On two occasions in the past 30 years, I have diverted some of my investment portfolio into buying a holiday home and potential rental property. On both occasions the properties were small houses by the sea, and in both instances in areas where I have or had a family connection. In each case I have owned the property in question for around seven years before selling.
The experience has been similar in other ways, too. In both cases, in 1987 and 2005 respectively, diverting funds into the property market meant that I avoided a subsequent stock market crash. Both properties also increased in value while I owned them, in each case adding about 70 per cent to the value of my original investment.
In the end, though, there is a fundamental problem with holiday homes. They tie you to one place. Owning a property is a commitment to a particular location. Given the scale of the investment involved for most individuals, you feel as though you should use the property for several weeks of the year, even though you might prefer travelling to other locations that, because they are less familiar or something new, excite a bit more interest.
The costs of a holiday home
Eventually, too, you tire of the costs involved. The usual expenses of utilities, insurance and property taxes have to be paid whether the property is used or not, repairs and maintenance inevitably cost money, and if the property has a garden, someone needs to be employed to keep it tidy in your absence. An offshore property might need to be owned through a local company for tax or other administrative reasons, adding a further layer of costs in the form of accountancy and other professional fees.
One solution to this is to let the property during the periods when you are unlikely to want to use it. In the case of northern hemisphere properties, this is likely to be over the winter months. A six-month tenancy over the winter months has the advantage that sufficient rent can probably be brought in to cover all or most of the annual running costs, and hefty winter fuel bills are paid by the tenant and not by you.
There are a couple of provisos, though. One is that the let should always be managed by a professional agent, who can vet tenants and collect the rent. This has more or less avoided, in our experience, the problems one can encounter of tenants who mistreat your property or run up arrears of rent. While it's an expensive solution - fully managed letting services can soak up around an eighth of your monthly rent - it is worthwhile, particularly if you live some distance from the property.
In our experience, too, there are tenants who will call out an electrician simply to change a light bulb, although a letting agent should keep a rein on this sort of spending. Similarly tenants who promise faithfully to keep a garden in good order invariably do not do so, so 'care and maintenance gardening' over the winter months has to be budgeted for.
Even during the summer months, though, there can be windfalls. A previous holiday home we owned was close to the Royal Lytham St Annes golf course and was profitably let out to some work colleagues during a year when the open golf championship was at that particular course. Our current property in the Isle of Man could be rented out during the annual TT motor bike races in June, although we have not tended to do so.
But beware of friends and relatives who see the fact that you own a second home as an excuse for a free holiday at times like this, and are distinctly miffed when asked to pay a share of the running costs.
The bottom line with holiday homes used as part-time rental properties is that, unless the property is permanently tenanted, the running costs will eat up any rental income, leaving most of your return, when you eventually sell, coming from capital appreciation (if any). This is by no means guaranteed.
In the case of our Isle of Man property, a small detached freehold with a garden, it has increased in value over the seven years we have owned it. But much less spacious leasehold town centre apartments a couple of miles away, that cost the same or more seven years ago, have, if anything, dropped in value - owing largely to a glut of such properties produced by the unrestrained enthusiasm of developers.
The income from a holiday home
In our case the numbers look like this. If the property were fully let for a year, gross rental income would represent a yield of around 5.4 per cent on our original investment (probably just under 4 per cent of current capital value). Agents' fees clip this to 4.7 per cent and, in a normal year, other running costs would reduce this by a further 45 per cent or so, taking the yield down to around 2.5 per cent, on which tax would also be due.
While that's a return that bears comparison with gilt yields, property like this lacks both the security and liquidity of gilts. These numbers also give the lie to the common assumption made by many investors that 'my property is my pension fund'. A second home might make sense in terms of being a savings vehicle, but the returns are inadequate when it comes to providing retirement income. Maligned though they sometimes are, even a return on an annuity would produce a better income than this for someone, like me, in their 60s.
The table below shows the returns from a property set to realise £200,000 under various scenarios involving different types of reinvestment.
Property income replacement strategy
| Investment vehicle | Amount invested (£) | Yield net of charges | Gross or net | After-tax income (£) |
|---|---|---|---|---|
| Ecclesiastical 8.625% Non-cum preference | 50,000 | 7.9 | Net | 3,950 |
| Invesco Perpetual Monthly Income + | 40,000 | 5.41 | Gross | 1,948 |
| Schroder Income Maximiser | 40,000 | 6.2 | Gross | 2,160 |
| iShare Dow Jones Emerging Market High Yield | 30,000 | 5.1 | Gross | 1,377 |
| New City High Yield Investment Trust | 30,000 | 6.6 | Gross | 1,782 |
| Cash | 10,000 | 0 | 0 | |
| Totals | 200,000 | 11,217 | ||
| After-tax yield on portfolio | 5.60% | |||
| Pre-tax income yield from a level annuity for a 65-year-old man* | 5.50% | |||
| Yield on property rental | 4.00% | |||
| Less: agents fees | -0.50% | |||
| Net rental yield before running costs | 3.50% | |||
| Less: running costs (say) | -1.50% | |||
| Pre-tax yield on property rental | 2.00% | |||
Based on a property realising £200,000 on disposal *But capital lost on death | ||||
Replicating rental income
Replicating a stream of rental income, after allowance has been made for costs of ownership, is not that difficult. In my own case, when this property is sold I have set myself a goal of producing double the after-tax return that I would earn currently if the property were let 100 per cent of the time.
I might also want to retain some equity exposure to the property market so that any recovery in capital values after I sell (if it occurs) would be reflected in the portfolio resulting from the proceeds. Above all, though, as the reason for selling the property is to boost my retirement income, I want to ensure that the exposure I have is in securities that have liquidity, security and predictability, especially where income payments are concerned.
This makes fixed-income exposure a natural choice. My first port of call is the preference share market. Preference shares have the advantage of being classed as franked income. That's to say the return you earn is already tax-paid. So, for example, the Ecclesiastical Insurance's 8.625 per cent non-cumulative preference share (TIDM: ELLA), currently priced at 109p ex-dividend, yields a tax-paid 7.9 per cent. That's a good foundation for any income-orientated strategy.
Ecclesiastical specialises in insuring churches and other religious buildings, schools, and heritage properties, and is a subsidiary of Allchurches, a registered charity. The business is well capitalised from a solvency standpoint and gets a rating of A- from leading rating agency Standard & Poor's. I already have this stock in my portfolio, and it pays a dividend twice a year, in June and December.
Regular income is also another consideration. While it's possible to arrange a portfolio so a decent flow of income comes through each month by purchasing stocks with an eye to their dividend payment dates and making sure that some income, wherever possible, comes in each month, investment funds that pay monthly income as a matter of course are another option.
The obvious choice here is Invesco Perpetual Monthly Income Plus. The income variant of this fund, which I have held for many years through my individual savings account (Isa) account, currently yields 6.7 per cent gross with an annual charge of 1.25 per cent. The portfolio is invested in high-yield corporate bonds, government bonds and equities.
For purer equity exposure with a smoothed return, a covered call fund is a reasonable choice. One of the longer standing of this type of fund is Schroder Income Maximiser, which targets, and in recent years has achieved, a yield around the 7 per cent mark. The income paying version of this fund currently yields 7.7 per cent, with a 1.5 per cent annual charge. The initial charge of 3.25 per cent can probably be avoided by buying the shares through a fund supermarket. The fund holds a portfolio of large capitalisation stocks against which it writes covered calls. This tends to smooth out the total return, with an additional portfolio income generated when the market keeps within defined boundaries.
Exchange traded funds (ETFs) can be a useful choice for income seekers. Investors are often quite rightly wary of investing in newly launched ETFs, since their liquidity and dividend paying power is untested. A recent new launch from iShares looks a possible candidate for my holiday home disposal reinvestment strategy. This fund (TIDM: SEDY) invests in high-yield stocks in a range of emerging markets.
Yield data is sketchy so early in the fund's life and dividends are denominated in US dollars. The rudimentary method of multiplying up the latest quarterly dividend payment by four would give a payout in the region of $2.00 (or £1.27) a share on an annualised basis, which on the basis of the current price in theory produces a yield of around 7.5 per cent. The yield on the underlying index, however, is 5.6 per cent. Annual management fees are around 0.5 per cent. The fund, which replicates its index through physical investments, has equity holdings in a wide range of emerging markets.
I'm looking too at high-yield options in the investment trust market. The best of the bunch here looks to be New City High Yield, which invests in high-yield bonds and which has a yield of 6.6 per cent. Performance has been consistent and the trust stands on a premium of 7.4 per cent to net asset value (NAV).
My wish to have some residential property exposure through a listed share appears to have come to nothing. The UK’s largest residential landlord, Grainger, has a yield of only 2 per cent, insufficient to meet my income criteria. Even the FTSE EPRA NAREIT UK property iShare, probably the closest ETF to what I want, yields only 3.2 per cent. So I am quite simply giving up the quest to continue with residential property income as a part of my portfolio.
By weighting the portfolio towards the fixed-income element in it, I can generate a yield in the region of 5.6 per cent after tax. The weightings are shown in the table. This return is better than the pre-tax return from a straight annuity and well over double the pre-tax yield from rental income on the property after allowing for agents' fees and running costs.
The result: more income and the aggravation of dealing with tenants, agents and mundane household property maintenance issues a thing of the past. Sorted.
