Are you wondering what proportion of your investment portfolio should be invested in brick and mortar assets such as residential and commercial property?
If you’re interested in property asset allocation – this article is a great place to start.
Buyers often find themselves in a quandary regarding property allocation; in part due to the high prices of properties in the UK.
The average price of a home in Britain ha soared over the last decade to £230,000 (2019), the deposit required to buy an ‘average home’ has risen to £33,000.
Buy-to-let investors, who are offered smaller mortgages than home-buyers, have found that they need to commit an ever-increasing chunk of their savings to acquire a single property.
This can be an uncomfortably large amount, leading to questions around what is the reasonable maximum amount we should invest in our first home?
Covering the property & portfolio basics:
This is a companion article to our ‘How to invest in property‘ article. That article sets out a diverse range of ways in which you can invest in properties.
Property is just one of several common assets classes which investors use to construct an investment portfolio for beginners. Other asset classes include cash, bonds, equities and alternatives.
Check out the article above to gain an understanding of the fundamental principles you should already know before continuing with this article. I assume quite a bit of knowledge about that content below.
Property could be an excellent fit for your portfolio if you believe that you have a risk profile of ‘Balanced’ or ‘Adventurous’. If you aren’t sure of your risk profile, you can start exploring it by completing my investment risk appetite questionnaire.
Property is only a feasible option for investors who can comfortable comit their funds for five years or more.
What percentage of your investment portfolio should be property?
In our guide to building a stocks and shares portfolio, we outline a few illustrative asset allocation strategies.
Our illustrations (which are exactly that, not a replacement for professional financial advice) suggest different levels of investment depending on your investment risk appetite:
- 0 – 7.5% for a cautious investor
- 0 – 10% for a balanced investor
- 15 – 20% for an adventurous investor
You might be initially surprised at these allocations. Are you wondering why they’re so low? For the rest of this article, I’ll explain my thoughts.
The answer is because property isn’t the highest performing asset class. (No really!). Despite what you’ve read about staggering property prices, the property asset class isn’t actually the most lucrative.
Equities (i.e. stocks and shares) have a greater compound rate of return, and therefore attract a greater share in any investment portfolio.
Why property isn’t the most lucrative asset class for a portfolio
A property is a relatively static investment – it’s capacity to generate income doesn’t naturally increase. An investor is, therefore, relying upon tenants or house buyers being willing to pay more for the same benefit in the future. The same applies when considering an investment in land.
While businesses hold back some of their profits to scale up their factories, launch new products and find overseas markets, a 3 bed detached house will remain a 3-bed offering without further investment.
It’s true that property returns in the last decade have been high. But this has been underpinned by:
- A low starting point – property prices fell by 16% in 2008 which set the scene for a rebound.
- Interest rates have remained at historic lows, providing mortgage seekers with abnormally large piles of cash to buy property.
- The UK has experienced a wave of inward investment to acquire property as an investment.
Investors cannot assume that all three factors will continue to support house price growth indefinitely.
Property isn’t a safe investment, but it isn’t the riskiest either. Therefore investors cannot expect to receive the highest return for owning it.
The diversification problem of property investment
Direct property investments have a high minimum investment (the full property price, or at least a deposit. As a result, property investments tend to be poorly diversified compared to investing in the stock market.
Given a higher allocation (and therefore more cash to spend), you could improve this slightly. But you’re unlikely to achieve the ideal target diversification of 20 individual assets unless you’re a multi-millionaire.
Therefore, having a large allocation to property will probably mean your entire portfolio will be very exposed to just a handful of individual assets.
In our article about the right amount to invest in a first-time home, we listed many external factors which influence the valuation of an individual house. These range from Ofsted inspections to noisy neighbours. Do you really want your portfolio to be held host to factors like these which you have little control over?
Many property investments are made with assistance from a buy-to-let mortgage. Investors like to use debt as leverage as it allows them to purchase a larger property than if they had to pay with cash in full.
A leveraged property portfolio will provide enhanced returns when property prices rise, but it will exaggerate any downward movements too.
As investors increase their asset allocation to property – buy-to-let mortgage debt will accumulate. This can lead to portfolios with £2m in properties, funded by £1.5m of mortgage debt and £500k of equity.
If property prices were to fall by 16% as they did during the financial crisis of 2008, the assets would shrink to become £1.7m property portfolio. Unfortunately for landlords, debt doesn’t shrink alongside a property portfolio. With debt unchanged at £1.5m, the investor’s underlying residual assets has fallen to £200k.
That’s a 60% reduction in the investment, caused by a 16% fall in prices.
This is the type of volatility sometimes experienced by a debt-heavy investment portfolio geared towards property.