We have been looking at various investing opportunities over the past few months and the one that continuously rears its head is real estate. The dream of seeing £1000’s a month of completely passive income is very persuasive and has led many people into this field.
There are two areas of real estate and two ways of profiting. You can divide real estate into residential and commercial.
In the recent financial shenanigans, commercial property has taken a serious nose-dive. In some areas, shops are boarded up – not so perhaps in leafy Surrey but certainly true in other parts of the country as well as over the pond in what is now sadly called the Rust Belt.
When businesses close, they die and no longer need premises. As the economy changes to online, fewer premises are needed anyway so even a recovery does not mean a return to health for commercial property. The future is not rosy for commercial real estate. Leave it out.
On the other hand, the former employees of the defunct businesses don’t die and will hopefully find new employment. So they still need a place to live, as will the rest of the population, employed or otherwise.
So residential it is.
In the past, people made a good income out of renovation for resale and the TV companies have feasted heavily on this diet. But that depended on a booming property market and a tame builder. When house price inflation was 10-20% a year (remember those days?), buying a run-down house and doing it up for sale meant that profit was assured, even though quite a lot of work was required. In fact, other than selling your own home and moving down market, this was the only way to profit from real estate inflation.
But this market has been killed by flat or falling house prices in the UK – except London – and as lack of housing is one of the major problems of our economy, I hope (without holding my breath) that by building the requiredstarter housing we will not return to those unhealthy days. Low but positive house price inflation helps preserve the value of your investment, but the sort of inflation we have seen particularly since the mid 80s has been unhealthy and we are paying the price for this now.
The last approach must therefore be letting property out – a business that has become very popular in the UK and one that frequently features on personal finance blogs as a way of building passive income. So let’s look at this.
The owners who are really cleaning up are those who already have substantial portfolios, possibly with no mortgages yet market rents reflect the current property prices. But we cannot turn the clock back and, individually, we are where we are. So let’s look at some figures.
Where do you look and what difficulties are there? What return on investment can you expect?
- A typical Manchester rental property is currently £102,000 which should yield a rent of perhaps £650 a month – a ROI of about 7.6%.
- Southampton currently gives the best yield of about 7.8%.
- London, due to its high house prices, the yields are rather more modest at 4-6%.
The proportion of privately rented households is still growing strongly as people are not able to find the deposits to buy even though average house prices are still about 10% lower than the peak of 2007. In fact the UK housing market has been very resilient these past few years despite predictions of doom and gloom – fundamentally we do not build enough houses yet the population is growing. So it is unlikly to fall that much further (other than in black spots) and now is the time to get into it.
When buying a property (or two…) to let, there are a number of gotchas. For any new entrant, it is likely that some finance will be needed.
Mortgages are not too easy to get these days but:
- What deposit do you have?
- Do you want a repayment or an interest only mortgage?
- Is there an upfront fee (which can be substantial)?
From this you can work out how much rent to charge at least to cover the mortgage payments.
Add all the other costs of renting out property:
- Landlord insurance;
- Allowance for time between tenants;
- The government’s slices –
- stamp duty (for houses over £125k),
- income tax against which you can set interest payments – as well as other costs of running the business – are tax-deductible but not capital repayments (which is why interest-only mortgages are popular in buy-to-let)
- capital gains tax over £10,600
- inheritance tax on assets over £325k (£650k for a couple).
All this is a daunting prospect for someone starting out on the passive income property ladder. Of course there is no guarantee in life but it does seem that, perhaps boosted by the Help to Buy programme, UK house prices have effectively bottomed out and that means that over the next years you will stand not only to make rental income but also some capital appreciation as well.
Before you sign on the bottom line though, remember what your aim is – steady income. So here are a few more questions:
- Is the property is in a healthy area which is likely to grow?
- Are services like transport assured?
- Is the property is easily saleable?
- Is it unlikely to be flooded or fall into the sea?
- What sort of tenant are you looking for – family, young professional, student, vacation, retired, short term, long term?
- Is this sort of tenant likely to remain plentiful?
- Recent cuts and restrictions in state benefits may put a damper on potential rent so what are the employment (prospects) of tenants?
- Consider property overseas if you like but of course there are legal and other issues there – many have been burned by investing in the Spanish property market.
As with all investment strategies, you need to think in the long term. And don’t forget that when you borrow money to invest – be it in property or stocks and shares – you increase your risk as well as increasing the potential profit you may make at the end of the day.
We aim to make a substantial sum of money over the next 5 years and clearly the returns on investment from real estate will not meet this need. But once we have achieved our target, we will consider the potential long term income from real estate and will look carefully at these questions again.