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Is Buy to Let a Practical Alternative to Fixed Income?


An Englishman’s home is his castle, so the saying goes. But here in the US we have our castles too! A local example from my state of Pennsylvania is Bowman’s Castle – originally built as a trading post in the late 1780s. That is ancient history for the US, and as settlers went west, the need for fortifications declined, until we got to California and Cinderella got a castle built for her in Walt Disney World in 1971.

Real estate has proven to be a good investment for many on both sides of the Atlantic, Bowman’s Castle protected early trade, and bricks and mortar have remained a significant asset for Americans with 22 of the country’s richest individuals making their money from property, according to the 2022 edition of Forbes 400.

Another four of the richest operate in affiliated areas like real estate management, and one cannot forget the sector gave the world the 45th President of the United States, Donald Trump. Real Estate has been making money for investors since the first caveman stacked a couple of rocks on top of one another and described it as: “An impeccably renovated, cozy and versatile pied-à-terre with flexible layout and endless possibilities,” on whatever Rightmove [LON:RMV] was in the prehistoric era.

Opportunity in adversity

Real Estate should be in all investment portfolios, and in the current economic climate investors should be having another look at the market, particularly those that have liquidity and patience. Especially, as is predicted in the UK, house prices will fall, and many will be forced into distressed sales as a result of rising mortgage renewal rates that have only been going in one direction, as the Bank of England intervenes to put a cap on out-of-control inflationary pressures.

So in terms of asset allocation, you might be asking yourself: “If interest rates are rising and bonds are boring, is owning rental property right for me?”

One of the wealthiest philanthropists in our area made his money building and renting commercial property.  He might have been considered eccentric, but he thought big.  Our county seat now has a museum because upon visiting the Louvre, he looked around and told his wife: “We could do this back home.”

Unfortunately, the community was less accepting of his idea for a bridge between Pennsylvania and New Jersey modelled after the Ponte Vecchio in Florence.  Why am I bringing him into the conversation?  Because I do not think he ever owned a bond or share of stock in his life.  To him, real estate was how you made money.

Asset reallocation

So, I’m going to go out on a limb here – especially as interest rates are rising – and argue that increasing your exposure to real estate, perhaps at the expense of some of your fixed income portfolio is the way to go in the current market. I’d argue – and this isn’t investment advice, but more of a personal preference – ditch the bonds, buy real estate and rent it out.

If you have liquidity and the ability to find the right unit, at the right price in the right area, there is a strong economic argument to go down this road. The market is working to your advantage. Yes, property prices are going to come down. The UK trends are already heading that way, but at the same time the cost of money is going up and the banks are pulling up their drawbridges and lowering their portcullises (to use a castle-inspired analogy) to borrowers.

The affordability of mortgage loans in the UK is becoming a real factor. Existing borrowers are having to deal with much larger outgoings when their mortgage deals come to an end, and they have to negotiate a new deal with much higher interest rates. And first-time buyer, despite spending years saving up for a deposit have been flummoxed by much higher borrowing costs and their current incomes (and I’m assuming that first-timers are a little less long in the tooth than me and might be in the early rungs of the career ladder) don’t match the affordability criteria of the banks when applying for a mortgage.

Forced selling

So, although house prices are going down, they still remain out of reach for many families. Moreover, existing homeowners, due to rising mortgage costs and negative equity, are going to be increasingly forced into downsizing or outright sale.

But if these people don’t own a property, they are not going to instantly dematerialize like Thanos just snapped his fingers. They will still need to live somewhere, and mom and pop’s garage isn’t an option for many, so they will be forced into the rental market.

Inflation hedge

There are many advantages to buying the stock that will inevitably come onto the market. First and foremost is as a protection against inflation.  If you buy a bond on the date of issue and get your money back at maturity, you might be getting your own money back, but the purchasing power has been eroded because of inflation.  When you buy real estate, the property theoretically appreciates over time.

The second benefit is the dynamic aspect of your rental income.  Fixed income is aptly named because your income is…well…fixed.  A government bond with a 3% coupon pays out 3% of the bond’s face value annually until maturity.  Insurance companies like that predictability, aging pensioners do not.  Fuel and grocery prices rise, but your income remains fixed.

Private landlords can raise rents when leases are due for renewal.  This has been a recent problem in England with some rents rising 20%.

The third benefit is there will always be demand for rental property, especially in urban areas.

There are downsides

But as we know there are always two sides to a coin. Owning rental property has its downsides, and here I speak from personal experience.  More on that later.  One of the major negatives is empty properties come with a cost to carry but generate no income.  If you have a property and the tenant moves out and repairs need to get done, you have a non-income producing asset on your hands while the cost to carry is still a burden.

The second downside is property maintenance.  Tenants are entitled to a liveable property.  If the heating unit fails, you need to repair or replace it.  Bonds do not require replacement parts.  These repair requests lead into the third negative factor: How involved do you want to be managing your investments?

In the stock market, you can outsource the day-to-day management of your portfolio to a money manager through a mutual fund or separately managed account.  In the world of rental property, you hire a property management firm that handles these repairs.  They also can find you tenants and draw up lease agreements.

When any of these activities occurs, the cash register rings and your monthly income declines.  The fourth downside comes with the human nature of the relationship.  Bonds pay interest on a schedule.  They do not call you up and say: “I’ll be late with this month’s payment.”

Variable income stream

Some tenants can be unreliable payers.  You would need to initiate the eviction process to get them out and bring in new tenants.  This is messy and no one wants to be Scrooge.  One more downside is liquidity.  If you need money in a hurry, you can sell a bond and get cash in under a week.  Selling real estate takes a lot longer.  Ever see ‘The Money Pit’? It included the line: “The point is you get to capitalize on another human being’s misfortune.  That’s the basis of real estate.”

We have had personal experience in this area.  We bought at the top and after market fluctuations over time, after carrying costs, we were losing a couple of hundred dollars a month for about a decade.  Sometimes owning rental property is like owning a boat.  The two happiest days are the day you buy it and the day you sell it.

Everyone likes statistics, now for the numbers bit: Is buy-to-let still popular in the UK?  Well, the banks are starting to release the post-Truss shackles for buy-to-let mortgages and according to (owned by UK property website Zoopla [LON:ZPG]), the UK population of 67.5 million people includes 2.74 million landlords.

If you looked at it from the household count of 28.3 million households, this implies almost one-in-ten UK households is also a landlord.  Obviously, this is an overstatement because it does not take into account businesses that are landlords.  The average UK landlord owns eight properties.  Buy-to-let mortgages in 2Q22 represented 13.6% of mortgages overall.  That’s about one-in-eight.  About 63% of landlords are over age 55.  A third are retirees.

Owning rental property can make you money, but you need to do it at scale and have access to trade and craft skills resources to minimize those expenses that increase carrying costs and decrease your overall return.

That said, as a diversification tool and an asset that will over time appreciate – often ahead of inflation – it is one to consider.

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This article does not constitute investment advice. Do your own research or consult a professional advisor.

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