I went to the offices of the Financial Times on Friday for an interview on investing in the big regulated property funds (commonly done through an IFA – Independent Financial Advisor) versus direct investment in property as many of us practice.
I have noticed that when talking to IFAs many argue that equities always offer a better return in the long term than property. I have always found this strange as my property investments have always outperformed my equities by many 10s or 100s of percent.
Then the penny dropped…
What most of them are talking about is investment in equity (stocks and shares) based funds vs. property based FUNDS which are usually essentially a pool of investors who have invested in large commercial buildings through a company such as Aberdeen, New Star, F&C, Henderson UK property fund or Standard Life UK property fund. It’s true that the equity based funds usually have better returns than the property funds long term but they are nowhere near as good as the absolute return you can achieve from direct investment in property such as buying a buy to let house whilst using a sensible amount of leverage.
So much of the interview at the FT was around why this was, here is an extract of the Q&A:
How does investing in a property fund differ to actually buying a property, or properties outright?
Direct property investment unlike property funds means no hidden or overt fees paying for layers of professionals in offices who sit on top of the fund, or profits to the fund.
If you get a property cheap you get the benefit of a good deal rather than the fund doing a transaction before the property goes in the fund to pull equity out of the deal which you don’t see.
You are likely to keep the property fuller, meaning less voids and will be more interested in sourcing better more relevant properties that tenants want to live in and in checking that those tenants are going to pay and follow the AST.
I’m constantly bidding on empty properties funds own often miles away which have paid too much, don’t really understand the area and are disconnected. They often don’t sweat the asset like you would yourself and will hence therefore experience lower returns for their investors.
The reality is that no one will look after your money like you will…. buying smaller individual properties are also nimbler.
So how do the returns compare?
A small investor can consistently get 20%+ cash on cash returns in direct residential property investment. This can rise substantially as an investor becomes more skilled and considers more involved strategies.
The returns which Funds generate always seem much less, often returning around 6% on average (income and capital) over the long term.
Funds can be illiquid, you usually can’t withdraw cash in bad times. We saw this recently after Brexit when many funds were gated for a period.
Conversely you can usually still refinance or sell a property if you drop the price possibly making it more liquid.
When might a property fund be a good idea and when is direct investing the better route?
Funds are usually hands off so they can save you a lot of time.
You can usually invest smaller amounts of money in property funds and invest any amount rather than a set sum in a direct property investment (e.g. 25% deposit plus legal’s, stamp and refurbishment). You can usually put money to work straight away in a fund.
What about the risks. What are your biggest risks when taking on buy to let?
One of the biggest risks are Interest rates going up a lot like happened in the ERM crisis of the late 80s, you can fix them to eliminate this risk.
Another thing to be careful of is a drop-in tenant demand. This is usually a localised risk, usually focussed on an industry going like the car component manufacturers closing in the West Midlands in the last recession. Or perhaps a major hospital closes or moves or maybe a University builds its own swanky blocks meaning that the local student houses you own suffer.
The other more topical potential risk has been tax changes. The forthcoming changes in tax legislation concerning the inability to offset all mortgage interest against rent has been a shot across the bows for many investors. Clearly purchases in a LTD company sidestep this but this along with stamp duty increases have put buy to let investors on their guard concerning what long term government intentions really are.
Most other risks can be insured against.
What about the costs you incur with starting a LTD company…Both in getting started and then ongoing maintenance?
Accountancy fees could be an extra £2k per annum.
Stamp duty increases will increase the price of a £100k property by £3k. Not insurmountable but something many investors are now using to negotiate the price of a new purchase down.
Around 20% of the gross rent goes to pay for maintenance and management on a single let. This could be as high as 30% on a HMO as it is customary to include utilities in the rent on these types of properties.
Can you hold direct property in an ISA or SIPP? How does it compare to a fund in terms of tax wrapper?
No you can’t directly hold property or borrow money within an ISA.
You can hold commercial property in a SIPP or SASS which can lead to great non-taxed compounded returns.
Your SIPP/SASS can also lend money to your property company to buy all types of property including residential. This creates great flexibility and can be a great way to buy properties cash and fund the renovation/conversion cost. Your pension effectively becomes a bridging lender to your property company and doesn’t pay any tax on the interest it receives on the interest which you company pays. Your company can then in turn offset this interest it paid to your pension against tax…making it quite tax efficient.
What are the different property sectors you can get access to in a property fund – you can get access to far more sectors via fund than investing directly can’t you?
It’s almost all commercial. Shopping centres, retail, industrial. There are some private rented sector schemes around but they are newer and seem to offer lower returns.
hilst yields with commercial can be higher, the big issue with commercial held long term is that it doesn’t appreciate as much as residential and can actually depreciate against when taking inflation into account.
London commercial has gone up 800% in the same period that residential has appreciated 8000%. No extra yield/income over residential can make up for this.
Do you invest in property funds yourself or only in direct property?
I Only invest directly
For many of the reasons I mention above.
- Higher return
- More control
- More liquid
- Lower risk
- No hidden fees
No deals before the property hits the fund…if I buy it cheap I get all the benefit instead of the fund manager or sourcer performing a transaction before the property goes into the fund to strip any equity/below market value element out – I don’t like this.
What affects the dynamics of your own property investments?
- Rental demand
- Interest rates
- Confidence in the economy
- Banks confidence
- Regulatory changes such as Licensing
How does that compare to what might affect your returns if you invest in a collective fund of properties?
Funds offer less flexibility, control and particularly nimbleness to pivot when things change.
Large funds are like oil tankers, £200m buildings take ages to sell or reconfigure and then getting that much money reinvested takes time.
What is the outlook for the UK residential market this year do you think and what’s going to drive it?
I expect 5% capital growth in the provinces (South East, Midlands especially).
Tenant demand will drive it
Tax changes affect it
The upcoming White paper on new housing strategy will be interesting…but there is always a lot of talk from the government on building lots of houses.
Often big headlines but too often the numbers of new homes they create are a drop in the ocean compared with the size of UK housing stock which is around 24 million dwellings. One of the biggest and most successful schemes, “Help to Buy” has helped around 200,000 people onto the housing ladder. It might be argued that it has stimulated the building of a similar number of extra homes but at 1% of the housing stock and relative to the ongoing supply shortage these numbers are still small. Most other schemes have produced much smaller results but create headlines which the government seem to like.
How Brexit have any influence do you think?
More EU migrants getting in quick before the barrier comes down, we are seeing lot more people from Bulgaria and Romania arriving.
The UK Economy seems robust since the leave vote- that was a great test for where the UK is within the economic cycle and how resilient the financial backdrop is.
What about the commercial property market – London seems to be very buoyant?
Yes rents are rising in many areas, especially industrial and lots of deals going through
Capital values in the Residential market over £1k/ft are still falling, residential rents are falling in prime London possibly due to less financial services workers coming in as banks look to other European cities post Brexit.
At the higher end there are Deals to be had, especially residential over £1M where Stamp duty has increased massively. Kensington, Chelsea, Knightsbridge, Mayfair residential markets are gummed up with few willing to pay the extra stamp duty required at this level.
As the government is taking less in stamp duty receipts as a whole it seems likely that they will be forced to rethink these changes at some point.
Which looks the better investment at the moment do you think – UK commercial or UK residential and why?
It Depends where. I like taking cheap unloved commercial buildings and converting them to residential. Pubs, cinemas etc. I do a high-end cluster flat model which can yield 18%+
Commercial side steps stamp duty changes and inability to offset mortgage interest issues but empty property rates and voids can be higher dependent on area.
The Yields in residential in the regions are much higher, hence many investors have moved their buying radar geographically further out.
Nationally tenant demand for residential is rising faster than commercial.