There was an interesting article on pensions in City A.M. a couple of days ago. Although I agreed with most things suggested by the article such as, the earlier you start saving towards a pension the better (even if it is just a small sum to start off with), I thought property was discussed in an overly simplistic manner. It was noted that 13% of those surveyed said their property was their pension. In pointing out that property does not necessarily provide a better return than the stock market, the article quoted James Sumpter of Bestinvest: “Contradicting common misconceptions, Sumpter notes the FTSE All Share index rose 1,038 per cent in the last 25 years since 1986, while over the same period house prices have risen by just 367 per cent – 427 per cent in greater London.”
Point 1: Leverage really juices up the return on property
The figures above give the impression that a £10,000 property investment would have grown to a value of £36,700 25-years later whilst the same investment in the FTSE All Share would have mushroomed to £103,800. However, if Joe Bloggs wants to buy a property he can borrow a good portion of the money needed to make that investment from a bank but Joe Bloggs would not be able to borrow as easily to invest in the stock market. This is best understood with the help of an example.
Just prior to the 2007 credit crunch 100% loan-to-value mortgages were plentiful. That is, you could borrow all the money needed to buy a house and sometimes even more. My friend bought a flat in 2006 for about £250,000 and all she put in was about £5,000 to cover the tax, legal fees and other purchase costs. She lived in the house for 3-years and then let it out because she was going abroad. The rentals she’ll get from the property over a 25-year period will likely exceed the mortgage repayments required but for simplicity, I am going to conservatively assume that the rent received exactly equals the mortgage and maintenance costs including the mortgage payments she made herself during the 3-years she actually lived in the property.
If history repeats itself and property returns 367% over the next 25-years, her profit will be £912,500 (that is, £250,000 x 367% - £5,000). Had she put the same £5,000 into the stock market, her profit would only have been £46,900 (that is, £5,000 x 1,038% - £5,000). That huge stock market return isn’t looking so juicy in comparison anymore, is it?
Point 2: the return statistics ignore some of the flexible cash flow opportunities that property offers in a way that the equity market does not and cannot
A little background: some of my thinking on property has partly been shaped by Robert Kiyosaki’s, Rich Dad, Poor Dad, I was reading that book at exactly the time that I wanted to buy my first property. Kiyosaki planted the seed in my head that the house you live in is not necessarily a great investment from a cash flow perspective. From the point of purchase, a home bleeds cash out of you due to the deposit required, legal fees and other transaction costs; then on an on-going basis the property also needs to be maintained. I was planning on buying a one-bed property at the time because that is all I could afford in the areas that I wanted to live but once I read Kiyosaki’s take on property, I changed strategy and shopped around for two beds. Although I was stretching myself thin I knew bedroom two could be let out to help with the mortgage. This is exactly what I did. I was also very lucky in managing to find fun, like-minded housemates every time the room was free. A pensioner can do exactly the same thing if they don’t want to sell their property. If there are free rooms in the house due to children fleeing the nest, why not let those rooms out to earn more money. With an equity portfolio, dividends only occur at very discrete points in time and indeed in a recession companies are prone to cancelling their dividends.
I know of another person who built a fabulous house on the coast somewhere in Australia. Every summer she worked abroad for three months during which time she let the property out. Those three months produced enough rent to pay off the entire year’s mortgage. Of course this option is not available to all of us but it is another example of the versatility of property.
Final point: buy to let
Many cannot afford to buy more than the property that they live in, however, those that can may intend to hold the property indefinitely and let it out for income during retirement. There is a certain obsession in Britain with climbing the property ladder: people buy one property, then once it increases in value they sell it to buy a bigger, better and more expensive property that they previously could not afford. Some people continue aspiring towards bigger and better even after they have found a property that comfortably accommodates their entire family. I personally don’t agree with this strategy, I think it’s better to live in a slightly less optimal house to make it more affordable to buy to let. The beauty of a buy to let is that someone pays the mortgage off for you. I see it is a way of saving using someone else’s money.
I won’t even go into the fact that many people don’t understand how stock investing works nor do they want to get involved in it because the idea makes them feel uncomfotable. Property investment is not a sure fire winner, it does sometimes result in severe regret either because one ends up buying in the “wrong” area or finds that the property has structural issues that cannot be easily resolved or for some other reason. Despite this property will always be high up on my list of favourite investments because it offers access to leverage and to cash flow opportunities.