Investment property is real-estate that you buy in order to earn a financial return. It can be residential, commercial, retail or industrial. Importantly, it is not to be confused with your personal home or holiday homes.
Investment properties are business deals – all that matters is financial return. Homes, on the other hand, involve emotions, convenience, personal preferences, and so on.
How can it be acquired?
Most simply, investment property can be acquired directly, you acquire an entire property that is for sale, and own it directly. You might need to borrow money and raise mortgage financing to be able to do this.
Alternatively, investment property can be acquired through trusts or funds that pool the money of several investors to acquire one property or many properties. These trusts can be privately held or listed, and in some cases are exempt from corporate income-taxes in order to be equivalent, from the perspective of institutional investors, to direct ownership of property. This exemption is usually subject to requirements such as paying out almost all the funds’ income as dividends. This is the case for American REITs – Real Estate Investment Trusts for example.
Direct investment poses a challenge for individuals: the sheer size of investments. While properties in secondary UK markets can be bought for £100,000, the price of an average home in London is £500,000, and non-residential property can easily be in the millions, outside the reach of all but the wealthiest individuals.
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Furthermore, even for relatively small residential properties, individuals must consider two issues. First is that the property will probably be a large portion of their overall net worth, and, as a large, undiversified, and illiquid investment, it runs counter to the financial principle of diversification. Second is that buying the property often involves mortgage financing, which brings with it risks associated to interest rate fluctuations and meeting the mortgage payments in adverse situations.
On the other hand, direct property ownership is a way for individuals to own tangible assets, and, precisely because of its illiquidity and risk concentration, one of the markets that allows individuals to obtain high returns, if they make successful investments.
Liquid real-estate investments allow access to much larger and more diversified pools of real-estate such as prime office buildings or many hundreds of residential units but because they can easily be bought and sold by institutional investors such as pension funds, endowments and so on, their prices and returns tend to fluctuate in line with stock and bond markets.
What are the benefits of buy to let property?
As mentioned above, investment property allows investors to put their funds into tangible assets that they can see and touch, which is comforting for some. And because every piece of property is different and the market is somewhat illiquid, it raises the possibility of individuals making above-market returns, in contrast to liquid financial markets such as those for stocks, in which it is very hard for an individual to consistently do better than average.
In terms of risk and return, historically real estate prices have kept up with inflation, providing a hedge, whereas bonds have their real returns hurt by inflation.
For those willing to undertake the risks, investment property is also the asset class available to individuals that most allows for leverage, in the form of mortgages. Property owners take out mortgages for very long terms (25-30 years) and, by and large, as long as they meet their payments, don’t have to worry too about short-term price fluctuations.
What are the risks involved?
The biggest and most common mistake in property investment results from not seriously considering the possibility that prices might go down, as well as up. Together with heavily mortgage financed investments, that was the cause of the real-estate driven financial crisis of 2008. It should be clear that property is a long-term investment.
It is essential that you take this scenario into account when investing. Are you comfortable with the risk of prices falling significantly, meaning that you have to hold the asset for several years in order to make back your initial investment?
Find out more: Download our Investment Property Guide.
Another risk is that of mortgage financing.
When you mortgage property, you are committing to the mortgage payment in order to finance rental revenue that is not completely fixed it is subject to the risk of vacancy. So when investing in property, it is essential to consider the risk that it becomes vacant, and how long you would be able to sustain mortgage payments on a vacant property, meaning you’d have to put in your own capital. If you do not meet the payments, in addition to harming your credit ratings, the resulting foreclosure would result in a fire-sale of your property, which could wipe out the part of the property that you own, net of the mortgage.
A second risk related to mortgages is interest rate risk. If a mortgage has a fixed interest rate all the way to maturity, you know right from the start exactly how much you have to pay each month. However, if your mortgage has tracker rates, when interest rates rise, your payments will also rise. Benchmark rates are currently very low by historical standards, so it is not realistic to assume that they will remain at current rates forever – eventually they are likely to rise. If you take out mortgages with tracker rates, make sure that even if benchmark rates return to historical averages over the life of the mortgage, you will be able to meet your payments.
In addition to these main risks, there are a few secondary risks when investing in property, such as taxes. Because governments tend to promote homeownership, they offer tax incentives such as capital gains exemptions for certain property purchases (for your personal home, in the UK) and allowing mortgage-interest to be deducted from income tax. However, in the face of rising property prices and investors building up multi-property portfolios, governments have been known to change these taxes. Notably, in 2015, the UK government imposed additional stamp-duty on buy-to-let properties. These tax changes can mean you are hit with an expense that you did not plan for, and can also reduce demand for your property, hurting prices.
Location-specific zoning changes or public works. Governments periodically change zoning restrictions, which can benefit some areas and hurt others. They also sometimes have to expropriate properties to build public works such as roads. The compensation payment does not always cover the full market price. Alternatively, ‘undesirable’ public projects such as power plants or prisons can hurt the values of nearby property.
Understand the markets before buying a property
UK Market
The UK market can essentially be grouped in 3 kinds of markets: London, the Southeast and secondary cities.
As the largest city in Europe, home to many multinational companies and a leading tourist destination, London is a prime destination for property investors from all over the world. Put yourself in the feet of a Middle-Eastern or Chinese investor and London, which you can fly to and have been to, is much more likely to be top of mind than Coventry or Peterborough, regardless of the investment merits of each market. Taken together with severe restrictions on new construction, this has caused prices of all kinds of property to soar and result in fairly low investment yields. For the average investor, it is a fully-priced market.
Find out more: Download our Investment Property Guide.
With London becoming increasingly unaffordable, investors as well as home buyers increasingly look to the Southeast – everything within a couple of hours of train from London. Prices in this region follow those in London.
Secondary Cities, such as Birmingham, Manchester, Leeds and so on, provide more accessible, and many say attractive, investment opportunities. However, each market has its own dynamic. Some cities are on the rise, while others face stagnation.
European Market
- Germany which historically, has had very affordable real estate. This is because of low home-ownership incentives and some painful market busts. As the country gained prominence during the financial crisis as the leading economy in Continental Europe and as its cities such as Berlin have become lifestyle destinations, it has attracted investors. Prices have risen in recent years.
- Spain whose primary markets of Madrid and Barcelona are on track to recovery from the financial crisis of a few years ago. Developments in tourist resorts and secondary cities still face high vacancy and economic difficulties.
- Australia market was red-hot for many years as China fuelled a mining boom. With China’s recent slowdown the Australian market has cooled off somewhat and now presents some opportunities. As in other wealthy countries, the prime Sydney market is very expensive, while some secondary cities offer more accessible investments. Western Australia, most heavily exposed to mining, is likely to suffer, though.
- USA market is similar to the UK in that the leading cities such as New York and San Francisco, which have booming economies and physical limits to new construction, are very expensive. However, the US has such a large and diversified economy that there are dozens of secondary cities that nonetheless have solid and diverse economies, are headquarters to major companies, universities and government bodies and would, in any other country, be treated as first-tier markets. This is a sophisticated and liquid market for investment.
Secondary market or off-plan?
When you buy property, you can either buy real estate that is already built, from its current owner, usually via an estate agent; or you can buy it directly from the developer, often off-plan – in other words, even before it is finished.
There are pros and cons to each.
- Buying on the secondary market ensures what you see is what you get, although depending on the properties age, maintenance might be due. On the other hand, unless you are dealing with an owner that needs to sell urgently, or you are an expert bargain hunter, you will most likely pay the market price. In fact, many individual property owners have somewhat inflated expectations of the value of their properties. Often because they have so much of their net worth and emotional baggage invested in them and are willing to lose the deal rather than be flexible on price. Finally, payment terms aren’t usually very flexible – you put down the deposit, obtain the funds and then pay the rest.
- Buying off-plan before the property is completed means you have to rely on the developer’s plans. As well, you are counting on the developer’s financial health and capacity to complete the project on time. However, in exchange for this risk, buying off-plan provides investors with a better price and staged payment terms, which can result in a higher return.
- This is because developing property is a substantial financial undertaking for developers themselves – they have to invest a large amount of funds for multiple years before the properties are ready to be inhabited. In order to match their cash inflows with their outlays, developers sell properties off-plan, sometimes in instalments – the buyer pays a monthly amount until the property is ready, and that is used for construction. The ideal world for a developer is one in which the properties they sell off-plan cover the entire cost of construction, so that they do not have to resort to outside borrowing or using their own capital.
- The more they can do this, the more developments they can run in parallel, and the higher their profits. Because of this, they are willing to offer these early buyers substantial discounts and favourable payment terms. Developers are rational rather than emotional sellers, – while they obviously want to make as much money as they can overall, it can make sense for them to sell properties at lower prices in order to attract buyers quickly, much like a supermarket might offer discounted prices to increase turnover.
- So off-plan investors and developers have a kind of symbiosis: For investors looking for higher returns, off-plan properties allow for slightly higher risk in exchange for slightly higher return, without concentrating purely in property price risk: They offer a mix of credit risk that the developer meets its obligations, operating risk – that the property is ready on-time and property-price risk that the market price is attractive vs. the price paid.
- The instalment structure can be attractive for both sides – while you want a property to live in to be available as soon as possible, it doesn’t matter if an investment property will take time to be ready, as long as your overall return justifies the pre-paid instalments.
- Some developers specialise in property sizes, types and locations that are particularly attractive for investors in terms of their flexibility, rental demand and total price, such as affordable 2-bedroom flats in convenient but less glamorous locations, priced between £100,000 and £200,000.
Investment property mortgages
The standard process for obtaining a mortgage and acquiring a property is to: Pre-apply for the mortgage. The lender will provide you with a non-binding indication of whether they are willing to provide you with a mortgage, called an agreement-in-principle. This is to avoid the risk of agreeing to a purchase and not being able to raise capital. Sign a purchase agreement with the seller and put down a deposit. Apply for a mortgage and, once approved, to pay the seller and transfer the property.
Find out more: Download our Investment Property Guide.
The ease with which you raise mortgage financing and the attractiveness of the rates that are offered is a function of common-sense factors. In all cases, the higher, the better for your chances.
- your credit rating.
- your income.
- the % of the purchase value you are putting down yourself rather than borrowing (typically 30% deposit).
- the monthly rent vs. the monthly mortgage payment.
First time buyers, who would otherwise face difficulties in raising mortgage financing due to their lower incomes, shorter credit histories and lower net worth, in certain countries have government incentives which make obtaining financing easier. In some cases, such as in the UK, the government guarantees these first-time-buyers’ mortgages, thereby allowing them to access subsidised rates.
Financial Advisors and Agents
Although, as a buyer, you can buy property by dealing directly with the seller or their agent and your mortgage lender, it is advisable to discuss your prospective investment with an estate agent that is working for you rather than for the seller or anyone else, or with your financial advisor, especially if this is your first investment property purchase.
Both an estate agent and a financial advisor with knowledge of real-estate investments will be able to provide you with some basic reality-checks on whether that seems like an attractive purchase in terms of the profile of the property quality, size, location and price, in addition to helping you understand the rental yield, net of taxes and expenses, that you are likely to make, and how that compares to your mortgage rate.
While an estate agent might have more specific knowledge of local market prices and conditions, it is not their role to advise you on whether the property investment is appropriate to your financial circumstances as a whole. In fact, they may even have a very clear bias towards your purchasing the property, in that they can then offer you rental property management services.
On the other hand, a financial advisor, especially if they already work with you on other issues, such as retirement planning and investment management, may know less about that specific market, but can provide you with a more high-level view of whether a property investment is appropriate for you at this moment, given your overall financial situation and financial plan, and is more likely to have an unbiased, independent position in his advice. This is particularly important because, as mentioned previously, property investments are usually very big vs. an individual’s overall net worth.
Property investment can be an important part of a personal portfolio, given how it can be financed, its role as an inflation-hedge and its lower volatility than equity. Off-plan properties are an interesting alternative for property investors in terms of their risks, returns and cash flow profiles. When investing in property, it is important, however, to understand price, vacancy and interest rate risks – prices and rates can go down as well as up! Because of the size and illiquidity of real estate investments, it is a good idea to consult your financial advisor before buying.
Find out more: Download our Investment Property Guide.
