It was easy to write off buy-to-let once the property market came off the boil. As a debt-fuelled investment based on a misguided faith in eternal house price inflation, it seemed to embody all that was reckless about Britain before the financial crisis.
Yet we should be wary of writing off a whole asset class, especially when it's one of only three that can generate returns from income (shares and bonds being the other two) as well as price appreciation. True, investors who bought identikit new-build flats in the provincial English cities, or were late to the party, are still well into the red, with no imminent prospect of getting their money back. But long-term landlords in parts of the South tell a different story. And recent history aside, now could be a good contrarian time to buy for those with cash to spare who don’t mind the hassle of a hands-on investment.
The key is to look past house prices - which in any case vary widely from one part of the country to another - to the fundamentals of the buy-to-let market. They boil down to the demand for rented accommodation, and its supply. And on that basis, the market looks strong.
Because potential first-time buyers can no longer afford to buy homes without family (or government) assistance, they tend to rent for longer. This has been a structural trend for over a decade, but it has accelerated since the credit crisis, which made mortgages harder to come by. In 2009/10, 15.6 per cent of all households rented privately, up from 9.9 per cent in 1999.
Rents, not prices
During the boom years bullish buy-to-let landlords absorbed that growth. But buy-to-let finance dried up almost completely during the bust, leading to a significant gap between demand and supply. That has pushed up rents in the kinds of places where young professionals would once have bought. In London, mainstream rents rose 16 per cent last year, according to upmarket property agent Savills.
That is a major opportunity for private landlords with sufficient cash either to buy outright, or put up the 25 per cent deposits lenders now expect. It also marks a sea-change in the investment case for buy-to-let, which used to revolve around using gearing to benefit from house price inflation. Yolantha Barnes, head of residential research at Savills, thinks the market for rental properties will gradually become a much more commercial affair, with capital values supported by income yield rather than first-time-buyers competing to get on the housing ladder. That may lead to dull capital growth in the medium term, but decent total returns driven by a growing income stream (see graph).
Of course, house prices are still an essential component of returns from any buy-to-let investment. Some bears - notably the consultancy Capital Economics - point to stubbornly high price-to-income ratios as evidence that values will fall further. The problem with this analysis is that people have to live somewhere. The choice is between buying or renting, not between spending money on housing or keeping it for something else.
This makes yield, which marks the balance between renting and buying, a more useful valuation measure than price. Across the whole economy, yield has now bounced back to its long-term average since the trough in September 2007, both as a result of falling prices and rising rents. So while it's hard to be bullish about housing in the medium term, on a yield basis valuations do not look stretched.
Know your patch
True, such generalisations need to be viewed with a fistful of salt in an increasingly polarised market. The recovery has so far rewarded quality – attractive family homes in the south east – as equity-rich owner-occupiers who have less to fear from rising interest rates have tried to pick up bargains. Since government cuts will disproportionately hit deprived areas, this trend will probably continue in the medium term.
The dilemma for investors is that quality homes come with a lower yield, so value lovers may prefer cheap one-person flats that generate a 6 per cent income stream. As with all value investments, however, it is doubly essential to do your research. The ruling coalition’s new caps on housing benefit will make rental payments unaffordable to social tenants in some areas, while public-sector redundancies will hurt rents in others. High-yield only works if your tenant does not default or leave.
The key is to understand the fundamentals of the local market. Where will demand for private rental properties come from, and how easily can supply expand to meet it? Understanding your own needs is also particularly crucial when buying such an illiquid asset. Do you need income, or are you happy with a paper-gain from rising house prices - bearing in mind that you can't top-slice profits as easily in housing as you can in shares. What is your holding period?
If it is properly thought-through and sensibly executed, buy-to-let offers the stability of bonds yet with a better chance of escaping the ravages of inflation – a highly attractive combination in the current economic environment. But only one of many things - the wrong property, the wrong area, the wrong price, the wrong tenants - can upset the equation. If that happens, the returns may well fail to compensate for the stress of buying and managing a second house.
