Are you an Investor, or a Speculator?
Market bubbles have occurred throughout history with remarkable regularity – it seems collectively we fail to learn from history every time another one comes along. But as individuals, we should: as George Santayana said: Those who cannot learn from history are doomed to repeat it.
The Dutch Tulipmania (1634-1638); the Mississippi Bubble (1719-1720); the South Sea Bubble (1720); the Bull Market of the Roaring Twenties (1924-1929); and Japan’s “Bubble Economy” of the 1980s, the property bubble (1970-74) The Dot Com bubble (1999-2000) and the property bubble (2006-2008) as just some examples of what Robert Shiller (Case/Shiller House Price Index) has called irrational exuberance.
Be your own Property Expert
During the property boom of the “naughties”, just like all the other booms, many property “investors” forgot that the value of an asset never exceeds the value of the future income it can generate.
If you are buying an asset expecting it to increase rapidly in value then you are a speculator, not an investor.
Investors look for assets which provide an income return (yield) which more than covers their costs and is comparable to an alternative such as bonds, stocks, or cash returns. Speculators are purely investing in hope, hope that the market will go on rising and push the value of their asset to unlimited levels.
The successful ones operate on the greater fool theory* or “pass the parcel”: that they will ride the tide up until they can off-load their investment to a greater fool. Many fortunes were made this way in the naughties.
However, many more fortunes were lost when unsuspecting amateur “investors”, many led by property investment “expert” advisers, were sweet-talked into buying off-plan city centre apartments in places like Manchester, Leeds and Glasgow.
Income Determines Value
Now those things have settled down, when most of the “experts” have moved on to selling solar panels or something, we see a different environment; at least until the next property bubble comes along, scheduled for around 2028?
If you invest in property you should do it on basic business principles: before choosing any investment you need to asses its potential income (yield) compared to alternative investments. Capital appreciation is something you will be looking for long-term, but in the current market, growth’s a bonus.
Is the income flow (rental income) dependable, in other words is there solid rental demand? Will the income (rent) grow over time; can you put up the rent? Will the investment be a good hedge against inflation? Is there scope for adding value – extra rooms, reconfiguring, refurbishing? Is the location improving, declining? Is the location dependent on one or two large employers? Will the value of the asset increase long-term?
Income Equates to Value
Any asset which falls behind alternatives in terms of income will inevitably lose value. A good example of this is retails shops in a recession. Many high streets are suffering loss of trade and shop closings. This could be short-term but in many locations these could bring a permanent structural change due to competition from out of town retail and the Internet.
As foot fall declines profit margins are squeezed and more shops close. In the short term the premises are “over-rented”, which means tenants are paying rents at a level set in the good times. When rents come up for review, or vacant shops are re-let, rent levels have declined. To retain or attract new tenants are faced with offering reduced rents, rent free periods and possibly accepting low security (covenant strength) tenants. Therefore the value of the asset declines.
On the other hand, an asset with an increasing yield of superior income flows will, over time, increase in value. The investor, unlike the speculator, does not buy assets per se; in effect they buy a future flow of income, an income stream which compares favourably with alternative forms of investment.
By buying good value, buying the asset at a bargain price, and then creating an income stream, you multiply the value of your asset.
Property investment lends itself to multiplying value, which is totally under your own control. Making improvements, splitting into multiple units, or adding more rooms can all increase the income a property will yield. Investing in stocks does not give you this control, unless you are on the board, you are relying on others, the management of the company, to add value by increasing income.
Make Sure you Buy Value
In order to know you are buying value, you need to be able to establish a realistic value yourself which we may define as the intrinsic value* of your investment. Valuing an asset is not easy because there are different kinds of value:
- Market Value is the most common value estimated by property surveyors and estate agents. It is generally defined as: the highest price a willing buyer would pay and a willing seller would accept, both being fully informed, and the property marketed in the usual way being exposed for sale for a reasonable period of time.
- Book Valueis the value at which an asset is carried on a balance sheet or in the books of the owner, taking into account any depreciation charge or appreciation in value of the asset over the lifetime of ownership.
- Value to a User or Value in Use this relates to value to a specific user rather than the market in general. It does not relate to the price level most individuals would be willing to pay. For example, if you owned a property next door, and you wanted to expand your business, then the asset for sale would be worth far more to you than to other purchasers.
- Insurance Value Insuranc value relates to the cost to replace after a total loss. It’s very important that you insure a building for its full replacement cost; otherwise you may not get the full cost of a claim: 25% under insured would mean any claim would only be paid at 75%. Replacement costs which include site clearance, professional fees and all re-building can work out far more or sometimes less than market value, depending on the type of property.
- Rateable Value or Assessed Value relates to the value of property established by the tax authorities purposes of establishing a basis for business rates or council tax. This is often based on market rental values.
- Going Concern Value relates to an ongoing, established business operation where as business is worth far less if it is to be liquidated. A property example may be a McDonald’s restaurant premises, which has a certain going concern value. This factors in that the franchise continues to occupy it. Take away this strong covenant tenant and the vacant building may have an entirely different value.
- Liquidation Value Liquidation value relates to the concept that the property requires immediate sale or transfer. Liquidation value would result with a short marketing period such as an auction or finance foreclosure sale. To arrive at a liquidation value a discount is applied to the property’s market value; the discount being based on experience with other liquidation sales.
How Dependable is the Income?
The key criteria when deciding on any property investment is: how dependable is the rental income into the future?
Property is capable of returning more income than most other alternative investments (stocks, bonds) but what about void periods (vacancies) and tenants from hell?
Tenant demand into the future is absolutely paramount. A property which cannot be rented turns your investment from an asset into a liability. You’re paying all the outgoings, with no income to cover them. This problem is particularly acute with commercial property where in the UK there’s no landlord relief for business rates and your property insurance bill, previously paid by the tenants, will probably double due to the extra risks with a vacant property.
Keep Your Local Market Under Review
You need to constantly review your local property market. Do you see any flats / apartments or houses which remain on the rental market for extended periods? What about commercial properties, how many vacant units can you count on your local high street? What’s the average time to let a residential or commercial property in your location? Speak to local agents.
You need to learn how to manage your rental properties with minimal time, effort, cost and risk. By following the advice – policies and practices – discussed throughout the LandlordZONE® website you will learn how to select good tenants 99% of the time and achieve low turnover by retaining your existing tenants longer.
*The greater fool theory states it is possible to make money by buying assets, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.
*Intrinsic value can be defined as the actual value of a company, property or any asset, based on an underlying perception of its true value, including all aspects of the business, both tangible and intangible factors. This value may or may not be the same as the current market value, the book value, or the value to a purchaser or investor.
Investment – More Articles in this Section:
- Letting for the first time
- Am I suited to becoming a landlord?
- Preparing the Property
- Marketing the Rental Property
- Sealing the Deal – Offers and Deposits
- Check-In and Check-Out
- The Tenancy Documentation
- Dealing with Agents – Fees and Costs
- The Tenancy Documentation
- The Main Landlord’s and Tenant’s Responsibilities
- Useful Links and Contacts
By Tom Entwistle
©LandlordZONE All Rights Reserved – never rely totally on these general guidelines which apply primarily to England and Wales. They are not definitive statements of the law. Before taking action or not, always do your own research and/or seek professional advice with the full facts of your case and all documents to hand.