The Buy to Let conundrum

Monevator posted a great article summarising the amount Brits have stashed in tax-exempt ISAs, questioning why there’s so little in there. The highest cluster of ISA saved amounts are in the £20k-50k range.

He’s got a point. Why so little? Well, whenever I hear middle-aged people talking about how to store wealth, there is one strategy that they focus on, that wouldn’t appear in the ISA tally.  It stands head and shoulders above anything to do with shares, gold, or setting up a business, which is kind of strange for a country that has made finance its engine of growth in a post-industrial era.

I come across it time and time again, so often that it must either be a sure-fire winner, or there must be something else unusual about this radiant flame that is circled by an endless number of moths.

Most of these folk have had regular salaried jobs for a while, that pay a steady income, month in, month out. Until, that is, that fateful day when the backdraft of downsizing comes its way, or they come to pick up their carriage clock and sign out of the office for the last time.

So what they really, really, want is an income like that job, or that’s reliable as they used to remember. They want a steady monthly income. And to many, many people, the first things that springs to mind is a highly unusual investment, that has a typical capital value performance over time that looks like this in real (inflation adjusted) terms.

It’s residential housing, better known as buy to let. Now the good thing about this capital performance is that it’s generally on the up. The bad thing about it is that you can get slaughtered in it for ten years at a time. I should know, I’ve been there.

Buying your own house

Everybody needs to live somewhere, and if you are planning to stay in one place for a long time (> 10 years) then buying the residence you live in is generally a good move.That 10 year condition is a big ask in today’s job environment. If you’re going to move, then it’s best to be able to do it at a time of your choosing, and indeed some BTL owners are accidental landlords who couldn’t sell their house at a price they wanted when they needed to move elsewhere.

Even if you screw up like I did buying in 1989, after twenty odd years the slow uplift compensates somewhat. If the mortgage and house maintenance you pay is less than the rent you would be paying on the house you get a cumulative benefit from it. However, what you can guarantee with you own property is no occupancy voids, and hopefully the residents don’t trash the place either 😉

Even buying your own house isn’t risk-free, however – as well as market risk it is such a large undertaking that you can end up out of pocket if you fall on financial misfortune and become a forced seller or worse still a repossession.

You’re already highly exposed to the graph above through the value of your own house, though it isn’t as bad as it looks because once you own a decent amount of your house if you are selling at a low point you are buying at a low point too, which is what saved my tail in 1998.

Such a good deal, many people want to do it again!

So people then extrapolate, and want to own another house for other people to live in. There are two variants of this. Some, looking for somewhere for a store of wealth, simply want to buy and get the rental income. Others want to gear up, borrowing money using a BTL mortgage, using as little of their own money as possible, as advocated here. Your house is normally your largest asset if you own it outright, so doubling up your exposure to the same type of asset is a huge unbalancing of the asset classes you use to store your personal wealth. It so happens that this asset class has done pretty well over the last 20 years, though it’s taken a few hits of late.

Now there’s nothing fundamentally wrong with this, provided you have asked yourself if this reflects your particular attitude to risk. Maybe you have particular skills working with houses, or tenants, or renting to students. You can use other people’s money, in the form of a mortgage, at low interest rates to gear yourself up. Which is great when house prices rise or there is high inflation, but it’s hell when they fall. I know this from personal experience.

That was twenty years ago, so a generation has grown up to believe that house prices only ever go up, and those that know otherwise tend to keep schtum. Never underestimate the soulless feeling of paying hundreds of pounds towards a mortgage that is higher than what you sold the house for. At least if you throw tenners on the fire you’d get warm from them!

What’s so attractive about residential property as an investment, then?

On the plus side

  • in principle it can give a regular income, voids excepted.
  • profitability is helped by tax breaks on interest payments
  • everybody has familiarity with the product.

On the downside

  • the capital value is volatile
  • This investment comes in big indivisible chunks
  • There is no geographic diversification
  • it is a high-maintenance operation showing people round and you have to get notice letters exactly right
  • there are a lot of hidden costs like letting agents, repairs

Some of these downsides would be addressable by residential real-estate investment trusts but I don’t know of any. It is a shame, because it isn’t just prospective buy-to-letters that would be helped with residential REITs.

Such instruments would allow prospective house purchasers to save their deposits in an asset class which reflected the price of what they were saving for. This would tackle a frequent complaint, which is in the recent past as you save towards a 20% deposit on a house the price races away from you. Residential REITs would lift the value of your deposit as you save. At the moment the only way I know of to simulate this is with spread-betting. Obviously if house prices drop your REIT drops too, but if you are saving for a house that’s not as bad as it seems.

However, in the absence of residential REITs, which could fix the large lumpiness, intra-UK geographic concentration and maintenance, that’s a lot of downside, particularly when you take the shocking lack of asset class diversification into account, which begs  the question

What’s wrong with the stock market?

Or, indeed, any other asset class, even if it’s bonds, oil futures, Apple shares, fine wines or tulip bulbs?

Two things are primarily wrong with the stock market. Everybody can see or touch a house, and provided they hold buildings insurance they feel it’s solid, reliable and will always hold value. Unlike some shares – in my earlier dotcom forays I held Videologic, Rage software, Ionica and Pace microtech. Rage software and Ionica went bust. You can’t argue with the logic that a house won’t go bust 🙂

The second thing people feel is wrong with the stock market is that they can’t see how to get a reliable income out of it. There are various strategies you can use to get an income – a high-yield portfolio, High Income funds, an annuity if you’re old enough and don’t mind your capital eventually disappearing, but none of them offers the comforting constancy of income that a salary or that regular BTL rent cheque does.

You need to have a much higher, almost entrepreneurial risk appetite to deal with a varying income, and better money management skills, which usually involve having a large float of a couple of years’ worth of essential living expenses. Now that isn’t your typical Brit, who relies on standing in the firehose of income supplemented with a good dollop of consumer credit to smooth out the lumpiness of running costs.

The sort of people that are looking to BTL as a way of preserving as lump sum can cope with the variable income because they have capital. However, I know personally that it takes a huge wrench to contemplate a variable income if you aren’t used to it. I have several years worth of living expenses in cash and I still bottled it, so I have arranged my affairs so I have a fixed income that keeps the wolf from the door and a variable income that is entertainment and investment budget.

I’ve got every sympathy for the desire for a fixed income, but sometimes a fixed income comes with a high capital risk, as investors in Keydata know to their cost. BTL is nowhere near that risky, but the steadiness of the income is only steady if you close your eyes to the fact you can lose a big chunk of capital. A diversified HYP has the same sort of risk – the stock market can fall 50% in a bad year, but because you can strategically enter it over a period of about 5 years you’d be unlucky to take such a bath on your total investment, provided you invested in a diversified basket of index funds, or diversified bunch of shares in different sectors and geographies.

Someone who isn’t used to the principles of sector, temporal and geographical diversification may favour an investment they understand that pays a regular income in a way they can understand. Compared to regular rental income, the uncertain proceeds of a HYP and evaluating how stable that would be is a very big ask. Evaluating how you look at growth and income stocks and derive an annual income also takes a lot of research and understanding, and even then there are no guarantees.

It’s so much easier to look at your house, which worked well for you over the 25 year term of your mortgage. And think of doing the same again, with BTL.

Know thyself

It might well be the right investment for you. But you can only say that once you’ve taken the time out to understand the more accessible alternatives, and what their advantages and disadvantages are compared to BTL. You must have a very good reason to throw out the only free lunch in finance – portfolio diversification. Just knowing that ‘everybody needs to live somewhere’ isn’t good enough. Everybody needs oil, but that didn’t stop people taking a hit on BP a while ago, and nobody needs anything made by Apple, but they made a good investment of late.

Balancing the opportunity costs is one of the things that makes investing hard. When you buy an asset, you’re also making the decision to not buy a different asset. Diversification derisks this, by stopping you putting all your money in one type of asset.

BTL is emotive in Britain, carrying the hopes of the ageing baby boomers who tend to have a high cost lifestyle and are distrustful of the financial system because they’ve just seen a huge financial crisis and may not have been lifestyle profiling their investments. And conversely carrying the unrealised aspirations of the Gen Y/echo boomers who want to buy houses around now, and who are finding prices running away from them and mortgage funding harder to find.

It’s difficult to believe that BTL is right for so many people, with its toxic mix of illiquidity, gearing, lack of geographical and sector diversification and hard to quantify risks and opportunities. If I said I was going to take out a mortgage to invest on the stock market most people would say I’m nuts. It’s not that clear to me why the same doesn’t apply to speculating on the housing market. BTL makes sense if it’s 10% of a diversified portfolio. As 100% of someone’s retirement savings it looks like a recipe for disaster to me. It isn’t just the return on capital that matters. The return of capital also matters.