Buy-to_let and Capital Growth

The IPD UK Annual Residential Investment Index for the end of 2013 reported that the total annualised return on residential lettings over the previous ten years was 8.5%. The bulk of this (5.9%) came from capital growth.

The long term trend has been for property prices to rise with earnings, fluctuating around the growth in earnings on a cycle that is typically about 10 years long – the deeper the trough the longer it takes to recover. In more recent years prices rose by significantly more than earnings, until the crash in 2008.

The last property cycle was unusually long. It lasted almost 20 years from a low point in 1990 to the next low point in 2009. This was followed by one of the most dramatic collapses in property prices ever recorded. There are lessons to be learned from what has happened over the last four or five years, but they tell us more about the impact of economic collapse than they do about long term trends in property prices. To understand these, we should look over a much longer period of time.
UK property prices nationally grew at an average rate of RPI + 2.04% per annum between 1975 and 2012. If we limit the period to 2006 before the crash then the average rate was RPI + 3.35%. The table below created using data from the Nationwide shows how this varied regionally around the country:

Many people think the increases in house prices in the years leading up to the crash were unsustainable, and that the crash was in effect a correction.

Up to the year 2000 the growth in house prices (RPI + 1.6% pa) fluctuated around the rise in earnings (RPI + 1.59% pa). But since then it has grown by significantly more, implying that people were spending higher multiples of their earnings on buying a house. In the 1970s mortgages to home owners were typically limited to three times income, or in the case of a couple to three times the first income plus the second income. Preceding the financial crash they were being offered at as much as five times income, and even now people are commonly offered four times their income.

It is only with hindsight that you can tell where in the property cycle we are. There are those who argue that prices today are higher in relation to incomes than has ever previously been sustainable. They point to the historically low rates of interest currently available and suggest that once these return to more normal levels prices can be expected to drop.

The market in London has been particularly strong, which may well be due in part to the huge influx of foreign investment, much of which is in the prime properties of central London.

On the other hand, there does not appear to be any possibility that the supply of housing will be sufficient to meet demand in the south and east of England in the foreseeable future. Elsewhere in the country it largely depends on growth in the local economy. Some of the more depressed areas of the country have seen a collapse in their housing market, with streets full of boarded-up houses. These and other issues affecting housing prices are examined in more depth in Economics of home- ownership.

Capital gains on investment property attract capital gains tax (CGT) which is currently levied at 18% for basic rate tax payers, or 28% for those at the higher rate. The first £10,600 of gain is tax free, and all the costs of purchase and sale can be offset against the gain, together with the cost of improvements. There are some additional allowances where the property has been your main residence at some point.

Unless you manage to pick up a real bargain, the total cost of procurement is invariably more than the value of the property, once stamp duty, legal fees, and other incidental costs are added, even where the purchase price does not exceed the valuation. It is important to buy well, minimising these additional costs. Buying at auction can be a good option, provided the property has been adequately checked beforehand. Buying from a developer ‘off-plan’ is also quite common, and the guarantees and lower repair bills that come with a new dwelling can be useful. Personal taste and preference are of less concern to the investor, than to someone buying their own home, and value for money becomes a more important consideration.

Going back to our example property, how might capital growth impact on the total rate of return? Given that on average landlords expect to keep their rental properties for about 20 years, the table below plots the returns over 20 years at various rates of increase in house prices. Inflation as measured by the CPI remains at 2%, and management, maintenance, repairs and rent levels are all projected to rise at 1% above CPI:

‘Return pa before tax’ Calculates the annualised return from capital growth, ignoring any profits from rent. Capital growth is the difference between the projected sales price, net of sales costs, and the total procurement costs. It is less than the growth in house prices because of the fees and other additional costs incurred when the property was bought and when it was sold.

‘Return pa after tax’ This deducts CGT at the higher 28% rate from the increase in the property price, after deducting all eligible costs and allowances. It the property was jointly owned by two people, the personal allowance for CGT would be doubled.
‘Total return on investment before tax’ This combines the profit from capital growth with any profits from rent. It is calculated as the IRR on the total cost of procurement of net rent income and the proceeds from sale of the property after 20 years.

‘Total return after tax’ This is the same as the previous measure, but taking income tax and CGT for a higher rate tax payer into account. It is calculated as the IRR of both the net rent income after income tax at 40% and the net receipt from the sale of the property after CGT at 28%. This and the previous measure are arguably the most useful for comparing investment in rental property with the performance of comparable investments in stocks and shares.
‘Geared return before tax’ This is the rate of return on the cash investment by the landlord, excluding the mortgage. It is calculated as the IRR of net rent income after interest charges, and the profit from the sale of the property.
‘Geared return after tax’ This is the same as the above, but deducts income tax and CGT assuming these are both at the higher rate.
None of these measures is universally recognised. The most widely used measures are the Annualised capital growth (ie return pa before tax) and the Gross return on investment (total return on investment before tax). The other measures may give a better indication of the overall value of the investment in practice.

The table below explores how much the rate of return increases the longer the property is held before it is sold. For this purpose house price inflation is held constant at 3% per annum, and all other assumptions are unchanged.

The geared return may seem like a rather complicated measure, but it is quite a useful one. It enables comparison with other ways in which the cash deposit of a little under £80,000 might have been invested, such as in a unit trust, or a cash savings account.

Our example property would have to be let out for a good ten years before the investment could be considered worthwhile, although this period would be shorter if house prices rose faster.

Getting to grips with these various measures of investment performance should help anyone contemplating a buy-to-let investment to better understand the risks and potential benefits.

A financial appraisal can reveal the different profile of risk from investing in areas where the economy is strong, such as London, compared with some of the weaker areas further north, or in prime locations compared with cheaper properties that might have a higher initial yield, but provide lower and riskier returns in the longer term. Those taking this more professional approach tend to invest in better quality properties, because in the long run they are more profitable.

Local knowledge can be invaluable in deciding which properties to invest in. Home owners often prefer houses with gardens in a suburb where the schools are good, whereas for investment purposes it might be better to choose flats close to public transport in an area showing signs of becoming increasingly attractive.

Financial appraisal does not provide definitive answers. It is a tool for exploring the way events in the real world might impact on the value of the investment. It should give you a better feel for the risks and benefits, and help to focus on what matters to make it work financially. But like any tool, it is only as good as the person using it. With unrealistic assumptions it will give unrealistic results. It is these assumptions, particularly on operating costs, that we shall explore in the next section.