Summary: Investing in rental properties is very popular in many countries. Should it be? Is it the best asset class for an average private investor? This page looks at the issues.
The years between 1990 and 2007 suggested that much of the population of the developed world was suffering from some form of hypnotic state about the investment potential of residential property.
There were a number of reasons that helped to push the real estate bubble upwards including cheap finance (low interest rates), reduced lending standards (ultimately leading to NINJA loans) and racy annual returns.
In addition to the financial benefits, there are also emotional reasons that make residential property a unique form of investment for most families. This emotional bond is one of the many factors separating residential property from investing in commercial property.
The real question though, is whether private investors should be investing in rental properties at all.
The risks associated with investment are actually much higher than people tend to think. Why?
- Property is illiquid. This means that it is not necessarily easy to sell. The ability to sell and available prices depend upon the property market generally and these can be influenced by a wide range of factors (for example, there could be a general recession or the largest employer in an area has recently closed or moved).
- Unlike many other assets, it is not generally possible to sell part of a holding. You either own the building or you don't. This means that it is not easy to reduce the exposure of a portfolio to residential property without making a full sale.
In many other asset classes, selling partial holdings to 'bank' some profits is a well practiced exercise, but very difficult - if not impossible - for most property investors.
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Many property markets are not very transparent. This means that it often
is very difficult to know what a property is worth until a buyer is
found. Other asset classes - such as the stock market - are very
different to this and asset values can be tracked minute by minute if so
desired.
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- Transaction costs are relatively high. The involvement of lawyers,
surveyors and real estate agents are on top of the goverment's tax. In
property transactions this tax is usually known as
stamp duty.
- Rental incomes are not guaranteed. There can be changes to rental values as a street or area becomes more or less desirable. Properties often need some form of updating or work when tenants move out. This work can cause periods where the property is empty (known as 'voids').
- Property prices can go down as well as up. Property is pro-cyclical which means that price moves are usually in the same direction as the economy as a whole. In poor economic times, expect property prices to fall.
- "They aren't making land any more!" is a well used phrase to justify high property prices. While there may be limits to the available amount of land, there are rarely limits to the creative uses for existing plots of land by developers. An oversupply of housing is actually quite common.
As an example of this, your author knows a British lady that has invested in a property in Bulgaria. The photos make the property and it's location look wonderful. When she bought there were very few properties like hers around. However, over the next five years, more than ten thousand similar properties were built each year - many of which remain unsold. The value of her property has fallen dramatically.
As the Scottish hedge fund manager Hugh Hendry likes to say, "Wise man not invest in overcapacity".
However, the flip side to this argument exists in small or densely populated locations. Your author has spent significant time in Malta, a small island in the Mediterranean Sea, south of Italy. It is a very small country and one of the most densely populated nations on earth. This combination means that real estate in Malta has some strong underpinning.
- Property is relatively expensive compared to average wages. These prices force many buyers to borrow money and (often) use very small amounts of upfront capital. General investment advice would normally suggest that borrowing to invest is a bad idea. It adds leverage to the returns that can be generated from a property investment, but it also adds a very significant amount of risk.
In the good times, this risk seems to be silly to most people. As the price of a property is increasing, it is generating a rental income and life is good. However, because property markets tend to follow the general economy, if things start to go badly, there will invariably be multiple factors going wrong at the same time.
For example, in a recession, interest rates are likely to go up. This makes it harder to pay the monthly mortgage payment. At the same time, there is less money in the economy and less jobs which may make a tenant hard to find. In such circumstances, many people have found in the past that they suddenly have more than one mortgage to pay from their monthly wage. As property prices have fallen, the house is hard to sell and the mortgage may be worth more than the value of the building (known as negative equity). The risks no longer feel so far away. Many people have been bankrupted by a set of events like this.
Are there other ways to invest in property?
We are not saying that investing in rental properties is necessarily wrong, or that in comparison the stock market is easy and risk free. However, we do believe that there are a great many more risk factors to be considered in property than is usually the case.
If you would like to read a comparative study between the property market and stock market we can recommend this document.
There are now a number of funds that invest in property portfolios and are much more liquid than direct property investment. Some funds focus on commercial, others on residential. Such funds make it possible to invest a much more limited amount of money and be able to withdraw funds much more frequently if required. It is, by definition, a lower risk and lower (potential) reward way to invest. Worth considering for a beginner.
An Oligarch's Insurance Scheme?
Something that has begun to come to light more and more since around 2012 is that high-end residential units are being bought in first world cities (such as London, New York and Geneva) purely as diversification. There are apparently now more empty properties in Mayfair in London, where an apartment will cost more than a million pounds, than there are with people living in.
If you already have lots of money and are worried about having assets outside of your home country in case of dire emergency, what asset would you buy? It seems that villas and excellent apartments owned through some sort of offshore structure is the answer to this question. These buyers may or may not ever actually visit the place, but if they need a few millions in the future, they will have these boltholes available.
The thing is, if you already have hundreds of millions or billions in assets, who cares about the rental yield, really...? Certainly in London, a city where real estate is already very highly priced, this just adds more to the squeeze that normal people living and working in the city face.
Perhaps linked to this are the small but growing number of naturalisation schemes springing up around the world. To governments offering deals they are citizenship for wealthy individuals that can afford to make an investment in a country. This is a good example from within the EU. To angry members of the press they are passports for sale. Either way, virtually all of these schemes require some form of commitment to residency which is usually demonstrated by purchasing a property or renting one long-term.
To read more about other investment topics, please follow these links:
A Beginners Guide To Investing
Different Ways Of Investing Money
What Is The Point Of Safe Investing?
Should You Be Concerned By Currency Exchange Risk?