4. Property

Tuesday, 22nd May 2012 16:19 - by David Harbage

Continuing our look at the opportunities and risks surrounding long term savings we turn our attention to physical assets.. Intuitively, it seemed to make sense to start by looking at cash - the normal currency of monetary worth - and then move on to longer term interest rates (one way of viewing bonds). Perhaps just as obvious as bank or building society savings accounts when contemplating how to build up a 'nest egg' for the long term, physical visible assets - such as property - come to mind. Amongst the prime considerations that come to the fore when thinking about long term savings, we would highlight: 1. The wish to protect oneself from the seemingly inexorable rising cost of living - this requires growth in income, otherwise a withdrawal of capital may be required to supplement income 2. An increasing tendency to focus on capital preservation, rather than the prospect of capital appreciation - prompted by disappointing returns from traditional investments or concerns about the current health of the local economy. In earlier articles we contend that cash cannot deliver on the first precept (as interest rates tend to go up and down in approximately equal measure over time), and conventional bonds can only offer the prospect of stable, rather than growth in, income. However, index linked bonds (notably, but not solely, gilts) can be a solution, although the absolute level of income is normally unappealing - typically below 2% - and they feature inflation-matching, rather than offering appreciation beyond such insulation. Historically, there have been other assets which have proven themselves capable of exceeding broad measures of inflation. These are termed 'real assets', and they include valuable scarce assets such as paintings or other fine art, and of course property. While the economic laws of supply & demand indicate that a paucity of, or a reduction in, the former will lead to a higher price - this does not always follow. For example the rare postage stamp or classic motor car may eventually deteriorate, and its market worth follow; or the vintage wine may not mature or be acclaimed as anticipated. But this writer does not intend to proffer an opinion on the investment merits or otherwise of such esoteric chattels, where it is to be hoped that the owner has special expertise and takes a hobby-like interest which can provide non-pecuniary satisfaction. The most critical or 'bottom line' point is that in order to entertain the hope of achieving above inflation returns in income (and with it, logically, the potential to see real growth in the underlying capital), almost certainly the investor has to accept some element of risk - the risk that the objective is not met. Human nature also demands an understanding, as well as belief, that the asset can deliver to expectations and promise but at times will inevitably fail to deliver. Owning a house, second home or property (not necessarily, or solely, as an investment) represents an acknowledged means of procuring an inflation matching, if not beating, asset over the long term. History would seem to back this assertion and most adults in our overcrowded island would probably tend to agree that property income (primarily rent) and capital (prices) values will rise in future. Successful businesses that own a lot of property may be similarly viewed; but more on that subject when we look at how one can share in the success of companies in a future article. The average UK house price, based on the Land Registry's data of transactions has risen by a factor of just over 2.5 times, from £62,329 in January 1995 to £160,372 in March 2012. With rental income increasing by a similar multiple, the overall total return has undoubtedly been positive over this time horizon. However, to make a fair judgement of an investment in residential property, one would have to consider the costs of repairing the asset and each house would have its own particular attractions and shortcomings - by reference to location, size and age. Usage and tenant experience would also be contributing factors, impacting in either a financial way or in time/worry consumption. For example, a property may have been used solely as a residence or have had wider leisure or commercial use, while maintenance may have been a major expense, notwithstanding insurance or the employment of management agents. Clearly, property is an individual asset - unless one is rich enough to diversify by owning many across different geographies and types - with historic data available via a plethora of agencies or websites, including the Land Registry. Commercial (rather than residential) property has been a core investment within many domestic pension funds, typically achieved by owning a direct interest in a wide range of shops, offices, farms, factories and warehouses - primarily in the UK, but also overseas. A recent review published by Pensions World suggests that over the past 20 years this asset class has produced a total return of 7.8% per annum, made up of 6.8% income and 1% capital appreciation. We will return to the subject of comparing historic returns when investigating the evidence (supportive or otherwise) for a wider range of asset types at a later date. For now, it is undoubtedly another useful benchmark - like overnight cash rates, 10 year gilt yields and inflation - when considering alternatives for long term savings. Although many readers may already own their home (either outright, or in partnership with their mortgage provider), and have enjoyed significant capital gain (perhaps aided or encumbered by building extensions or other improvements), a few cautionary considerations deserve mention before seeking to replicate that experience via a second home or property investment. Without wishing to state the obvious, a house cannot be readily bought or sold on the market; the process is often beset with unseemly delays (conveyance chains) albeit alleviated by auction, and incorporates cost (stamp duty, solicitors, estate agent and surveyors fees). Accordingly, property must be viewed as a long term investment, in particular to overcome inevitable periods of flat or negative performance in property prices. We expect domestic house prices to remain relatively subdued over the next two years, as consumer confidence remains inhibited by job insecurity and first time buyers struggle to access a mortgage market which penalises applicants with limited deposits. Looking further out to a more normal level of economic health, one would expect to see house prices recover as pent-up buying appetite is expedited. Partially as a consequence of the current hurdles to buying, the UK rental market has remained robust, with the current average annual rent of £705 per one bed flat property (according to the LSL lettings agency) equating to an income yield of 5.1% per annum. However, significant variation applies across the country (with 7% being available in the north of England) and, of course, these returns take no account of maintenance, agents fees, voids (vacancies) and income tax which would depress returns for taxpayers. Many UK citizens have bought second homes overseas, notably in holiday destinations such as Florida, Greece, Portugal and Spain. Leaving aside the complexities and additional costs of buying abroad, the owner has probably taken a lifestyle decision, rather than solely a financial one - making the investment more akin to the natural inclination to acquire and own a domestic home. Finally, UK taxpayers must also appreciate that any capital appreciation in a second property (any beyond their principle residence) will typically be subject to capital gains tax, upon its disposal. In the next blog we will look at another physical asset which many have warmed to in recent times: commodities. These range from precious metals like gold and silver, through to other assets (such as agriculture and industrial minerals) which appear to be enjoying strong demand from the world's emerging economies. Some of these commodities appeal because of their relative scarcity or limited supply, others as an alternative form of monetary currency and most because they are visible and apparently easily understood.