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Room for optimists

Yields on investment in residential property have fallen consistently over the past five years – leading to claims that the sector is no longer attractive and announcements from some quarters that the buy-to-let market will collapse.

These conclusions appear far too simplistic. But, as with any investment, money can be lost if the investor does not understand the key drivers of the market and make an appropriate assessment of the risks involved. For buy-to-let investment, as with any other, the basic issues are simple to define. What generates income? How sustainable is this? What are the costs? How might these rise? What is the scope for capital gains or losses.

Most of these factors can be assessed with a reasonable degree of confidence and suggest there is still considerable value available.

The prime driver of income is clearly rental levels. In general, demand for rental properties is increasing, particularly among young adults who appreciate the flexibility and low movement costs associated with renting. Surveys show that, over the past 10 years, rental levels have risen at about four per cent a year – a rate very much in line with average earnings and we would expect them to continue to rise at this rate.

Of course, one cannot guarantee that income will rise at this level. All depends on individual circumstances. Prolonged void periods will cut into expected income, and statistics showing that void periods consistently averaged 28 to 30 days over the past five years, and that a landlord can expect a void to occur once every two years, will be of little consolation if a property is empty for three months for the second time in a year.

Many landlords are happy to sacrifice an annual rate review to keep reliable and considerate tenants in their properties. However, when viewed on a national level, the prospects for rental growth appear good and rental income can be expected to remain stable.

The private residential rental market is a large one of some 2.5 million households. The market’s size suggests it will not be subject to sudden variations – at national level, there is little prospect of change in either supply or demand on a scale that would cause major moves in the market.

Of course, locally, specific factors may affect demand (the sudden closure of a major employer, as with Rover at Longbridge) or supply (completion of major new development). As ever, careful assessment of individual investment opportunities is always required.

With rental levels being relatively stable, trends in investment yields are largely determined by what happens to house prices. As property prices have risen over the past five years, so income yields have fallen. This is only to be expected as the property market, along with other investments, adjusts to the UK’s current low interest rate-low inflation environment.

Whether yields are sufficiently attractive to justify investment is a question only individual investors can answer. But our estimates of typical buy-to-let deals indicate that average returns are at least as good as those available on any retail savings product. And, judging from the current market, the answer to this question must be yes.

Demand may not be as strong as shown by the extra-ordinary levels of business recorded in the first half of last year but it has certainly not declined in line with the more pessimistic predictions made last summer. Indeed, demand has been rising steadily since the turn of the year. Part of the reason for this may have been the expectation that interest rates have reached their peak and the downturn may be sooner rather than later.

For most buy-to-let investors, interest costs are their biggest expenditure. The prospect of a reduction in these costs must be assumed to improve the prospects for the market.

The final element in assessing the investment is house prices. Whereas the trends in the other elements may be projected with a degree of confidence, there is greater uncertainly surrounding the likely trend in house prices – particularly in the short term.

The range of published forecasts for house prices is remarkably wide – from optimists who continue to see prices rising at five per cent a year to Capital Economics with its, now traditional, forecast of a 20 per cent fall in price levels.

Clearly, if you really believe the housing market is about to suffer a sharp fall, then this is not the time to invest. But if, like most players in the housing and mortgage market, you believe prices are likely to stay relatively stable over the next few years, then the right investment opportunity will be profitable.

For most buy-to-let inv-estors, it is not the prospect of short-term capital gains that drives their decisions. Surveys of investors consis-tently show that most people involved in this market are investing for the longer term, which they generally define as being at least 10, if not 15 or more, years.

While the prospects for house prices and capital gains in the short term may be uncertain, the prospects for the longer term appear to be sound. What better long-term hedge could any investor have against inflation than the bricks and mortar of residential housing?

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