When we speak to people who have money to invest, often their first thought is to buy a property to let. Purchasing property as an investment vehicle for income purposes has been very popular in the past 20 years. Many people feel comfortable with this option because you can touch it and see it, maybe even visit it now and then, not to mention the high gains that property has enjoyed in the recent past. Perhaps a lack of awareness of the alternatives is also a factor. Whilst letting property can be an ideal way of generating additional income, it does have complications and pitfalls which investors should be aware of.
Although this article very much focuses on these pitfalls, property rental can be worthwhile and lucrative in certain circumstances and with the right property. Here are a few of the main issues to consider.
Lack of Liquidity
The ability to realise part or all of the investment is not well catered for with property purchase. It is not possible to make a "part withdrawal" of the value of the property; you can't just sell a few of the bricks to raise some cash! If you do need to to release some capital the property must be either sold or mortgaged, neither of which are cheap or quick, or without consequences; ongoing repayments with a mortgage, or cost and possible tax liabilities to sell. Depending on market conditions, you may find that you are unable to realise the value of the asset at a price at with which you feel comfortable.
High Purchase and Sale Costs
Due to the complex legal process in buying and selling property, there are inevitably considerable costs involved in acquiring or disposing of property. Purchasing involves solicitors fees, stamp duty, search fees, surveyors, land registry fees etc. Sales involve solicitors and estate agents fees. Taking these costs into account the overall yields can be significantly reduced.
A stamp duty surcharge of 3% will also apply if you already own a property. For example, buying a property for £250,000 which is not your first property, would incur a Stamp Duty charge of £10,000.
High Minimum Investment and Lack of Diversification
Due to the high cost of property it would be necessary to commit a significant sum to property purchase, or have exposure to a large mortgage. If you have a large investment portfolio this may not be an issue, however if the property will represent a substantial proportion of your assets you will be left with the problem of lack of diversification; the "all your eggs in one basket" scenario. Should property values remain suppressed you may not experience growth in your investment at all. Should prices fall, your entire investment will be exposed to this, with no potential to offset losses by gains elsewhere as would usually be the case with a well diversified portfolio. Furthermore, many people have significant exposure to property prices through ownership of their main residence, therefore further exposure may not be desirable.
High Ongoing Costs
Once purchased, there can be significant levels of ongoing costs to let a property. For example; the property must be insured, unless you find a tenant and manage the property yourself you will incur letting agents fees which can typically be around 10%+VAT of the rental income, inventory and check-in/check-out fees, annual gas safety inspections, electrical inspections, professional cleaning and energy efficiency tests which must now be carried out for all let properties. If the property is leasehold you will need to pay ground rent and any communal maintenance or service charges. The income will need to be declared to HMRC therefore you may incur additional accountancy fees for calculating net profit/loss. Any rental income is of course taxable.
In addition to these regular expenses you should also expect to incur ad-hoc maintenance costs to keep the property in good condition.
All of these ongoing costs should be factored in, and deducted from the expected rental income so that you can calculate the true rental yield.
Any periods of rental voids you experience will have a severe impact on the annual yields. Clearly if you are reliant on the income, a rental void would be a problem as it is not possible to make partial encashments of the property to fill the gap. Along similar lines, the process for evicting a troublesome tenant can be complex, costly and lengthy. The property could be left in a poor state of repair when you eventually regain possession from such a tenant, resulting in more bills to reinstate it to a condition suitable for letting or selling.
Any income generated from the property will be subject to Income Tax. Following recent changes, if you have a mortgage it is no longer possible to obtain higher rate tax relief on the mortgage payment. Our article dedicated to this subject explains more, which you can read here.
Capital Gains Tax
In the event that you sell the property for a profit in future, Capital Gains Tax will be payable for any gains in excess of the annual CGT allowance (£11,000 for the 2016/2017 tax year). It is not possible to make part disposals each year, therefore the entire gain will be taxable in the year you sell the property; there is very little scope for planning to reduce CGT liability. However, if the property is held until death, the Capital Gains are effectively wiped out.
Furthermore, gains on residential property do not qualify for the new lower Capital Gains Tax (CGT) rates; the old rates of 20% and 28% still apply, depending on whether the gain, when added to your income, takes you above the higher rate threshold. From April 2020, it will be necessary to pay any CGT due within 30 days of disposal of the property.
Although property has been popular as an investment and can work well, it is very important to be fully aware of the factors which can have a great impact on the overall yield of the investment. It is not uncommon for the ongoing costs to reduce the income yield to a point which makes it unattractive compared to other types of investment.
If you wish to consider property as an option, obtain some property particulars from local estate agents to get an idea of what type of property you would be able to buy, and the level of rent you could realistically generate. We would be pleased to carry out further analysis and talk through the pros and cons in more detail with you, so feel free to get in touch.
This article is intended for information purposes only and should not be considered to be a recommendation. This article is based on our understanding of current and draft pension and tax rules as at the date of this article. Please note that tax and pension rules are subject to change; if you are at all uncertain about the suitability of any option for your circumstances we strongly suggest you seek personal financial advice. You should not take action solely on the basis of this article without seeking advice specific to your circumstances. Please get in touch to find out more.