House prices in Britain have risen at an average annual rate at least 10 times higher than in other developed nations, such as Japan and Switzerland, and twice as fast as in the United States. The research by Policy Exchange, a Right-wing think-tank, shows that since 1970, prices have gone up by more than four per cent a year over inflation.
Property prices in Britain have risen for 13 successive years, and in the past decade the increase has been particularly steep. The price of an average home has risen from £70,000 when Labour came to power in 1997, to nearly £200,000 today. In the same period, the retail price index rose by only 30 per cent.
Should landlords sell & lock in gains
This all suggests on the face of it that a landlord should sell now and thereby lock in the capital gains they have made over the last few years on their residential buy-to-let investments.
However, a simple analysis of figures that show by how much the value of an asset has gone up doesn’t always give a clear indication that an asset is over valued. Any investor who has watched the rise in the price of gold in the last few years can verify that. Equally landlords who have watched the value of their property investments double in the early part of the Millennium only to watch them continue to spiral upwards in value all the way to the end of 2007 would have lost out on huge amounts of capital growth if they had taken such a view & sold.
An evaluation of the correct value of housing and residential property investment is far more complex than ‘prices have gone up a lot & therefore its time to sell’.
We as landlords really need to understand the factors that drive the value of residential investments and the housing market.
One key factor is affordability.
The fact remains that buy-to-let investing takes place in a housing market which is still dominated by homeowners. Therefore a key factor in setting a price for a property is its’ affordability, particularly by the vast majority of purchasers who are buying a property for owner occupation.
Traditionally, the key metric has been the multiple of average income to property value. Historically this has been about 3.5 times average household income; it now stands at over 6. Some economists argue that this measure is no longer relevant because of a paradigm shift downwards in long run interest rates, making higher multiples more sustainable.
In the 80s interest rates were for most part in or near double figures; in the 90s they probably averaged 6-7%. This is still high by current levels; particularly when the fact that mortgage margins have reduced i.e. the differential a borrower pays above the prevailing base rate. In the 90s it ranged between 1-2%; before the recent credit crunch this had shrunk to in some cases to zero reducing the real costs of a mortgage even further. Even today after the ‘credit crunch’ it is possible to get a lifetime tracker at 6.39% or 0.89% above the Bank of England base rate.
House price “Bulls”
What the housing ‘bulls’ (those individuals that still believe we are in a rising market) argue is that what is more relevant in judging housing affordability is the proportion of household income paid out each month on servicing housing debt. After all they argue, people don’t think of multiples or margins when judging whether they can afford a property.
Their first thoughts are how much it will cost per month and how much income they have got after tax and other vital household expenses. For an indication of this we can go to the statistics provided by the Council of Mortgage Lenders (CML). These stats make interesting reading. The good news for the ‘bulls’ is that the latest figures for interest payments as a percentage of median household income was 18.8% in November 07 which is well below the 27.1% reached in the first part of 1990 at the time of the house price crash of the early 90s.
However it should be remembered that this high rate was prompted by interest rates which reached 15%. What is important is that this rising figure is the highest since 1992 when the housing market was still languishing in the depths of the last housing depression. Whilst these figures are not conclusive on their own; it shows that by any measure the costs of servicing a housing debt are becoming an increasing constraint on future house price rises.
One measure which has always been popular with property investors is the gross yield.
For landlords with a good memory, they may be able to recall when gross yields on some investment properties were in double figures. It was also up until relatively recently that many landlords could secure a reasonable level of income from their residential investment properties. However, for many residential landlords those days have gone. Small rental increases have not been sufficient to keep pace with rising capital values and rising interest rates.
The result is that the last Association of Residential Letting Agents (ARLA) review showed that gross yields had fallen to less than 5% as a UK average. This falls to 4.6% when taking into account rental voids. If management charges are also taken off, then the net yield is likely to fall below 4%. All this means that many landlords now face a cash outflow, which will remain with them for a number of years whilst rents increase and / or interest rates fall.
Housing ‘fully valued’ so shouldn’t I sell?
In conclusion then it looks on the face of it that UK housing is fully valued. Therefore, shouldn’t a landlord sell up and lock in their profits now? The decision on whether to sell a buy-to-let investment property isn’t quite as straight forward as it might first seem for a landlord. For instance, here are 5 things to consider before a landlord puts their buy-to-let property up for sale:
1 There is the small case of capital gains tax (CGT)
The Chancellor is proposing a new tax regime with a 18% band for all. However, that is still near enough a fifth of any gains a landlord has made. If a landlord has held their property for 10 years or so this is going to be a fairly high percentage of the overall value of their asset, meaning that they will have considerably less assets to reinvest in any alternatives following a sale.
2. Selling a residential investment property is not cheap.
Where an estate agent is involved and including legal fees and the new Home Information Pack (HIP) a landlord is probably looking at a minimum of 1.5% of the value of their property and that could easily increase to 2.5 or 3% in certain cases such as investment properties in London.
3.On top of this a landlord who tries to sell their residential investment property is probably best selling their buy-to-let property with vacant possession i.e. without tenants.
By doing this a landlord’s residential investment property should also appeal to the almost 90% of the residential market that are owner occupiers. This means that their investment property is empty and no rent is received during the sale period. A situation that can be particularly painful for a landlord where they still have a mortgage in place because not only are they missing out on rental income but they are also having to pay out ‘dead money’ whilst the property is being marketed. Even worst, every property speculator come opportunist knows this and assumes that you the landlord is in trouble and has to sell up. Therefore and in particularly at the moment be prepared for silly offers unless you are the lucky owner of a ‘trophy asset’ property.
4. Many landlords also buy a residential property for security.
In a world of increasing family & relationship break ups, having an additional property should the worse happen is seen by many landlords as an insurance policy against themselves or a member of their family being homeless. In addition many landlords have invested considerable time and effort buying, refurbishing and setting up their buy-to-let investment so the outright sale of their buy-to-let investment property is a large step for many landlords to take.
5.The other dilemma for landlords is what to do with any investment funds released following the sale of their residential investment property.
Many landlords have been ‘stung’ by previous investments in other asset classes such as shares. Whist the short-term gains are potentially higher, these investments are far more volatile than investments in a physical asset such as a residential investment property. At the moment cash savings are attracting a good rate of interest in the order of 6%, however most experts predict interest rates to fall throughout 2008 which means that the base rate could be as low as 4.5% by the end of the year reducing significantly the returns on cash investments.
Long -term landlords
The reality for landlords is that it’s not easy to respond quickly to trends in the housing market. For instance to sell up now and then wait 12 months to buy on a low. For a start, on a cost basis, the transaction costs of buying and selling will probably amount to 5% of setting up an investment by the time estate agents fees, legal costs and stamp duty have been factored in. Then there are the practical issues and time of identifying a suitable residential investment property, agreeing the deal and then putting it into a lettable state, not to mention finding suitable tenants. This probably goes a long way to explaining why a recent survey by the Alliance & Leicester revealed that the average period that a landlord planned to hold their investment for was 18 years. This means that most landlords choose to take a long-term approach and thereby ‘ride out’ any short term weakness in the housing market.
Financial sustainability & opportunities
A key objective for landlords now should be to ensure that their residential investment portfolio is financially sustainable. Landlords should focus on their cash-flows and take a conservative view over future property price projections.
The very nature of a property market in a slump, which appears to be the likely outcome for the UK housing market in 2008 is that it will throw up potential residential investment opportunities. Distressed sellers, repossessed buy-to-let investment properties sold at auction all make potentially excellent investments if a landlord has done their research properly, does not over borrow & invests in a ‘cash cow’ using a traditional repayment mortgage. This way a landlord will be sheltered from any down turn in residential values, as the tenant will be paying for any costs associated with these investments. A repayment mortgage will deliver a constantly reducing loan amount that should protect a landlord’s equity even in times of small falls in residential property values.
Therefore, my thoughts are that landlords thinking of selling should think through their decision carefully and make sure they are comfortable that it is the right long-term decision for them. Equally, for some landlords they might want to see the current turmoil in the credit markets and slump in house prices as a long-term buying opportunity. One thing that we are sure about is that landlords can no longer bank on rapid gains in housing values that they may have become accustomed to over the last decade. Whether a landlord decides to buy or sell; they should make sure that their investment strategy adjusts to this ‘new reality’.
Chris Horne is an experienced landlord and property professional who now runs the website Property Hawk, a site aimed directly at UK Landlords. The site incorporates free property management software that enables landlords to track all their financial data relating to their portfolio. It allows users to print tenancy agreements and other forms FREE FOREVER. The site generates a real time rent book for each property as well as calculating a landlords tax liabilty. The service is totally free to use at propertyhawk.co.ukShare on Facebook