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An introduction to property

Property is one of the four most common types of investment alongside cash, bonds and shares, and is the world’s third-largest asset class after bonds and equities. But what is it about property that makes it so popular?

In this investment briefing we take a closer look at the asset class, its benefits and risks, and the ways in which customers can invest.

Why do people invest in property?

Property is often said to combine bond-like income with equity-like capital returns and on the whole its long-term performance lies somewhere between these two asset classes. The income comes from the rents paid by tenants, while the potential for capital returns comes from increases in a property’s value.

When we think of renting property we immediately think of buy-to-let residential tenants on leases of between six and twelve months.

But in the commercial world leases are much longer: the average across the UK is eight years, while tenancies in London can be up to 15 years.

This provides regular long-term income, and one with built-in annual increases that have the potential to protect against inflation.

A key benefit of property is its ability to diversify a portfolio and smooth total returns. Property values move independently of other asset classes and aren't typically affected by what's going on in the stock markets.

However, property returns are very closely linked to the domestic economy.

  • When the economy is doing well, there is an increased need for both residential and commercial properties.
  • Competition for prime office space (for example) allows landlords to demand higher rents, and this in turn makes the property more valuable providing the potential for capital gains.
  • Conversely, when the economy is doing badly, tenants can become bankrupt or decide to down size, and this can lead to falling rents and declining property values.

Risks of investing in property

Like all other forms of investing, property prices and demand for rentals can go down as well as up, and you might get back less than you invested.

Property valuations are the opinion of the valuer and properties tend to be revalued at infrequent intervals. For this reason, sale values may be different to the opinions relied on for regular reporting purposes.

Properties – especially commercial properties – can take a long time to sell and it may be difficult to convert your investment to cash quickly.

For these reasons property investments should only be considered by investors with a ten-year time horizon or longer.

Technological advances are creating significant changes to how we interact with the world and with each other, and can make some types of property obsolete.

  • Online shopping has decimated bricks-and-mortar retailing, but has made some types of warehousing facilities more desirable.
  • Remote working can allow companies to operate from smaller premises.
  • On-site 3-D printing may make large-scale component manufacturing and warehousing unnecessary.

Routes to investing in property

There are several ways customers can gain exposure to the property asset class.

  • Buying an investment property
  • Real estate investment trusts
  • Property investment trusts
  • Property unit trusts and open-ended investment companies
  • Investment property funds
  • Land banking schemes

Direct property investing

In recent years there has been an increased interest in the buy-to-let market either on a long-term basis or as holiday lets.

However, this is very capital intensive. The price of a property can exceed many people’s entire savings including their pension savings. Unless they are very wealthy most people can only afford one property outright: the financial equivalent of putting all their eggs in one basket.

Doubling down: the power of borrowing

But investing in property gives you access to one tool that is not readily available to individuals investing in stocks or bonds: leverage. This is borrowing money to invest with the aim of making a higher return than the costs of servicing the loan.

If you want to buy a stock, you have to pay its full value up front when you place the order. But by using financing you can “own” and control a property the minute the contracts complete whilst committing a fraction of the total value up front (the deposit).

If you decide to apply for a buy-to-let mortgage, you'll need a much higher deposit – up to 40% of the value of the property – and lenders may require a rental income that’s around 125% of your monthly mortgage repayments. You can also expect to pay higher interest rates because there's greater risk to the lender. Set-up fees can also be more expensive.

But using the financing route has emboldened some private landlords to take out a second mortgage on their personal homes to use as a deposit on two or three other properties.

Risks of direct property investing

Buy-to-let investing is very different to owning your own home. When you become a landlord, you’re effectively running a small business – one with important legal responsibilities.

There will also be running and maintenance costs. A letting agent can do all the heavy lifting when it comes to vetting potential tenants and fielding phone calls, and can ensure robust contracts are in place, but they charge a fee for providing these services. Major repairs or difficult tenants might increase your costs – and trouble – unexpectedly.

The income received will need to be declared on your annual tax returns although you can offset mortgage interest payments and some costs against this.

  • higher and additional rates of tax relief are being phased out and will be restricted to 20% for all landlords by April 2020.

If you make a profit when you sell your buy-to-let property, you’ll be liable to pay Capital Gains Tax, although some capital investments can be offset against any gains.

Buying and selling costs are high compared to other forms of investing with estate agent and surveyor fees, stamp duty, land tax, and solicitors’ and conveyancing fees to consider. From 1 April 2016, second homes and buy-to-let properties have attracted an extra 3% on top of the appropriate Stamp Duty band.

Selling a property can take a long time if demand for properties is low. And whilst having a sitting tenant can be a bonus for another property investor, it can put off people looking to buy a home for themselves.

And keep in mind that if using a mortgage or other financing to invest in property, this can come with additional, sometimes significant, risks:

  • If your property remains empty for a long period you will need to meet repayments from other sources of income or from your savings.
  • In extreme cases your property – even your home – could be repossessed.
  • Mortgage interest payments may rise faster than rents, especially if there is an over-supply of properties in your area.
  • If you need to sell the property at a loss, you might not be able to pay off the mortgage. You would need to make up the difference and could be pursued through the courts for redress.
  • Repeated re-mortgaging can have an effect on your credit score. This can influence all future borrowing (not just mortgages) and the rate of interest a lender is likely to offer.

Limited opportunities

Private landlord investments are generally limited to residential property. Commercial properties can command huge rental incomes but cost millions of pounds to purchase or build and, in most cases, they're impossible for smaller investors to buy outright.

Even re-mortgaging your home may not raise sufficient capital to use as a deposit for a commercial property and most mortgage companies would not allow this activity.

Indirect property investments

To gain diversified exposure to commercial property, most of us will have to turn to specialist investment funds. Common examples of these are:

  • Real estate investment trusts (REITs)
  • Property investment trusts
  • Property unit trusts and open-ended investment companies (OEICs)

Real estate investment trusts (REITs) make up the vast majority of these vehicles. They are listed companies whose core business is commercial real estate where long-term leases provide regular income.

You invest by buying shares in the REIT and these can be held within an ISA. It is important to distinguish between equity REITs (EREITs, which own buildings) and mortgage REITs (MREITs, which provide property financing).

EREITs have a special tax treatment that makes them similar to direct property investing. Each EREIT comprises:

  • a ring-fenced property letting business which is exempt from corporation tax,
  • non-ring-fenced activities like property management services which are not exempt from corporation tax.

Provided the EREIT distributes 90% of the income it receives, payments from the tax-exempt element are treated as UK property income for the investor and are paid net of basic rate tax; ISA investors receive payments gross of tax and non-taxpayers can re-claim the tax deducted.

Payments from the non-exempt element are treated the same as any UK dividend and are paid with a tax credit. Because EREITs pays less corporation tax they have the potential to return more profit to investors.

However, REITs are not subject to direct supervision by the Financial Conduct Authority (FCA). If you invest in a REIT, you will not be able to go to the Financial Ombudsman Service to make a complaint or claim compensation from the Financial Services Compensation Scheme (FSCS) if the company goes bust.

Property investment trusts are also listed on a stock exchange and are companies that own, develop and manage properties on behalf of shareholders.

They are similar to REITs but lack the tax benefits. Tax on dividends from the 2018-19 tax year is 7.5% for basic-rate taxpayers on any dividends over £5,000. This increases to 32.5% and 38.1% for higher and additional-rate taxpayers respectively. Again you invest by buying shares in the company and they can be held in an ISA.

Property investment trusts are also not subject to direct supervision by the FCA so you can’t go to the Financial Ombudsman Service to make a complaint nor claim compensation from the FSCS if the company fails.

Property unit trusts and open-ended investment companies (OEICs) also pool investors’ assets to buy and manage properties. Again, units can be held in an ISA. They are traditional mutual fund structures and therefore fall under supervision by the FCA, and investors can seek compensation from the FSCS if things go awry.

The main difference between investment trusts and unit trusts/OEICs, is in the former’s ability to use leverage (borrowed money) to boost the amount they can invest over and above that received from selling shares in the fund. While this can enhance gains in a rising market, it can magnify losses if returns fall.

Risks of indirect property investing

As well as the general risks outlined in the preceding sections, if a fund invests in overseas properties, currency movements can have a significant impact on returns. If they are in emerging markets, they may be subject to additional risks including lack or loss of private ownership rights.

Fund managers charge fees for their services, which can reduce potential earnings.

Beware of the lock-in

While it can feel like it takes a long time to sell a residential property, it can take a really long time to sell a commercial property. This is because there are fewer buyers and sellers.

And in times of economic or political crisis, investors can find themselves unable to redeem their shares (they are said to be ‘locked in’). This is because property funds can halt redemptions for investors wanting to exit if there are "exceptional circumstances." This aims to prevent a forced ‘fire sale’ where properties are sold at rock-bottom prices to release cash.

This happened in the aftermath of the Great Financial Crisis of 2007/08. As values plummeted, fund managers found it increasingly difficult to achieve the prices they needed to meet redemption requests.

Under FCA rules, property funds can suspend trading for 28 days while they try to raise funds by selling properties. This 28-day period can be reapplied until enough capital has been raised, and during the financial crisis of 2007/08, some lock-ins lasted up to 12 months.

The pros and cons of property investments

✔ Property can provide a regular income stream with the potential to increase faster than the rate of inflation.

✔ Property can provide long-term capital returns.

✔ Property returns are independent of equity and bond markets so have the potential to diversify a portfolio.

✔ Property can smooth out total portfolio returns

✘ Demand for property is closely linked to the health of the economy.

✘ Property values can only be certain at the point of sale; all other valuations are subject to personal opinion.

✘ Property can be difficult to sell and you might not realise the full value of your investment at short notice.

✘ Property prices and demand for rentals can go down as well as up, and you might get back less than you originally invested.

Other ways to gain exposure to property

Indirect property funds are unit trusts or OEICs that invest in the shares of property companies listed on the stock market such as house builders or commercial property managers. Units can be held in an ISA and the funds are generally regulated and authorised by the FCA.

Returns are gained like any other investment in shares, through share-price appreciation and dividend income, rather than directly through property price increases and rental income.  Because these funds invest in shares listed on the stock exchange (which trade on a daily basis) they don’t have the potential liquidity problems of direct commercial property funds.

However, they do not have the quite the same diversification benefits as investing in direct property funds as the shares can move up and down in line with stock markets.

  • You can also invest directly in these stocks yourself if you feel confident in your ability to pick good companies.

In land banking schemes you buy a plot of land (either individually or collectively) in an area that has not been given permission for development but on the expectation that planning permission is likely to be granted in the near future; the value of the land will then jump and can be sold at a profit. These are the claims.

However, these schemes are very high risk and there is a history of scams being perpetrated on the unsuspecting public. Often, the land can’t be developed because it’s protected or has high levels of industrial pollution.

Most land banking schemes are not authorised by the FCA and are not subject to any rules or regulations on the fair treatment of customers or the handling of clients’ money. If things go wrong you can’t go to the Financial Ombudsman Service to make a complaint or claim compensation from the FSCS.

If a land banking investment scheme claims to be structured as a collective or pooled investment, it must be registered with the FCA so check this, too. The shares are eligible ISA investments.

Conclusion

Property can play an important role in a diversified portfolio.

  • It can provide regular and increasing income streams with the potential for long-term capital returns.
  • It can also reduce risk at the portfolio level as its returns move independently of the other major asset classes.

It is why we include it in our discretionary models.

But property should be considered in the context of your total investment portfolio as it can leave you highly exposed to a single investment.

We believe that the property element of your investment portfolio should also be diversified so the use of select unitised vehicles managed by specialist portfolio managers is our preferred option.

Building your own property portfolio requires not only a significant monetary commitment but also the time to research the market and manage the physical assets.

As always, we recommend customers take professional advice before considering investing in property.

Important Information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise. No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions. Any views expressed within this report are our in house views as at April 2019 and should not be relied upon as fact and could be proved wrong. The information contained in this document has been derived from sources which we consider to be reasonable and appropriate. This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

Lloyds Bank plc. Registered Office: 25 Gresham Street, London EC2V 7HN. Registered in England and Wales, number 2065. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority under number 119278.

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