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Safe as Houses?
By Will Myers
“An Englishman’s home is his castle”. Actually, nationality doesn’t really come into it, this idiom is very much indoctrinated into the psyche of the majority of individuals; get a job, buy a house, start a family. In a reasonably crude search, the earliest noted reference to this that I could find was from Richard Mulcaster, the Head of Merchant Taylor’s school in ‘Positions, which are necessarie for the training up of children’ in 1581, where he states “He [the householder] is the appointer of his owne circumstance, and his house is his castle”. Indeed the end of the 16th Century seems to be a period where this notion becomes increasingly appointed in the zeitgeist. It is also worth noting that other commonly held beliefs were that the world was 7,000 years old (no offence to the Trump administration), that potatoes were an incomprehensible exoticism and that a Spanish Armada could navigate around the Isle of Wight.
I’m aware that there is a somewhat facetious opening to a financial article on the relative benefits of asset class allocation, however it does laud the point that tenure of belief has an enormous influence on an individual’s motivation to make crucial life decisions. A common thread that we have across all spectrums of our clients is a desire to build up a portfolio of property asset that will fund retirement, citing the success of well advised entrepreneurs in this field such as Robbie Fowler or even that this has worked for their own family in generations before. However, when you examine the efficiencies of such an approach against the diversified usage of other instruments and asset classes there is raised a number of challenges as to how effective this really is in an individual’s financial makeup; the financial equivalent of Jamie Oliver trying to make a school lunch for some malnourished school children and only able to use the aforementioned New World potato. A pretty powerful metaphor I am sure you will agree.
Firstly, let’s examine the benefits of a property portfolio. I have always considered that the perceived strength of this is the safety that is felt in being able to physically see and touch your investment. I can understand that it can be a leap of faith for new investors to be able to go onto google maps and literally check in on where their money is as a sign of comfort, rather than it moving from an account where it is just numbers on a screen. I would also however suggest that that is becoming generationally weakened, as the digital age begins to dominate and increasingly people’s entire worlds are run via a 6 inch high portal, although the argument remains. People are always slower to change when it involves their money, and a tendency to rely on history rather than technology prevails. In time this will shift, and as the emergence of industries such as AirBnB and Uber where the physical asset is not even a part of the company have marked the beginning of an industry/environment where shared asset through a membership is the norm. At the recent BMW AGM, Norbert Reithofer, their CEO announced a development of their 2014 car sharing scheme and that he expected this to be the rule in the next 10 years, and that individuals would not own one car, but have a membership and the capacity to change their vehicle depending on the circumstance of that day. This is not to say that the initial point no longer has validity, and it would be churlish to discount the resonances of the collapses of Lehman Brothers and Northern Rock for instance, however, it is certainly of my opinion that this mindset is becoming less relevant; or moreover that the tangibility and trust of something online is becoming increasingly more robust.
As alluded to earlier, I do think there is a latent mistrust of markets, and it is easy to highlight destructive events to consumer confidence in the dot.com bubble burst, black Friday, as well as, of course, 2008 to name a few. The run to safety, the perception then goes, is back to bricks and mortar and that the returns on this are consistent and stable. The reality is very different, and the key thing here is that property is still an asset class. It still has cycles. It still has peaks and troughs. The difference is that until a property is sold you don’t really know the price, and equally people have a much greater capacity to ride out the markets. The instant access to price of a portfolio investment, in this scenario, actually works to its detriment-because people can log in to their account and see hourly traded figures on the values of their investment it instills worry, which then can lead to demand for change and so on. As a company, we always try to stress the importance of timescale of investment; if we have designed a portfolio to come to fruition in 30 years time, then short term volatility is less of an importance than long term structure and diversification. Further to this, the housing market is far less stable than the commonly held view. A figure that we get quoted a lot from clients is that property prices rise by about 10% per year. Now, I am acutely aware that I am creating the evidence here, which, the quick thinkers amongst may have guessed I am going to shoot down, but I am sure that figure will have some sort of resonance with yourselves as well. The graph below shows compelling evidence that the facts are some way away from that perception.
There are two things I would like to pick out here, firstly of the trend showing an just 2.9% annual return over the 40 year period, but more importantly the huge ranges in volatility, and the clear evidence that the market is cyclical-as every market is. What is unique about the housing market is that this is generally not thought of to be true, and further to this, it is the only market in which domestic gearing is commonplace. In the three step ready guide to life in my opening gambit (job, house, family) I did not mention mortgages, but that is a significant factor to consider. If you are gearing by a factor of 5 (assuming a 20% deposit) then you are of course multiple times more sensitive to market fluctuations; If you put down a £200,000 deposit on a £1,000,000 property portfolio and so having £800,000 of borrowing, a 10% dip in the housing market would see a £100,000 loss, half of the initial capital investment. Conversely if we asked a client to borrow £800,000 on a retirement investment design for them, we would lose our licence.
I would like to reiterate that I am talking about the concept of building a property portfolio to fund a financial goal, usually retirement, not the purchasing of a first home, or even upgrading or downsizing as appropriate through life. This is still an efficient way of investing the benefits of which are of course very apparent-the money that would have previously gone on rent going towards the value, no Capital Gains Tax on disposal (in general) and of course the price appreciation along with the capacity to time a sale. You will have of course had to pay Stamp Duty at the outset however.
In April 2016 the government brought in significant Stamp Duty surcharges on a second property (see table below) which immediately means that, on top of any inherent borrowing costs, your investment is starting from a stymied position from the outset.
Aha, the Monopolytm battle hardened tycoon within you triumphantly points out, but property is not just capital appreciation, you get a rental yield as well. This is true, you have indeed been studying the finer details of the Bow Street small print, bravo, however the reality is that this yield becomes rapidly diminished when you factor the realities of owning a property portfolio. First and foremost the rent that you accrue is subject to income tax, regardless of the time of life you are at, and at your highest marginal rate. Secondly, properties are expensive to maintain, boilers break down, walls need painting, gardens need maintaining, these costs often are not included within the perceived yield, yet they are a direct cost on this as an investment vehicle. Thirdly, the properties will need managing. Whether a company, individual or yourself are used in the capacity, there is a knock on effect on time and money, and the resultant return on your capital input. Fourthly, you must take off the mortgage rate that you have agreed on from the rent that you are bringing in. There are of course limitless variants around similar themes.
It is difficult not to become evangelical about this topic and begin to talk about liquidity issues (you can’t just sell a bathroom if you need £20,000 in a hurry) and how that leaves an individual imperiled to market movements, having poor tenants, and so on, and I fully appreciate that an embedded mindset is difficult to shift, however much as the school dinner of our dear Headmaster Richard Mulcaster has developed and evolved, so should our approach to investing. Diversification, in both diet and investing is a key element, and overexposure or reliance to one such element has the potential for disaster. (See Ireland, 1845).
Whenever any financial plans are made, it is vital to remember that nobody knows what is going to happen. But that is something in itself. Exposure to a variety of different asset classes (UK and Global Equity, UK and Global Property, Fixed Interest, Governmental Bonds, Alternatives, Bio Tech, Natural Resources etc) within your risk profile, in a sensibly managed portfolio of wrapper assets (ISAs, Pensions, VCTs, EISs, Onshore Bonds, Investment Accounts etc) allows an individual’s money to be as tax efficient as it possibly can be, but also the best chance of steady, consistent returns in an uncertain market.
I shall leave you with the words of esteemed social commentator, Edmund Blackadder on seeing the potato for the first time “people are smoking them, building houses out of them… they’ll be eating them next”.