Property as an Investment
Property, as an investment vehicle, needs to be judged against other forms of investment, taking into account all those factors which are of prime importance.
Although property is a special case, in that most of us need to invest in it either as a place to live or work, it is unlikely to be, and indeed should not be, the only place to have your money. These are some of the important factors to consider:
My Investment Philosophy
What is the rationale behind my wealth creation strategy: is it based on sound analytical business principles, savings, hard work and taking a long-term view. Or do I favour the get-rich-quick approach, borrowing big, taking big risks and “sailing very close to the wind”?
Both methods can work, but the latter requires a lot of luck, good market timing and nerves of steel.
Return on your Investment
This takes two forms: (1) the income or yield the investment gives you on a regular basis, and (2) the capital appreciation or growth you get during the time you hold the investment. The two of these combined is known as the Total Return.
Risk and Uncertainty
Investing your hard earned savings / capital is a scary thing. It’s even scarier to borrow funds and invest them, knowing that the risk involved is only your own calculation of the probability of getting a good return. There’s always the uncertainty of unknown and unknowable events occurring which might ruin the whole thing.
On the other hand, you can lose just as much by doing nothing: having your money sitting in an safe bank or building society in periods of low interest rates or high inflation, coupled with the eroding effects of taxation, means that over time your capitable goes down in value.
This describes the ease and certainty with which you can withdraw your funds into cash. A bank or building society account is relatively risk free and liquid, in that you can withdraw your funds without notice.
Stocks (equities) likewise are relatively liquid in that you can telephone your broker and instruct him to sell on any working day – the sale will be completed within hours – but they are not risk free. Property, on the other hand, is an illiquid investment: it can take months or even years to dispose of a property asset, making it difficult to time the sale to your advantage.
Time Involvement and Property Management
How much of your time is going to be taken up in managing your investment? Unless your money is in cash investments or a managed fund you are going to need time to research and manage your investments be they stocks or properties. This is fine if you are a full-time investor, or you are retired, but most of us do our investing whilst managing a family and a full-time career.
Time Horizons, Wealth and Attitude to Risk – these are important factors which are personal to you. It’s inevitable that when you are young your investment funds are low, but maybe you’re prepared to take more risks. In your middle years you may have more income and funds but also more family responsibilities so only medium risks are acceptable.
In your later years, hopefully having built-up your funds, you have more capital, but you don’t want to risk losing too much because time is not on your side to build it up again. You may, depending on your total wealth and requirements at any stage in you life, take a portfolio approach. Here, a smaller or larger portion of your wealth is in higher risk, high potential return investments and may be spread across many investments.
Taxation and your personal circumstances
Are you a high rate taxpayer? Is your spouse earning, or can you claim all of his/her personal allowances against joint investment income? What are your retirement plans and what about Inheritance Tax? Would it be worthwhile investing through a company? These are all quite complex questions and will depend on your own personal circumstances and future plans – you may need some professional advice. It’s always a good idea to plan your exit strategy as soon as you can, preferable even before you invest.
So you’re looking for the perfect investment
One with low risk, high income, high growth prospects, high liquidity, minimum management time and low tax. Sadly, it’s very unlikely you’ll find all of these in one investment. You have to trade off these factors against each other, and if you want to balance your risks and returns you need to consider a portfolio approach. See Figure 1 below.
The Capital Asset Pricing Model (Simplified)
This model shows the relationship between risk and return. At zero risk you might get, for example a cash deposit, a 4.5% return on your investment. But in these types of investments there’s no capital growth, so 4.5% is all you’ll get and then you need to take inflation and taxation into account. With inflation running at say 2.5% to 3% a year, year on year, the value of your capital is gradually being eroded. Take away your tax and with a cash investment you don’t have much left, if anything.
As you move to the higher risk investments your potential returns increase. All of these higher risk investments will demand more management involvement that the simple safe cash investment, but the more time you are prepared to put in in terms of research, monitoring and management, the more you are likely to get back in terms of income and capital growth combined – your total return.
Some people are lucky enough to have the resources to start investing young, but most are in their 30s, 40s or even 50s before they have the time and the savings to start investing seriously. An investment priority should always be your own home and getting on the so called housing ladder – no easy achievement for younger people as they often have student and other loans to pay off in their 20s.
Invest in a Home First
Your own home is perhaps one of the best investments you can make, giving you long-term security, capital growth and some generous tax breaks. It also gives you a growing equity stake (collateral) which you can use to borrow against for increasing your asset base in the future.
Invest in a Pension
It’s beginning to dawn on all of us that we can no longer rely on the state or our company pensions to adequately provide for our needs or desires in the future.
Younger people (generations X & Y) are likely to have to work longer before they can draw their pensions, which are likely to be far less generous than the Baby Boomer generation had before them.
It’s going to be more important than before to think through your savings and investment strategy – to develop your knowledge on investment and finance and to have clear goals and targets.
Study and Understand the Principles
Having decided on the need to save and invest, you should devote some time to study: to understand the principles and techniques and to understand yourself.
Are you willing to take some risks (can you sleep nights?) or are you more conservative and risk averse? Have you got time to be active, or would a passive investment strategy suit you best, say investing in managed funds?
Would you be investing for income, capital growth or a mixture of both? Are you looking at cash savings, bonds, shares, property or other assets like commodities or works of art?
Compound Interest, Cyclical Markets and Gearing
There are three very important principles to bear in mind about investments: (1) Compound Interest (2) Cyclical Markets (3) Gearing.
(1) Compound interest – Albert Einstein famously referred to the power of compound interest as the “8th Wonder of the World”.This highly underrated concept is the real power behind investing. Take the figures in the table below taken from Barclay Capital’s Annual Equity Gilt Study. This table shows annual real (inflation adjusted) returns over a variety of periods for different types of asset.
|Period – Barclays Capital (2005)||Shares%||Gilts%||Cash%|
|Last 3 years||14.8||2.8||1.6|
|Last 10 Years||4.2||5.7||2.8|
|Last 20 Years||6.7||6.2||3.9|
|Last 50 Years||7||2.3||2|
The Power of Compounding
These figures might seem paltry at first sight, after all what’s a 6.7% gain in shares over 10 years?
Well, what it means is that if your investment can equal the market average of gains over 20 years, then through compounding every 10 years you double your money. £100k invested 20 years ago would now be worth £400k.
Now, with a bit more work and careful investing your individual investment my beat the market hands down. Say you can get your portfolio to achieve double that – an average 13.4% – not at all an unrealistic figure – in fact Warren Buffett has achieved something like 20% over 40 years.
So now, you double your money in 5.4 years, which would mean in 20 years you turn your ?100k investment into something like £1.6m in 22 years. That’s the power of compounding!
The Dot Com Crash
The DotCom Crash knocked the stock market for 6 for a long time, but the property market has soured over the last 10 years until it peaked in August 2007.
In the years 2002 to 2005 the stock market returned a respectable 14.8% and the commercial property market a total return of over 20%. However, comparing shares with property investments can be confusing because property returns involve borrowed funds (gearing) whereas the returns shown on the table above are not geared at all.
Markets are Cyclical
All asset markets are cyclical in nature, meaning that they move up and own over time, but generally the underlying trend is up. This is shown clearly in the table above where the stock market has achieved an average 5.2% growth over 105 years, whereas at times growth has been much higher or lower throughout this period.
One thing you can say with almost absolute certainty: markets always regress to the mean – they return to their long-run trend line in the long-term. This makes investing a whole lot safer if you know that so long as you can hold on long enough, most assets will return to the average growth trend, however low the market gets, unless there’s a problem with your particular investment.
This point is particularly relevant in 2008 when property and stock markets are sliding.
Gearing and Loan to Value Ratios
Gearing – borrowing money to invest is a great way to accelerate your gains. This works very well when markets are advancing – prices rising steadily – but it also accelerates in reverse. When prices are falling losses are also multiplies.
Borrowing to invest in the stock market is very riskier, unless you are a professional, and even then losses are possible – witness Lehman Brothers!
Borrowing to invest in property is much safer and is the norm, because property has an underlying asset value which is very unlikely to return to zero, though prices, as we have seen, can drop considerably.
Warning: Investments in property can go down as well as up in value and property can sometimes take a long time to dispose of. Never invest money in property which you may need in the short-term – invest with a long-term perspective and get trustworthy professional advice..©LandlordZONE® – legal content applies primarily to England and is not a definitive statement of the law, always seek professional advice.