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publication date: Feb 25, 2012
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Residential property has made some people fortunes – and it’s bankrupted others – since the credit crunch. While many invested in property believing ‘bricks and mortar’ were safer than the stock market, that’s not necessarily been the case.

Although buy to let property, and overseas properties in particular, are now increasingly sold on the basis of rental yields, residential property is still not as well researched as commercial property and other asset classes. Newspapers and financial web sites devote pages to discussing house prices - but there is rarely any discussion of total returns, or rental yields, making it difficult to compare with other assets.

So how does residential property compare with, say, quoted shares, or warehouses, or cash?

With base rates stuck at half a per cent, you might think ‘houses versus cash’ is an open and shut case. However, investors can get much better returns on their cash balances by looking for a good fixed term account. Currently, the best five-year fixes are returning as much as 4.7 per cent, while IPD, the property research house, says residential rentals are yielding 3.4 per cent. And with cash, there is no possibility that the nominal value of the deposit will fall – whereas house prices might. Equally, of course, house prices might go up, in which case the total return on property would probably equal or surpass cash. But no one is forecasting more than a two per cent rise in house prices next year, so it seems unlikely that this will make a huge difference.

By the way, one interesting feature of the current interest rate environment is that Libor, the rate at which banks borrow from each other, has historically tended to be set at about 20 basis points above the base rate. Since the credit crunch, though, it’s been much higher – in December 2011 it stood at 1.07 per cent, or 57 basis points above base rate, nearly three times the historical average. That may sound pretty technical, but what it means is that banks think the Bank of England’s base rate is too low. They think there is substantially more risk in the market than half a per cent suggests.

Overseas resi investment
Overseas residential property might represent, in some cases, a much more attractive proposition than UK buy to let. Several markets are offering much higher yields; for instance in Dubai 12-13 per cent is achievable, while many US markets offer substantial income returns. Atlanta and Detroit, with government-backed rental markets, offer strong yield together with recovery potential. 

High yield commercial
UK commercial property offers much higher yields. On some recent corporate transactions, initial yields of 12 and even16 per cent have been reported; the average is lower, but even so is nearly double the income return on residential at 6.2 per cent against 3.4 per cent (annual, to June 2011). While industrial properties offer a slight edge, with seven per cent yield, all three major classes of commercial property trade around the same level. However, investors have been looking beyond those three classes to improve their yield. IPD noted in its mid-year report that the ‘other’ segment of property, which includes healthcare properties, student accommodation, and hotels, has seen increased investment recently – more than either regional or City offices. IPD believes this reflects investors’ decision to diversify their portfolios; these are also high yielding sectors, though, so it’s also likely that investors are chasing higher returns. (Healthcare has also been an attractive property sector for stock market investors seeking yield, with Primary Health Properties, for instance, yielding 5.7 per cent; its share price has fallen marginally this year, a much better performance than the market.)

The comparison against shares is even more difficult to make than against commercial property. One way to assess value is to look at the dividend yield on shares, which currently stands at around 3.6 per cent for the FTSE 100 top shares index, bang in line with 40 year average dividend yield on the FTSE All Share Index, as it happens.

However yield is a dynamic figure. At the start of the credit crunch, many companies cut their dividends as they simply couldn’t afford to pay. Banks were affected by the economic environment, while BP was forced to shelve its dividend after the Deepwater Horizon disaster. In the past twelve months, though, equity dividends on the FTSE 100 have risen 9.7 per cent. That’s comparable to residential rents, which have also risen over the past year. LSL Property Services says residential rents have risen 3.5 per cent year-on-year to November 2011, though that’s a deceleration from earlier, higher levels.

Compared to that, commercial rents have been weak, particularly outside London. IPD says that High Street retail, outside South-East England, has seen a 10.6 per cent fall in rents. Even though many leases retain the condition of upwards-only rent reviews, with a high rate of insolvencies, there’s a certain amount of portfolio churn, and new tenants appear to be paying lower rents as well as, in many cases, getting initial rent-free periods and other sweeteners.

Rentright, which produces a rental property index, says average rents in England have risen from £1186 a month in November 2010 to £1414 in November 2011 – a 16 per cent increase. That beats other investments hands down over the year, though rental prices did slacken in December 2011.

While in theory the value of an investment is the net present value of its income stream – that is, it should be valued purely on income – capital growth is responsible for an important part of the total return to the investor. That’s where IPD’s figures are useful in setting residential property in context.

Its 2010 residential index (the most recent full research available) shows that though residential lets underperformed commercial properties on income return, returning only 2.8 per cent against 6.4 per cent, in total returns terms they have been better performers over both the last three, and last ten years.

The beauty of bonds
Over the last three years, equities have marginally outperformed. But the stand-out performer was bonds, as economic recovery lowered the risk of default, and yields shrank to record lows. For that very reason, bonds cannot possibly match that performance over the next couple of years; and yield investors should note
that not only is the yield from investment grade bonds now very low, their capital remains at risk (which is not the case with cash deposits).

Only double-B bonds and worse credits (double-B is the best rating of junk bond) still show more than respectable yields; 7.3 per cent for double-B and 10 percent for the junk bond class as a whole. Meanwhile, yields on UK ten-year gilts (government bonds) are below two per cent. 

Beating inflation
What hasn’t been mentioned so far in this article is inflation. Though investors who have had their fingers burned in property or the stock market may prefer to hold their wealth in cash, where the capital
value isn’t at risk, inflation is gradually destroying the value of their money. Despite recent falls, inflation is still nearly five per cent, so even on the best fixed rate, investors are seeing a 0.3 per cent fall in the purchasing power of their savings – and that’s before tax.

Residential property investment, on the other hand, narrowly beats inflation if you take LSL Property Services’ latest figure for yield of 5.3 per cent. Though with average prices falling this year, the total return will be lower than that.

Of course the difficulty with looking at total return is that we’re back at the beginning of a circular argument, trying to predict house price rises for 2012. But at least, along the way, we have a richer idea of exactly how the return on residential property is made up, and how it compares to other assets.

Student schemes
Just as commercial property has seen investors targeting non-mainstream properties in search of better yields, residential property has seen increased interest in non-standard accommodation such as student halls of residence and hotel properties. Let’s leave aside bamboo and other eco-investments, which are also proving popular with sophisticated retail investors.

Yields for student accommodation are typically higher than for other residential property, starting at six per cent and with some schemes offering yields as high as 9-10 per cent on purpose-built accommodation. A number of funds specialising in student accommodation have also been set up, for sale through IFAs, some of them targeting returns in excess of 12 per cent per year. 

A bed for the night?
Hotel properties are also popular with institutional investors, and an increasing number of schemes are being offered to make hotel properties available to the retail investor. Yields of six to 10 per cent are quoted, though initial yield is generally lower; it takes some time to build up occupancy levels and improve rack rates.

Property Frontiers is now offering investment in the 204-room Holiday Inn Express at London Excel. Ray Withers of Property Frontiers says the London hotel market is expected to show double-digit growth for 2011, and this property allows investors to gain affordable entry to the market. The yield should grow to 10.5 per cent by year five, with a £125,000 in-price.

Some earlier hotel room schemes foundered on the lack of a resale market. To address this, the Holiday Express investment includes a buyback scheme.

It’s also managed by Holiday Inn, a major global name, rather than being a one-off hotel brand.
Assetz also offers hotel properties; currently, a Cape Verde hotel scheme with a seven per cent fixed income over the first ten years. Unlike residential property, Assetz points out, hotel room investments are fully SIPPable, as long as there is no personal use element. That may make such properties popular with IFAs hoping to find tax efficient investments for their clients. 

The known-unknowns 
However with all properties, and particularly overseas properties, interest rates and currency movements remain, as Donald Rumsfeld would say, “known unknowns” – there are many and widely conflicting opinions on what is likely to happen next.

UK interest rates, for instance, have remained at all-time historical lows for nearly three years now, something no one expected when the rate was reduced to 0.5 per cent back in March 2009. That has certainly helped property owners, by keeping mortgage rates low. Whereas at the peak of the boom, many new buy-to-let landlords were subsidising their properties, with mortgage rates at six or seven per cent and rental yields at only three or four per cent, now the gap between residential yields and buy-to-let mortgage costs has closed up.

But what is likely to happen to interest rates in future? Currently, the slackening of inflation together with low economic growth mean that most economists don’t expect rates to rise in 2012, and some are forecasting low rates till 2014 or 2015.

However, complacency could be misplaced. It’s evident that a large number of homeowners are in financial difficulty; figures from the Council of Mortgage Lenders show 827,000 households in negative equity, or eight per cent – that’s almost exactly the same level as the CML’s expectation for total housing market transactions next year – while 166,000 mortgages are in arrears by more than 2.5 per cent of the outstanding balance. That figure is expected to increase by more than eight per cent next year.

Banks and building societies have already been ratcheting up their mortgage rates over the last few months; so even with stable base rates, it’s possible we could see mortgage rates increase, and that will put the squeeze on financially-challenged owners.

The challenge of Europe
The biggest challenge, though, remains Europe. The difficulties of solving peripheral nations’ debt problems while retaining the Euro have created a highly volatile environment. If the euro does collapse, or one of the peripheral nations defaults, there will be a knock-on impact on the UK market and we’ll almost certainly see a second credit crunch – in which case, all bets are off.

So far, the euro has been muddling through, and it could continue to do so. But currency will continue to be a major consideration for buyers of overseas property – more so now than ever before, as even strong currencies such as the Japanese yen and Swiss franc have devalued.

Currency fears have certainly led to many buyers steering clear of the Greek market. If Greece does leave the euro, the successor currency will certainly devalue and that could wipe 40 per cent or more off the sterling value of a property overnight. For borrowers with euro-denominated mortgages, devaluation
could leave them heavily in negative equity. Even French property, long a favourite with British buyers, could be a poor investment if the euro suffers.

Of course, one man’s euro fear is another man’s opportunity. Smart Currency Exchange has seen an increase in buyers looking for money transfers to buy in France. As the euro has fallen against sterling, French properties have become attractively priced.

None of these figures give a hard and fast answer whether this is the right time to invest in residential property. But at least, it appears to bear the comparison with other asset classes over the long term – which says that while most of us will be buying a home to live in, it’s still perfectly appropriate as an investment, too.



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PROPERTYdrum Magazine May2012