Join our community of smart investors

Think carefully before you buy to let

Our reader should do his sums before he ploughs money and debt into buy-to-let
November 30, 2017, James Norrington and Naeem Siddique

Dalvir Hayer is 45 and has been investing on and off in shares for over 20 years, and in funds for around a year. He's also recently started a portfolio of funds for his wife and is putting money aside for his daughter. He funds his contributions to his investments from his salary and hopes soon to get an additional income from a buy-to-let property.

Reader Portfolio
Dalvir Hayer 45
Description

Funds, shares and cash

Objectives

Purchase buy-to-let property, make investment return of 5 per cent a year

Portfolio type
Investing for goals

"My short-term objective is to get a buy-to-let property – hopefully this year – which will produce an income in my retirement," says Dalvir. "We have a small mortgage on our house of around £5,000, and as we will need a deposit worth at least 25 per cent of the value of the buy-to-let property, I will re-mortgage for £30,000.

"I'm looking to work until I am between 55 and 60, and then draw an income from my investments and buy-to-let property. So for the next 10 to 15 years I will continue to put money into funds and the mortgage. I'd like my investments to make around 5 per cent a year.

"My attitude to risk is high and I would be comfortable losing up to 30 per cent. I take a long-term approach so I'm prepared for downside in the short to medium term, although I switch funds if I think I have made a good profit.

"I will continue to put money into my funds on a monthly basis so if markets move down I will be buying on the way down. At the moment I put in £300 a month.

"I'm also putting cash aside because I think there will be a market correction, at which point I intend to invest more heavily.

"I'll look to switch into income funds in around 15 years' time.

"I recently sold 90 per cent of my holding in Vanguard US Equity Index (GB00B5B71Q71) as I think the US market is overvalued, and also sold my holding in Fundsmith Equity (GB00B41YBW71) for the same reason, as over 60 per cent of its assets are listed in the US.

"I recently added Marlborough UK Micro-Cap Growth (GB00B8F8YX59) as I'm thinking positive about UK small-caps despite Brexit. This has made 20 per cent over the short time I have held it. And I've started putting £50 a month into Baillie Gifford Japanese (GB0006011133) as I think this is a good speculative play.

"I am interested in the Schroder Recovery (GB00B3VVG600) and Majedie UK Equity (GB00B88NK732) funds, but would need to sell some of my existing holdings to add these as I do not want too many funds in my portfolio."

Dalvir's portfolio
HoldingValue (£)% of portfolio
Baillie Gifford Japanese (GB0006011133)241.180.8
CFP SDL UK Buffettology (GB00BKJ9C676)555.191.84
CF Lindsell Train UK Equity (GB00B18B9X76)909.593.01
Lloyds Banking (LLOY)1,9806.55
Marlborough UK Micro-Cap Growth (GB00B8F8YX59)1,973.566.53
Scancell (SCLP)499.971.65
Vanguard FTSE Developed World ex UK Equity Index (GB00B59G4Q73) 975.223.22
Vanguard LifeStrategy 60% Equity (GB00B3TYHH97)1,289.884.26
Vanguard U.S. Equity Index (GB00B5B71Q71)325.431.08
Cash21,493.7271.07
Total30,243.74 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS READER'S CIRCUMSTANCES.

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

The most notable feature of this portfolio is its huge cash weighting, which you have because you think there'll be a market correction at some point. But I'm not wholly sure that this is wise.

There are reasons to think the market is too rich and this justifies a high cash weighting. But what concerns me is your belief that you'll be able to get into the market at the right time.

Even if a correction occurs it might do so from a higher level than the market is at now. Overpriced shares can become even more overpriced. The cliché that "markets can stay irrational longer than you can stay solvent," is a cliché precisely because it's true. Many people have waited for a correction, then despaired of it happening and bought at higher prices just before the correction did actually happen.

And if the market does fall it might continue to do so. Putting money into equities after a fall does not ensure that you'll buy near the bottom.

Also, when the market is at the bottom, the same things that have caused shares to fall might also make you nervous about buying. What makes you think you'll be confident enough to buy when everybody else is scared?

For these reasons, I'm wary of using one's own judgement to time entry or exit into markets. I prefer to rely upon rules, and you're already using one of these – pound-cost averaging. That, I suspect, is wiser than waiting for a fall. 

And regular investments not only take advantage of pound-cost averaging but, even better, get you into the habit of saving. This matters, because your retirement wealth probably depends more on how much you save than what exactly you invest in.

 

James Norrington, specialist writer at Investors Chronicle, says:

The first thing to do is a sense check on your objectives. Your overriding aim is to create an income for your retirement but have you thought about how much you will actually need? The first consideration should be what your fixed financial commitments are going to be, and how much you would like spare for emergencies such as a new boiler or luxuries such as holidays.

With a buy-to-let property you are adding a potential income stream, but you are also creating a new liability in terms of the mortgage if you can't afford to buy the property outright. You also plan to borrow more against your home to purchase the buy-to-let, which will increase your monthly outgoings.  Interest rates have been at record lows but these can rise – as they did at the start of November – so you should be aware that the cost of servicing any debt could get more expensive in the future and swallow up your income.

The government has made buy-to-let less attractive with changes to the tax code. Since April 2016, you have had to pay additional 3 per cent stamp duty for a buy-to-let property and tax relief on the mortgage payments is being phased out. You need to carefully do your sums to ensure that the buy-to-let net income can cover the mortgage costs and leave you with enough money to meet your lifestyle needs.

Buy-to-let has been a great investment in the UK over the past 30 years but that doesn't mean it will continue to be. There are practical considerations, such as will you be able to ensure the property is occupied and therefore paying an income? And there are costs in terms of the money spent on the upkeep of the property, and meeting health and safety standards.  All this is time consuming, too. (Also see our article on the buy-to-let expenses minefield)

The big worry, however, is that by having so much of your capital tied up in the UK housing market, and on leverage through your remortgaged home and the additional loan you would take out for the buy-to-let, you'd be massively exposed to a crash. The risk is that your equity in the properties would be diminished at a time when the economy is likely to be in recession and you might have to charge less rent. But your mortgage obligations would still exist. Given that interest rates have only just risen 0.25 per cent to 0.5 per cent, it is unlikely finance costs will diminish to a significant extent to mitigate this.

Your income requirements will be lower if you just pay off the mortgage on your home. You should also give thought to other ways to generate retirement income that will give better diversification and won't incur fresh liabilities – like a buy-to-let property. 

Think very carefully and seek independent professional advice before taking on more debt to invest in an illiquid asset such as buy-to-let property.

Another way to invest in property is real estate investment trusts (Reits) – closed-ended investment companies listed on the stock exchange. These pay a good dividend when the commercial property market is doing well. However, they are in demand so their shares often trade at a premium to their net asset value (NAV). But with Reits you aren't leveraging yourself to gain exposure to property income.

 

Naeem Siddique, investment manager at Redmayne-Bentley, says:

Holding cash in anticipation of a market correction and having dry powder in reserve is a sensible idea. However, in practice, calling tops and bottoms in markets is notoriously difficult.

If you can absorb a loss of up to 30 per cent then your risk tolerance is strong. And given your investment time horizon of 10 to 15 years your risk tolerance may suit a large allocation to equities, as these are where the bulk of returns are expected to come from over the medium term.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

It's not at all foolish for for you to hold lots of cash because of your intention to get a buy-to-let property. This is because when you find the right property it may not be the right time to sell equities. If you are fully invested you might have to sell shares at the wrong time – when they are too low – to fund your buy-to-let deposit.

This also poses the question of whether you should have a buy-to-let property. Buy-to-let income will be taxed, whereas equity returns within an individual savings account (Isa) or self invested personal pension (Sipp) won't. This matters, because I'm not at all sure that pre-tax returns on buy-to-let will be higher than pre-tax returns on equities over the long run.

Another consideration is the two systematic risks of buy-to-let property. One is cyclical risk: an economic downturn could mean that house prices fall and it is less certain you get continuous tenants. This is nasty because in a recession you would you lose money on equities and perhaps your job would be at risk, too. Buy-to-let property also incurs liquidity risk as property can be hard to sell quickly. You should only have it if you can be certain you'll not need to raise cash quickly.

But much of what you're doing is right. Your expectations of returns of 5 per cent a year would be reasonable if you were fully invested. You're right to limit your number of fund holdings as by doing this you avoid ending up with an expensive closet tracker. And because you are flexible about when you retire, you have a way of adjusting if your returns fall short of expectations.

 

James Norrington says:

Property, and especially UK property alone, shouldn't be the only asset class that you look to for income. There are other investments, such as global listed infrastructure funds, which offer well supported income streams.

You could also consider a strategic bond fund. Bonds are expensive, and there is a risk of capital loss as prices are sensitive to interest rate rises. But over the longer term a well-managed fund, of which the manager keeps an eye on duration, liquidity and credit risks, has a good chance of providing a steady income stream.

A good quality, internationally diverse global equity income fund would also be a good investment. Look for a fund that monitors the operational cash flow of the companies it invests in and the extent to which this covers the dividends paid out, as well as the dividend growth rates of the companies it invests in. Proportionately how much debt these companies have relative to operating cash flows and equity capitalisations are also strong indicators of robust income generation capacity.

If your goal is income you might be better off selling out of the small holdings and Lloyds Banking (LLOY), and buying four or five funds that can help you meet your income requirements.

Also make sure you keep aside enough cash to cover emergencies.

 

Naeem Siddique says:

I am an advocate of active management so where justified, seek to invest in fund managers with a proven record in their investment areas.

The most effective use of an active manager is with small caps. Your UK funds are focused on smaller companies but I would also look further afield, so Standard Life Investments Global Smaller Companies Fund (GB00BBX46522) could be a good addition. 

You have recently begun investing in Japan via Baillie Gifford which has a very strong reputation in this area. Baillie Gifford Japanese seems to be a good way to benefit from the corporate governance changes taking place in Japan via an established investment house with a strong track record of investing in this country.

Other funds suitable for a long-term investment horizon include BlackRock Frontiers Investment Trust (BRFI), which invests in countries that exhibit strong fundamentals such as rising income, low government debt and improving education levels, similar to where emerging markets were a decade or so ago. The trust has a yield of about 3.3 per cent, and had one of 3.6 per cent in 2016 and 2014, 4.8 per cent in 2015, and 1.4 per cent in 2013. This is a bonus as its focus is on capital growth. The trust has also exhibited low volatility over the past few years as global markets have risen almost in tandem, however, this could change going forward. But your use of pound-cost averaging could mitigate the effects of volatility or drawdowns.

I would also add some fixed interest, for example, GAM Star Credit Opportunities Fund (IE00B510J173), which invests in the junior debt of investment grade companies. Junior debt ranks lower down the repayment order of the issue, however, investors are compensated for this with higher coupons than on the higher-ranked debt from the same issuer. You could hold the accumulating units over the next decade and switch into income paying units as and when required.