Property funds vs buying UK investment property

Everybody knows property investment is a great way to grow your wealth. But should you put your money into a fund or an actual property?

This week, I’m going to explain why most people should avoid investing in one of the above altogether.

Let’s get into it.

Buying property is something investors have been doing since the dawn of time.

In theory it couldn’t be simpler. You buy a house. You find some tenants and then watch your bank balance grow through capital gains and rental yield.

Property funds on the other hand are a bit less common and a bit more modern.

A property fund pools investors money together and uses it to purchase buildings that generate income.

In theory, there are a number of advantages to investing in a property fund. Particularly for expats that live overseas.

Here are the main ones:

Advantages of a property fund

• Diversification – instead of focusing your money on one house, on one street, in one area, of one city, your money will be spread over lots of different properties throughout the UK
• Less cash needed – even cheap houses bought with big mortgages need thousands of pounds for deposits and fees, you can buy a share in a property fund for less than a fiver
• Liquidity – houses take months, sometimes years to sell, whereas shares take minutes
• Tax benefits – you can hold property funds in tax sheltered accounts
• No work involved – even fully managed city centre apartments have some work involved. Funds require a couple of mouse clicks once or twice per year

All those are great benefits, but here’s the thing. You get every single one of them from investing in a general fund ie a fund that contains the shares of all kinds of companies. Not just property.

Good examples would be an index fund or ETF that tracks the entire UK stock market such as the FTSE All Share or one that tracks a global index like the FSTE All World.

In fact, in most cases the advantages you get with a property fund are magnified even further with index funds and ETFs, particularly diversification and liquidity.

It’s easier to sell a big index fund than it is to sell a property fund and whilst your money will be diversified across hundreds of properties in a property fund, it’s easy to spread it over thousands of companies throughout the world with a global index fund.

Some people think they may get better returns from property funds, but there doesn’t seem to be much evidence of that.

Property funds vs the wider stock market

The graph below compares US shares with US property funds. I’m using US data because UK data just doesn’t go far enough back to get a good idea of what’s going on.

Along similar lines, I’m going back to 1994 because that’s as far as the data goes.

It’s not perfect but I think it gives us an idea about how the two compare.

Source: Portfolio Visualizer

The blue line shows US stocks (shares) and the red line property funds (Real Estate Investment Trusts).

You can see there have been some periods where one has done better than the other but over the long term they aren’t really that far apart. In case you are wondering it’s 8.5% for property funds vs 9.8% for shares.

(The UK situation isn’t much different by the way)

But it wouldn’t surprise me if there was a reversal any time soon and that in the end they just more or less tracked each other.

And that’s because, property funds are just baskets of shares in companies that do property.

When is a property not a property

Whilst land is a different beast to shares, we aren’t really talking about land investment.

Stick a building on some land and you get a bit closer shares. Turn that building into a business and you are closer still. Grow that business until it’s big enough to float on the stock market and you’ve moved about as far away from pure land and as close to any other large business as you are going to get.

In other words, property funds are more like other funds than they are like land investment. The only difference is that your money is focused on one type of business.

A single BTL is somewhere between. We are coming to what makes these special investments later.

So essentially a fund is a fund is a fund. If you want the benefits of a property fund outlined above you are almost always going to be better with a fund that tracks all kinds of businesses ie a global index tracker or ETF.

By investing in a property fund rather than one that contains everything, you are essentially saying, property is going to outperform other areas like IT or energy otherwise why would you do it?

That’s a big call, because it’s one that most professionals get wrong.

Putting the odds in your favour

The fact of the matter is, if you want to put the odds in your favour you would be better putting your money in a low cost index fund that tracks the wider stock market. Research shows that is likely to get you better returns than 90% of professionals.

Anybody with an investment account can invest in global index trackers these days. There’s no work to do and you are likely to get equal or better returns than you would do with a dedicated property fund.

Average returns for UK shares

The best research on shares comes from esteemed finance gurus Dimson, Staunton and Marsh at Credit Suisse. Based on over a hundred years of data UK shares have provided 9.1% returns on average annually.

Remember, you wouldn’t have had hardly anything to do for that return.

And that compares pretty favourably with property by the way.

Investment returns from property

Here’s a quote from the London School of Economics based on over 150 years of UK property data.

Between 1845 and 2016, UK home prices grew at an average annual rate of 3.8 percent.

LSE

That’s less than half what we would have had from shares. It’s also a lot less than what many in the property industry would have you believe too.

The 10 year double?

I’m talking about the golden rule that house prices double every 10 years.

A 3.8% average annual increase per year rather puts the kibosh on that I’m afraid. At that rate it would take over 18.5 years for a doubling.

“But things are different now,” I hear you say. How long does it take for house prices to double in modern times? That’s the important thing!

Well according to the Land Registry right now the average price of a house in the UK is £286,489.

So you’d expect the average price to be half (about £143K) ten years ago ie 2013. That is, if the rule holds true.

But what you actually find is this isn’t the case. In 2013 the average house price was over £175K and in fact to find house prices at half what they are today we need to go back to 2004 ie almost 20 years!

So much for the house prices double every 10 years rule.

Source: Land Registry

Sure there are times when house prices do in fact double in a decade, but let’s not confuse that with an average.

Hope that they do, know that it’s possible that they can, but whatever you do, don’t expect it.

Now if you’ve got this far, you maybe thinking it’s all over for property. But that’s not quite where we are going with this.

Property is still a valid investment, just not usually via a fund.

Rental income & mortgages

Whilst 4% for property vs 9% (rounded) for shares seems like a done deal, it doesn’t tell the whole story.

The pros buying investment property have a couple of tricks up their sleeve to put the odds back in their favour.

I’m talking about rental income and mortgages.

First, a few words on rental income.

Whilst you can buy a property for cash and let it out to tenants and make some money every month after fees, that’s not usually going to be the case when you use a mortgage.

That’s because there’s a little thing called mortgage interest to pay. That plus other fees usually wipe out your rent and in many cases you’ll have a short fall to pay.

Now, I should prove that with a string of complex calculations now, but I’m not going to do that for a couple of reasons. It will make things more complicated than they need to be and I’m hoping I will be able to make my point without them.

In other words, for the purposes of this exercise we ignore rental income because it gets swallowed up entirely by our mortgage interest and other costs (particularly when interest rates go above 5%).

Why use a mortgage when you have to pay mortgage interest?

So why use a mortgage if your rental income will be swallowed up by mortgage interest then?

The short answer is, to juice returns.

Invest in an unmortgaged property and you’ll usually get inferior investment returns to shares and work to do for your trouble!

But, the minute a mortgage enters the equation things start to change. Let me explain.

Typically, you can borrow up to 75% of the property price when purchasing a buy to let (BTL). This is what is referred to as 75% LTV.

We’ve already established that on average property goes up 4% (rounded) per year in the UK.

Let’s say I buy a £100K property. An average increase of 4% gives me £4K.

But what if I took out a 75% LTV mortgage to go along with my £100K. That would mean I could buy a £400K house.

If I buy a £400K property, an average increase of 4% gives me £16K.

And don’t forget, I still only invested £100K so in actual fact I’m getting a 16% return!

It could be worth taking a moment to digest that.

…………………………….

OK back to it.

Now, in reality, you probably won’t get quite that much due to additional fees and this and that but you get the picture.

And would you believe it if I say we are only just getting started with this?

Remember house prices are going up and your mortgage is staying the same. (assuming interest only which is what most people use for BTLs).

Whilst we’ve already established that house prices double every 10 years only occasionally, that doesn’t mean they don’t double. We’ve certainly established they do that.

It’s just that on average it takes a little longer ie 10 years x 2 or more perfectly put….20 years!

But here’s the thing. Investing is a long term affair. All types of funds can drop double digits from time to time and not come back for the best part of a decade so you’d better be in it for the long term.

And if you are in it for the long term and hold on for a doubling have a think about what that would do to those numbers above.

When 4% is 32%

Imagine that £400K house you bought with a £100K deposit and a £300K mortgage has now doubled in value.

That means, your house is now worth £800K. (And you still only put £100K into the deal!)

A 4% increase on £800K is £32K.

In other words you are getting a 32% return on your £100K investment now!

OK those nasty fees and expenses are going to reduce that, but you’ll still a large chunk of it.

And not to poor too much cold water over this, but that kind of effect also happens with shares too. And remember, we’ve already talked about the advantages of those (no work!)

However, there’s another tool in property investing that’s almost as powerful as the mortgage itself. It’s something seasoned property investors swear by.

And that’s…. wait for it……

A little something called a remortgage.

Mortgage magic

Look what happens when we remortgage the above example.

So whilst I had to wait a long time, I’ve now got an £800K home.

Providing I’m not in some kind of financial difficulty I should be able to remortgage at 75% LTV again.

75% of £800K is £600K.

In other words I should be able to get £600K from a bank. Of course, I’ll still need half of that to fund my original mortgage, but that still leaves an additional £300K.

What about if I used that money to get a new house?

Because if I did use £300K to buy an additional property I’d now have £1.1 million pounds worth of property.

4% of £1.1m is £44K. And whilst I’m in danger of sounding like a broken record here, I still only put £100K into the deal so now I’m getting a 44% annual return on my original investment!

NOW I’M GETTING A 44% RETURN ON MY ORIGINAL INVESTMENT

Yes, yes and yes I’ll be knocking some of that off for fees etc but I’ll still get a big chunk of it.

You might want to take another minute or two to digest that.

Risk

Now, there’s a few things to point out here.

First and foremost, whereas you can invest in shares for next to no effort, property is a different kettle of fish. Even fully managed properties have decisions to make and work to do.

Also, I hope, it’s pretty clear that I’m not describing some kind of get rich quick scheme here. In the example above its taken 20 years and some jiggery pokery with mortgages to get our outsized investment returns.

I’m also not saying you’ll definitely get those investment returns.

And on that note, it’s also it’s worth repeating. I’m dealing with averages here. Whilst you can get better than average, you can also get worse.

As I’ve already mentioned, there could be additional costs and fees that lower returns.

And even though mortgages are one of the safest types of debt you can ever take on, that doesn’t mean they don’t come without risk.

If interest rates rise your mortgage payments can go up. In some cases, dramatically!

And though not usually over the long term, over the short term this whole magnifying returns thing can work in reverse.

-4% could become -16% or -32% or even -44%!

Imagine when there’s a recession or something similar. Property prices going down would be bad enough, but what about if your tenants lost their jobs and couldn’t pay their rent. Even worse what about if you lost yours at the same time!

Unlikely, but it happened to some in 2008. In fact, some property investors never recovered from that event.

But if you do it right, are in it for the long term, ensure you don’t take on more debt than you can afford and always have contingency plans for when the proverbial hits the fan, then you should be able to weather any storm that comes your way.

That’s why it’s essential to find yourself a specialist mortgage advisor by the way. Ideally one that deals with buy to let. The fees you pay will pale into insignificance if they can find you a better deal and ensure you don’t take on more debt than you can afford.

Don’t make the classic mistake of thinking you save money by approaching lenders directly thus skipping fees. Lenders give you the deal that’s best for them. Mortgage brokers get you the deal that’s best for you.

The bottom line

So to sum up, general funds that invest in all kinds of businesses are usually a better option than a dedicated property fund. You get the benefits of a property fund and more.

However, if you want to maximize returns then property is probably going to be the one for you. Just know you’ll need to put some work in, be in it for the long term and use a mortgage (& remortgage) to really make it worthwhile.

And if you do go down that root ensure you find yourself a good specialist mortgage broker to ensure you get the best deal and don’t take on too much debt.