mortgage. Then you have to consider the area that you will be buying in.

Buying something local to where you live makes it easier to establish a more hands-on approach, but a better yield may be achievable by going elsewhere; somewhere where property is cheaper, for example. It’s also important to learn as much as you can about the area in which your property is situated. For example, properties that are close to new railway lines will be more attractive as they will draw in more tenants, and the property will rise in value by more than areas less well served by public transport.

Also find out how much rent is being charged on similar properties. You may decide to undercut other rents by a small amount. This will help to keep a tenant happy and encourage them to stay put.

This helps to minimise the risk of a void period between two tenants. When this happens you don’t get any rent but you will have to continue paying the mortgage, if you have one. It is also important not to ignore a host of other costs that can really add up.

Having bought your property, you then need to furnish it, and cutting corners on quality is usually a false economy. Insurance is also a must, covering the building and contents, and also malicious damage, something that some policies do not cover. Try to secure a policy that offers emergency assistance as well. It will save you money in the long term, and tenants will be reassured that they don’t have to wait around before a plumber turns up to fix that burst pipe. Then you have to include fire alarms, gas certification and a host of other regulatory requirements.

You then have to decide how you are going to attract a tenant. Many landlords pay an agency to do this because the agent will be responsible for making all the relevant checks on a potential tenant, including their residency rights and creditworthiness. Establishing a rapport with an agent is extremely useful because they can steer you through the process and help you avoid most, if not all, the pitfalls, and will find another tenant if the existing tenant leaves.

Another important point to remember is to make sure you give all tenants a copy of the ‘How to Rent’ guide. If you don’t, as a landlord you cannot evict your tenant using a Section 21 notice.

 

Issues that affect the price of property

Property adheres to the same basic rules that govern any asset. When demand exceeds supply, prices go up, and when supply exceeds demand they don’t. However, this can lead to significant imbalances. When, for example, the financial crash hit, investment in new commercial property died overnight. And that’s how it remained for years. Speculative development was completely off the menu, and banks were busy trying to reduce their bad loan books, so borrowing became difficult if not impossible.

As a result of this, when demand for commercial space started to revive as the economy recovered, there was simply not enough developed space to go around. And this remains the case, as supply accelerates to catch up with demand. Before it does, rents have been given a key pillar of support. Development in the regions outside London has seen a significant increase in demand as these areas slowly come out of the decades of stagnation that followed the closure of key industries.

Overseas money is also moving in as investors look for a return on their assets that will beat the paltry rates of interest on offer from more traditional low-risk assets. Such investment has also been largely behind the meteoric rise in property values in prime central London.

This trend also attracted the attention of the Treasury, which, in an attempt to make money, introduced higher stamp duty charges, which had the unintended consequence of knocking residential values down sharply, and prompting developers to adjust their plans where possible to provide new accommodation at lower prices.

It’s also important to understand and react to other factors that influence property values. Aberdeen, for example, witnessed something of a property boom as a result of its involvement in the development of North Sea oil. Unfortunately, when oil prices fell so did activity in the North Sea, and Aberdeen experienced its very own mini-property crash.

Development in the regions outside London has seen a significant increase in demand as areas slowly come out of the decades of stagnation”

Understanding property regulation

Leaving the EU is unlikely to make much difference when it comes to regulations affecting property; they will remain extensive. While it is possible to develop a brownfield site, you can’t start digging until plans have been presented to and approved by the local authority. This can take years and there can be objections, which can sometimes lead to a public enquiry. For a property company this means money spent, assets tied up and uncertainty, none of which will impress shareholders. Various attempts have been made to speed up the planning process, but nothing significant is likely to be achieved without a material increase in resources – something that cash-starved local authorities can’t provide without more money from the taxpayer.

It is also compulsory to work with the local authority to agree on Section 106 requirements. These can be best summed up as add-ons designed to improve the area under development, and can include a developer having to meet certain requirements; that might include a new school or surgery for example. Some legislation can actually be advantageous, a typical example being change of use. This piece of regulation was introduced to allow areas where there was a glut of unused office space to be redeveloped into residential use. This was an attempt to provide another way of meeting the housing shortage, although in some areas it simply ended with a shortage of office space.

 

Investing in residential property – the continuing case for buy-to-let

Buy-to-let is something of a hot potato at the moment, following a series of smash-and-grab raids by the government to collect more taxes. There may have been some altruistic motivation based on the assumption that provoking buy-to-let landlords to sell properties would make more units available for the long list of potential buyers, but this was a non-starter from the very beginning, as many people can afford to live in a house that they rent but would have no chance of being able to afford buying it.

There are more than 5m private rented properties in the UK, and this number is set to increase – for two reasons. The first is that there are more and more people looking for somewhere to live; the second is that despite all the incentives introduced by the government, many young people are not prepared or are financially incapable of raising sufficient finance to buy a property outright.

For the buy-to-let landlord there are some attractions that will help to mitigate the increased tax burden. Increased demand will help to underpin rents, and this will be especially advantageous for those landlords who are not saddled with a mortgage and who have no intention of buying another property, thereby missing all the tax hikes.

The other supporting factor for the buy-to-let market is a lack of supply of existing or new-build homes to buy. The new-build market was decimated in the wake of the financial crash. And while the big publicly quoted companies survived, the smaller operators were nearly wiped out, and more than 300,000 skilled workers – plumbers, bricklayers and electricians – left the market, for good. That shortage in skilled labour is now coming home to haunt the market. And if there are restrictions on imported skilled labour as a result of the UK leaving the EU, the situation can only get worse.

Increased demand will help to underpin rents, and this will be especially advantageous for those landlords who are not saddled with a mortgage”

Get your buy-to-let sums right

The private landlord has been targeted by the government in a move to raise more taxes. Some of these measures have yet to come fully in to force, but it is essential to take proposed legislation into account. The consequences of not doing so would be the same as sleep-walking into a financial disaster. There is already a 3 per cent stamp duty surcharge – introduced last year – that is payable on secondary property. That includes holiday homes that are not even rented out. In fact, the legislation even catches people out who complete the purchase of a new home to live in before they complete the sale of an existing property. You then have to claim a refund after you have sold your existing home.

New legislation that came into play this April cuts the amount of tax relief you can claim on a buy-to-let mortgage. Unlike conventional mortgages, where tax relief has been abolished, buy-to-let mortgages had until then been eligible for tax relief. This is now being phased out over four years, and for some highly geared landlords it is likely to make being a landlord uneconomical.

You will have to work out your own financial obligations, but here is an example. You earn enough to pay 40 per cent income tax, and your buy-to-let property earns £20,000 a year, while the interest-only mortgage costs £13,000. Previously (pre April 2017), you only had to pay tax on the profit, which in this case is £7,000. So after deducting £2,800 in tax, you made £4,200. Now, the gross profit is the taxable amount, subject to a tax credit allowance for the next few years which will gradually restrict all relief to the basic rate. By 2020, when the new tax regulations will have been fully phased in, tax will be due on the full rental income less a tax credit equivalent to basic rate tax on the interest paid on the mortgage. So your tax bill will be 40 per cent of £20,000 (£8,000), less the 20 per cent credit on the interest (£2,600). After paying £13,000 mortgage interest you would be left with just £1,600.

The best way to avoid this is not to have a mortgage at all, but for many people that’s not an option. The effects can be looked at another way. If, in the example given, your property cost £300,000 to buy (after paying stamp duty), your gross yield is 6.7 per cent. But after tax this drops to 0.5 per cent. There is always the capital appreciation of the property to add on to this, but remember that when you sell it you may be liable for capital gains tax. There are ways to reduce your tax liabilities, the easiest of which is to switch a second home into the name of your other half – if they are not earning a salary or are earning less than you their tax bill will be lower.

The rise of build-to-rent and how to play it

Build-to-rent is nothing new; housing associations, and previously local authorities, have been building homes with subsidised rents for decades. However, a prolonged period of low interest rates has prompted large financial institutions such as pension funds to explore ways of generating a better return without materially increasing the risk ratio.

Up until now there has not been an obvious conduit for institutions with plenty of money but no expertise in the housing market to proceed. But that is changing. For private investors, though, the only practical way of investing in this small but fast-growing part of the property market is to invest in the companies that are responsible for construction. Many investors will be wary of buying shares in a housebuilder, partly because their performance is cyclical and also because current valuations look stretched if using conventional valuation metrics.

Yet the build-to-rent market is different because, for the most part, the financial risk is borne by the investor and not the builder. The latter will identify a site, gain planning consent and build the properties. In some cases, but not all, they may even offer management services after the tenants are installed. However, the process is forward funded by the investor, which means that the builder has no funds invested, and therefore has more money to use elsewhere, thus improving the return on capital.

Two players in this sector are Watkin Jones (WJG), which specialises in building student accommodation but is branching out into residential build-to-rent, and east London-focused builder Telford Homes (TEF), where build-to-rent could generate half of group revenue in two or three years from now. PRS REIT is set to come to the market this summer as the only real estate investment trust dedicated to building for the private rental sector.

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By Jonas Crosland,
19 May 2017

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