The recent changes to the way buy-to-let investments are taxed could turn out to be property funds' - and their investors' - gain, argues Paul Munn
Buy-to-let was once a golden egg for investors. Properties could be bought with relatively small deposits, tenants covered mortgage payments and other costs and, 20 or so years later, the investor owned a mortgage-free property and was sitting on a significant capital gain. Simple.
In reality, a mortgage-free property may not always have been the end result, but only because interest-only-mortgages have been far and away the most popular option for buy-to-let investors. The attractions of buying this way were greater for most people.
Since mortgage interest payments could be offset against income tax, by only paying back the interest, investors paid less tax and had smaller monthly repayments, leaving them considerably more free cash each month.
They typically used these surplus funds to grow their buy-to-let portfolio or invest elsewhere - perhaps with a view to paying down their mortgage debt later. Or they could simply enjoy the additional income.
But all this has now changed. The introduction of an additional 3% stamp duty surcharge on second homes and the replacement of tax relief on mortgage repayments with a 20% tax credit has considerably undercut the appeal of buy-to-let, which anyway has never really been an investment suited to those who want to just sit back and let their money work for them.
Being a buy-to-let investor means being a landlord, and being a landlord carries with it a great number of responsibilities, potential pitfalls and headaches. For starters, there are tenants to consider - finding suitable ones and dealing with nightmare ones being a particular issue for many investors.
This can be outsourced to an agent, but doing so comes with additional costs, while property upkeep and maintenance is another potentially expensive and time-consuming element of the job. Add on the many ancillary expenses, administrative costs and chores, and it is clear that buy-to-let is not for people looking for a low-maintenance or stress-free investment.
But just because the buy-to-let golden egg is, for now at least, well and truly scrambled for many investors, it does not mean they need give up on the benefits of property investment. Residential property funds may represent an attractive alternative - not least because the institutional investors who manage them are at an advantage to private investors when it comes to buying and selling property.
There are numerous reasons for this but, in the context of the higher costs now faced by private buy-to-let investors, economies of scale, lower relative purchasing costs and lower taxes are prominent benefits that are passed on to end-investors in property funds.
And, anyway, in some property hotspots, such as London, buy-to-let was increasingly out of reach for many investors as valuations have soared to well above their previous pre-financial crisis peak. Conversely, some cities have yet to fully bounce back from the crash and, in our view, it is in these where the best opportunities lay.
In particular, we have identified significant value in some of Scotland's largest cities. Edinburgh, Glasgow and Dundee enjoy a combination of prices below their 2008 peak, supportive demographic trends, rising housing demand generally, a significantly growing private rented sector as home ownership declines, and rising rents.
All of which are coupled to housebuilding rates across Scotland that are well below government targets - currently some 16,000 new homes a year are being built versus a target (set in 2007 and so now arguably too low) of 35,000 a year. It has been forecast that property capital values will grow between 6.7% and 18.7% between 2015 and 2020, compounding at between 1.2% and 3.5% a year over the period.
The investment case for properties north of the border appears even stronger if you contrast this situation with areas of England that have seen some of the biggest rises in property values over the past decade - the south east in particular, where prices appear to be now stagnating, or at least highly unlikely to continue rising apace.
What Scotland does have in common with England is that the changes to buy-to-let affect investors in a similar way. Rates of Land & Buildings Transaction Tax (LBTT) - Scotland's version of Stamp Duty - are in fact generally higher than in England, making the addition of the 3% surcharge harder to bear for private buy-to-let investors, particularly the higher-rate taxpayers hit hardest by the end of mortgage interest relief.
As such, it is not surprising it has been predicted the tax changes may give rise to a wave of buy-to-let properties coming on to the market as private investors sell up rather than bear the increased costs. Should this happen, private investors' loss may turn out to be property funds' - and their investors' - gain, because institutional buyers will be able to pick up bargains offering some very attractive yields.
Other advantages that institutional/fund investors have over private investors include:
* The ability to acquire properties at wholesale prices from banks and large property investors looking to reduce exposure or liquidate their positions - in some cases at 30% or more discounts to their market value.
* Economies of scale.
* Access to more competitive bank/debt funding.
* The expertise to add value by actively managing property portfolios and oversee lettings and sales in line with market conditions - something a private investor may struggle to do effectively or successfully.
* The resources to carry out repairs and refurbishments cost-effectively in order to increase yields and capital values over the duration of the holding period.
* Diversification - funds hold a portfolio of properties of different types and spread across different cities and regions and so provide a much greater degree of diversification than the average buy-to-let investor, with one or two properties, could typically hope to enjoy.
* A residential property fund can held tax-efficiently in a SIPP, unlike directly owned residential property.
Importantly, institutional investors and property funds also pay less tax. The 3% surcharge private buy-to-let investors must pay on top of stamp duty or LBTT does not apply to corporate purchasers buying six or more properties in Scotland. Also, corporate investors can average their purchasing costs across a portfolio, which can meaningfully reduce liability to LBTT.
Both these factors mean they are able to put more money to work in the property market. All else being equal, institutional investors should therefore be able to generate better returns than a private buy-to-let investor. And that is before you factor in all the other advantages institutional investors have over individuals.
So, what sort of returns can be expected from a fund investing in Scottish (and selected English) residential and buy-to-let property? We think 7% compound annual growth is readily achievable - in fact, recent past fund performance is significantly in excess of this - equating to around a 40% return over five years. Given the favourable market fundamentals, this is actually a conservative estimate of achievable returns.
For financial advisers, too, the declining appeal of buy-to-let may represent an opportunity. Many buy-to-let investors have tended to be approaching or have just entered retirement. Such individuals are often faced with a sometimes-bewildering range of complex financial decisions to make and are likely to benefit from high quality professional advice.
Cautioning against bricks and mortar, perhaps in favour of a residential property fund, may prove to be the kind of wise counsel would-be buy-to-let investors need from advisers at the moment.
Paul Munn is a partner at Par Equity, a venture capital and property investment manager
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