Buy to let vs index funds – expat focus

Which is the better investment buy to let or index funds when you live abroad? Lots of expats face this question. With the ease of access to index funds through low cost brokers and somewhat of a media revival for buy to let, this topic has returned to the forefront of many a would be investor’s minds.

This is one of those decisive questions that tends to get heated because both types of investments have ardent followers who swear by nothing else. Most of the BTL brigade won’t touch an index fund with a barge pole.

In fact, I bet the vast majority don’t even know what an index fund is. On the other hand index fund investors probably think BTL investing died in 2008.

Being currently invested in both and living overseas, I feel pretty well positioned to give an honest and fair comparison with an expat slant.

In this article we’ll cover positives and negatives of each when you live abroad. But most importantly, we’ll do some number crunching to really see how things add up. After all, though not the only important thing, investment returns are certainly the most important thing.

Let’s get into it.

House keeping

There are all kinds of fees and taxes to pay with both property and index fund investing. I’ve taken some artistic license with these to keep things simple.

In fact, I’ve pretty much ignored them for index fund investing and assumed you lose a third of everything you make in property investing. Research and my own experience suggests we aren’t too far off with either of these.

Yes, there are costs involved with index fund investing, but most people are in a position to avoid the vast majority of them through tax sheltering and low cost investment platforms. Think ISAs and SIPPs for UK investors. Whilst expats don’t usually have access to those, they often have alternatives or can avoid paying tax on investments anyway.

That’s just to say, its not just the UK that has tax sheltered accounts. Many places do. Not only that but many of the most popular British expat destinations are considered low tax destinations.

And if by some quirk of fate you don’t live in a ‘low tax’ destination or have access to tax sheltering you can take heart from the fact that index funds are extremely tax efficient anyway.

Spoiler alert

Spoiler alert! Just in case you can’t be bothered to read on or if you’d like a summary of what’s said, then here it is in a nutshell.

In terms of investment returns, done right BTL probably beats index fund investing for investment returns. But there are two components that must be present for that to work.

• You must put some work in
• You must use a mortgages

If you put the work in, use a mortgage and especially if you remortgage you’ll likely get better investment returns through property investment than you would with an index fund.

But if you don’t let your property out and/or don’t use mortgages you are almost always going to be better with index funds.

And for expats, you are going to have to put a bit more work in at the beginning to choose a decent property to account for the extra costs required by doing thing abroad. Nine times out of ten you will pay more tax, have to pay a letting agent to do everything for you and pay a higher mortgage rate.

Put simply – with index funds you get similar returns for a lot less work. This is even more the case when you live abroad.

OK let’s get into it.

Expected returns

Though not the only thing, investment returns are usually the most important thing so lets begin by taking a look at how these compare.

The very best historic returns I can find come from the London School of Economics. Based on 150 years of history, UK house prices have gone up on average just under 4% annually.

For your information a 4% annual increase would take 18 years to double in value. So much for the house prices double every decade saying. It’s more like every two decades but anyway….

But just to be clear. This is an average. For sure different property types in different areas will have different returns. All things being equal the rental yield is greater with HMOs (Houses in Multiple Occupation), but at the same time the capital growth is often lower.

HMOs also tend to require more work than more ‘vanilla’ alternatives such as centrally located apartments and houses let out to professionals. And this makes the latter more suited to expatriates that aren’t on hand to deal with problems.

I’m assuming 9% for index funds because that’s pretty much what a broad basket of global shares would have done in the past too. (This again comes from the what the consensus seems to think is the best data out there on stock market returns from the London Business School and Credit Suisse – Global Investment Returns Yearbook).

Now, I know what you are thinking. 9% vs 4% seems like a bit of a non starter. Haven’t index funds won before we’ve even began?

And whilst I can understand why you might think that, fortunately for BTL, property has a couple of tricks up its sleeves. Namely:

• Rental income
• Mortgages

Now, the thing about rental income is this. It tends to get swallowed up by your associated fees. There are all sorts of costs associated with BTL, but the main one is mortgage interest.

Sure, taking out a mortgage only to have to spend all our rental income on the interest payments seems a bit counterintuitive at first. However, it soon becomes clear why you might want to do this when you look under the hood.

Should I take out a mortgage?

The power of mortgages in property investment is best explained in a little example.

Imagine you have £100K to spend.

If you spend it all on a house and house prices increase 4% you make £4K.

But if you use that £100K as a deposit alongside a mortgage something rather interesting takes place.

You see, you can usually borrow up to 75% of the asking price with a BTL mortgage. Typically this is referred to as a 75% LTV mortgage. In this case that would be £300K to go with our £100K deposit.

And with £300K from the bank and £100K deposit you could buy a £400K property.

A 10% increase on that would be £16K. And don’t forget you still only invested £100K of your own money so that’s a whopping 16% return.

Now whilst it looks like the pendulum has swung back the other way entirely, that’s not really the case. Not yet anyway.

The fact of the matter is. You wouldn’t get all that. There are tonnes of fees and taxes that will need come out of that. Experience says somewhere around two thirds is probably a more realistic number.

So by borrowing money we are back in index funds territory but as already touched on above index funds require next to no work. Even fully managed city centre apartments will have things to do, so at this point, it would be hard to argue that index funds still don’t trump property.

Index funds are pretty much hands off. And you didn’t have to borrow money to get your similar returns to property.

So surely it’s all over for BTL?

Well, unfortunately for our index fund, BTL still has one little trick up its sleeve and that’s a little something called remortgaging.

Why remortgage?

So why remortgage? Well, we’ve already established house prices in the UK go up on average 4% per year. Based on that house prices double every couple of decades (18 years).

Imagine we zoom into the future and your £400K house has now doubled and become an £800K house.

A 4% increase annually on that is £32K or 32% on your original £100K investment. Assuming we only keep two thirds of that after fees you are still looking at over 20%. How good is that?

But don’t get too exited because the same kind of thing would also happen with your index fund.

(And whilst I’m in danger of sounding like a broken record, index funds require next to no work!)

Where buy to let starts to edge forward is with what happens next.

Why remortgage impacts investment property

Assuming we remortgage for 75% of the current house price, we could borrow £600K. Now, we’d need half of that for our original mortgage but what about the other £300K. Couldn’t we just buy another property with that money?

Because if we did we’d now have £1.1 million worth of property. A 4% annual increase on that would be £44K. And even if we assume we only get two thirds of it, we are still talking £29K and wait for it…….

That’s a 29% annual return on our original £100K!

For sure, an index fund will go up in value and get higher returns annually based on your original investment but not like that.

If we say, taking out a mortgage evens the game, then remortgaging shifts it firmly in the BTL’s favour.

29% investment returns!

Let’s be clear. There’s no guarantee that you’ll get 29% annual returns, but if you put the work in, let your property out and persistently remortge your investment returns will probably trounce index funds.

And think about it this way. In our example, we only took out mortgages twice. In practice, we could have done a lot more than this. We could have remortgaged faster and bought more properties with cash and then remortgaged those.

Not only that, but the whole time we have been dealing with averages.

Property is a little different to shares. With shares the research is pretty conclusive these days. It says buy an index fund because when you do that you’ll get the average market returns and in doing so beat 90% of the pros.

But property isn’t like that. If you put the work in, do your research and gain experience there’s a good chance you’ll get better than average returns.

But just know, you need to put the work in when you live abroad, and that it is a long term way to gain wealth.

And most importantly, it only works if you let your property out to good tenants and use mortgages.

It’s worth saying a few words on each of those.

Good tenants

Some landlords never have any issues with tenants. Others have no end of trouble. Most get the odd problem from time to time.

There are all kinds of things you can do to minimise the chance of having a problem.

Using a letting agent’s full management service is a big step in the right direction. Expats will usually have to do this anyway. Not only will they be able to handle reference checking and the like, but they will also know how to make the tenants life easier so that they don’t have issues.

Property type can have a big impact here too, so ensure you do plenty of due diligence before you make a purchase if you are new to property investing. You don’t get the outsized returns without at least a little effort.

I’ve never had an House in Multiple Occupation (HMO) but I’m pretty sure they have the potential to generate higher returns than other property types but at the same time layer on the incremental hassle if you don’t take a hands on approach.

In other words, they won’t be suitable for most expats.

BTL mortgages

It’s worth saying again.

Unless you use a mortgage index funds are nearly always going to be a bettor option if you live overseas.

Index funds are better than property without a mortgage or tenants because you expect greater returns (9% vs 4%) for a lot less effort. Unless you love bricks and mortar its a no brainer.

However, it’s also worth saying this again.

If you use mortgages wisely you can get much better investment returns with buy to let property.

But there are a couple of things to be aware of with mortgages.

• Costs
• Risk

Mortgage costs

I don’t think it’s an exaggeration to say a BTL mortgage can make or break your investment due to the costs involved which are nearly always a tad higher for expatriates.

There are all sorts of fees involved with mortgages, but the big one is nearly always mortgage interest.

All things being equal you want the mortgage with the lowest interest rate. Shaving 1% off your interest rate can save you tens if not hundreds of thousands of pounds over the long term. There’s a mortgage calculator here you can try if you want to test this for yourself.

In recent years higher arrangement fees have become more of a thing.

Typically, mortgage companies charge higher arrangement fees so that they can reduce interest rates. In some cases a higher arrangement fee will be worth it. Other times it won’t be.

Definitely worth getting putting a spread sheet together to crunch the numbers. Even better get your mortgage broker to do it for you.

Debt risk

It’s also absolutely essential to be aware of the risks involved with mortgages.

Mortgage debt is considered to be one of the, if not the safest form of debt out there. Which is why banks will lend you so much money to buy a house. But all debt comes with risk.

To start with, all that mortgage magic we used in our example above could work in reverse. Instead of making big returns you saddle yourself with major losses.

The key is that this is usually short term. And as long as you can make your repayments to your lender you shouldn’t get in any trouble.

Hoping for the best, but planning for the worst never did anyone any harm.

Again. Spread sheets and mortgage brokers should be useful here.

Recent buy to let issues

There’s a recent article dedicated to buy to let problems here, which is probably worth a read if you are new to the space, but here’s a quick summary:

Safety precautions following the Glenfell Tower tragedy, and problems with leases like doubling every 10 years mean many properties, particularly apartments, are severely undervalued right now because lenders simply won’t touch them until these issues are sorted out.

The Government does seem to be having a go at tackling these problems, changing leasing laws, providing funding for safety work and putting pressure on industry to stump up the costs.

But as things stand many apartment owners will be sat holding properties with values that are probably less than they paid for them, particularly if they paid for them at the top of the property bubble in 2008 (some 16 years ago!).

Does that mean you should avoid apartments? Probably not. That would be fighting the last battle. If anything, now could be a time to get yourself a bargain. The next major property problem is almost guaranteed to be something else.

Not long ago it was HMOs, now it’s apartments, in the near future it looks like houses are going to be hit with new EPC regulations. Who knows what government legislation could come along in the years ahead.

Expat property investment

Living overseas adds another layer to BTL.

To begin with, finding a property can be more difficult. Sure estate agents will help and there are even companies like Viewber that will do viewings for you, but you’ll have to pay.

Then when you find a property you’ll usually have to pay more tax than a UK resident would, and pay more for your mortgage.

Not only, that but most expats are going to need to pay for a full letting service to manage their investment.

While costs impact investments, as long as you do your research and pick a decent enough property, they are unlikely to break your deal.

You just need to pay more attention and put a bit more time in the beginning finding decent companies to work with.

And if you aren’t willing to put the time in, you will probably be better with index funds.

Simplify you life

If you want to simplify your life the index fund takes a lot of beating. Whilst some index funds aren’t available to all, index tracking exchange traded funds or ETFs certainly are.

We’ve waxed lyrical about the differences between the two here but here’s the headline. Expats can buy index tracking ETFs easily these days.

And with ETFs anybody with a brokerage account can easily invest in thousands of shares in one click with funds like iShares MSCI ACWI ETF or Vanguard FTSE All-World UCITS ETF.

With these, you get little pieces of all the businesses around the world that matter, rather than a single property on a single street in the UK!

These businesses will be working 24/7 globally on your behalf. When Mr Li buys a coffee in Starbucks Shanghai an incy wincy teeny weeny bit of that profit is on its way to your investment account. When Francois uses Booking.com to pay for a Hilton hotel room in New York an incy wincy teeny weeny bit of that profit is on its way to your investment account….. Think about a friend you know, and think about all the products and services they use in a day. Slowly but surely they’ll be lining your pockets too.

Index funds or index tracking ETFs are low cost, tax efficient and simple to take advantage of, even if you live abroad.

And in practice, all you need to do is add money to your chosen fund whenever you have it. For most people this will require no more than a couple of mouse clicks a month.

I can guarantee you’ll have a lot more to do with a BTL.

The bottom line

So at the end of the day I think it comes down to this.

Most people, most of the time, will get greater investment returns from BTL than index funds.

But just know, for those outsized returns you must put some work in and take on debt because after all that’s what a mortgage (and remortage) is.

Whilst mortgage debt is perhaps the safest form of debt out there, at the same time any debt carries risk. But as long as you don’t take on more debt than you can handle and use a good mortgage broker you should be fine.

On the other hand.

Anybody who wants to avoid work or debt would probably better with an index fund.