How to Invest in Property

Welcome to Financial Expert hub page on how to invest in property. Property, also known as real estate, is an essential asset class for any diversified portfolio. Millions of working britons purchase a house, but a house for living in shouldn’t be considered as part of your investment portfolio. This naturally leaves most portfolios underweight in property, and thus discovering how to invest in property is a vital piece of knowledge.

Property in Asset Allocation

Property is a great investment to have in a portfolio due to its low correlation to other asset classes. This low correlation means that property acts as a ‘stabiliser’ of your investments. In the long term, property has performed well, although it has underperformed equities when you look back 50, 100 years. It is partly for this reason that portfolios are built around a core holding of equities, rather than property. Nevertheless, property is an attractive component.

Fundamentally speaking, property prices are likely to hold their value given that the population of the UK is expanding within the confines of a relatively small land mass. There are no doubts that property is expensive, costing on average 7 times median earnings compared to 3 times earnings within the last few decades. However, I personally believe that this higher price level will persist, as the frustration of first time buyers is bending to the burning desire to own, rather than to rent property. I encourage you to come to your own conclusion on the direction of house prices. Those who have a negative outlook on house prices (many of whom can be found at HousePriceCrash.co.uk) are vocal, however wishing a price lower and actually causing the price to drop are completely different things. The demand for property, especially houses, has been higher than ever, whilst supply is as sluggish as ever – evidenced by behemoth house builder Taylor Wimpey’s visible move away from the ‘volume’ house building model.

Collective Investment Schemes

You may be surprised to hear that the number of ways in which you can gain exposure to property prices are vast.  This article will identify how to invest in property indirectly, and will detail the merits and drawbacks of each investing in property method. Purchasing a flat, piece of land or house is the first thing that comes to mind when we think of ‘property investment’, but there are many indirect routes to ownership which may be more affordable and lower risk. I will also mention taxation treatment in this article, as tax is a key difference between several of the methods. Tax information is by its nature subject to change, so please research and check that the treatment detailed below still applies and read our disclaimer.

Shares in Listed Property Companies

Listed property companies include construction firms, house builders, property developers and large landlords that are listed on the stock exchange. See ‘How to invest in shares‘ for a guide on share buying. Owning shares in a property developer will not be identical to owning a house, but these companies will generate higher profits when house prices rise, which will deliver higher dividends and/or capital growth. You may already hold shares in such companies already, but this can be multiplied through an investment in a real estate themed exchange traded fund (ETF).

Merits: Highly liquid and efficient. UK listed shares can be held in a tax-free ISA subject to annual limits.

Disadvantages: Not a pure play on property prices.

Property Unit Trusts & Investment Trusts

Unit trusts and investment trusts are popular with retail investors seeking exposure to a wide range of sectors and asset classes, and property is no different. You can find a rough list of property unit trusts here, on the website of ‘The Association of Real Estate Funds’.

Merits: Shared ownership in a diverse range of property, with the ability to buy and sell units quickly. Small minimum investment. Many are ISA compatible.

Disadvantages: Potentially high initial and annual management fees. (up to 5% and 2% respectively).

Property Authorised Investment Funds (PAIFs)

PAIFs are investment funds (similar to the above) but with special tax privileges over unit trusts. In return for meeting criteria set by HMRC, PAIFs incur no tax whatsoever within the fund, and pay the proceeds to investors net of basic rate tax, like bank account interest. This is slightly more efficient than unit trusts and OEICs because these have to pay corporation tax on elements of their internal profits, before distributing to investors.

Insurance Company Property Funds

Exposure to property can be gained through life assurance contracts such as unit-linked bonds. These investments sometimes tax free, but this comes with inflexibility (must be held for 7.5 years before encashment) and the mandatory life insurance element may be inappropriate for your situation. Holding an equivilent unit trust inside an ISA should deliver similar returns, similar tax allowances but with few penalties for withdrawal.

Merits: Potentially tax free if is a ‘qualifying policy’.

Disadvantages: These investments must be packaged with life insurance, which you may be expensive or unnecessary.

Real Estate Investment Trusts (REITs)

REITs are a fairly modern type of listed investment company. REITs have only been around since 2007, but offer benefits that have quickly made them popular with investors. The government has allowed these companies, which operate under extra rules, a taxation regime that almost replicates directly holding property yourself. The core business of REITs (letting) is protected from corporation tax, allowing the distribution of rent payments from their tennants to flow straight through to your dividend without being hit by extra taxes. If you hold the REIT in an ISA, your dividends will be received gross. Tax conditions are subject to change.

A REIT is a vehicle that should provide good levels of income and capital growth. This is because REITs are allowed to borrow to finance their holdings, resulting in a higher yield and they are forced to pay out 90% of the profits from their core business within one year, meaning a steady stream of dividends will be provided. This also means that if you do not hold a REIT within a tax wrapper such as in ISA or SIPP, you will pay income tax on this income.

REITs are listed on the stock exchange, and several feature within the FTSE100 including British Land plc and Land Securities plc.

Merits: Liquid, could provide similar returns to holding property yourself.

Disadvantages: Some investors do not wish to receive income for tax reasons. Capital gains-only REITs do not exist.

Direct Investment in Property

The ‘old fashioned’ method of investing in property is to get in touch with the ever-hated estate agent and purchase some investment property. This usually takes the form of a holiday home abroad or a flat/house to let in the UK. Naturally, house prices represent a large chunk of ones lifetime salary, so such purchases are usually made possible with buy-to-let mortgages.

Risks of Leverage

The use of mortgages on investment property is a curious phenomenon – because retail investors are heavily advised to not add leverage to any of their other asset classes. ‘Margin’ stockbroker accounts are only suitable for experience investors, (More on how to invest in shares) and leveraged commodities Exchange Traded Funds are widely considered to be dangerous and not suitable for long term investment. (More on how to invest in commodities). Adding leverage to a volatile investment further exagerates the gains and losses to the investor, and damages total returns in the long run, resulting in a high level of risk against reward.

Yet leveraged investment in property is the norm, not the exception.

Example: If John buys a house in cash for £300,000 which subsequently drops in value by £50,000, he has lost 1/6th of his investment. If he invested with a £30,000 investment and £270,000 mortgage, then the £50k fall in value would represent a 166% loss of his original investment. In this case, a relatively small market blip has left him owing more than he originally invested.

The use of mortgages for investment property reflects the almost risk-blind vision of property investment prior to the 2008 house price dip, which left many new investors in negative equity. The old attitude was that ‘house prices will always go up’, which eased even conservative investors into leveraged investments.

Extra Risk of Investing in Property Directly

Lack of diversification is the main issue here. The simple science of diversification, obtainable through  the collective investment schemes above, protects your investments from what is called ‘specific risk’. Specific risk is the risk that an event will occur which will either benefit or disadvantage your property, independent of all other properties. Examples of specific risks are; being unable to find enough tennants, having a house fire, incorrect surveys. Specific risks increase the volatility of your returns from a single property. The more properties you own, the more these ups and downs will smooth out to give you the market return – affected only by risks that affect the whole market.

In conclusion, I believe that property has a place in many well-rounded portfolios. Research more into the options above and see whether and of these options can fill a gap in your portfolio. If you’re not from the UK, you will probably find similar investment schemes with various tax advantages in your own country.

 

Simon OatesHow to Invest in Property