With gilt yields near historic lows and bank accounts paying next to nothing, income-focused investors have increasingly gravitated toward buy-to-let in recent years. The concept seems simple: Find the right property, fund a deposit with your savings or pension pot, find tenants to cover your mortgage and then some, and reap regular cash flows and big returns when you eventually sell. Some buy-to-let investors even boast of annual yield as high as 20%i! In reality, though, buy-to-let has many drawbacks, and for many investors, the benefits don’t outweigh the costs.
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Tax Changes Trigger Troubles
For one, several recent and forthcoming tax and regulatory changes have made buy-to-let significantly costlier for investors. In April 2016, stamp duty on second homesii rose three percentage points, and property was excluded from capital gains tax reformsiii, forcing landlords to pay relatively higher capital gains taxes. The Bank of England is toughening buy-to-let mortgage requirementsiv, which likely drives borrowing costs higher once the rules take effect in 2017. But the real killer comes in April 2017, when the government begins phasing out buy-to-let tax relief, replacing the mortgage interest cost deduction with a 20% tax credit (the change will be in full effect in 2020). This is not an even swap: It can transform profits into losses, and further add to landlords’ tax bills by bumping them to a higher tax bracket. A recent Spectator article by Merryn Somerset Webb shows the math:
Here’s a quick look at how this works in practice with an example from Brewin Dolphin. A landlord paying tax at 40 per cent has an 80 per cent loan-to-value mortgage. He gets £10,000 in rent and pays £8,000 in interest. On his £2,000 profit he currently pays 40 per cent of £2,000 (£800) leaving him a net gain of £1,200. However, come 2020 his tax bill will be calculated on his turnover minus a 20 per cent tax credit. And 40 per cent of his £10,000 turnover is £4,000. The relief comes to 20 per cent of the interest (£8,000 × 20 per cent = £1,600). The result is a £2,400 tax bill. Add that to his mortgage interest and you will see that his annual profit of £1,200 has turned into an annual loss of £400. Nasty.
Several buy-to-let investors have already begun leaving the market as a result—including the country’s biggest “amateur landlords,” a couple from Kent, who have unloaded nearly half of their 900-home portfolio.
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Yet even before these changes, buy-to-let wasn’t all it’s cracked up to be. Being a landlord is far more labour-intensive than owning shares, funds or fixed interest. Dealing with tenants, routine maintenance and unexpected repairs takes time and money. Some landlords hire property managers to ease the burden on their time, but that is an additional expense.
Those who boast about buy-to-let’s supposedly high yields mostly ignore these and other related costs. Their math is simple: Buy and remodel a home for £150,000, split it into multiple units, get £30,000 in rent from tenants annually, and presto, you have a 20% yield! But this calculation omits mortgage costs, taxes, insurance, upkeep, potential legal fees, utilities and the occasional new roof or plumbing disaster. It also assumes the property will be fully let at all times, ignoring the costs of tenant turnover and unoccupied units. And what if your tenants fail to pay? Earning enough to live on in retirement is far more difficult with real estate than advertised.
Finally, real estate is illiquid, and home prices rise as well as fall. If you need emergency access to your savings, and they’re all tied up in rental properties, selling can be difficult—and selling in a hurry might require you to accept a lower price. And then, of course, you’ll be hit with that relatively higher capital gains tax rate.
In our experience, a liquid investment portfolio with shares, fixed interest and other securities is a more cost-effective, tax-friendly and reliable way for investors to generate cash flow in retirement. Whilst people view shares as more volatile than real estate, this isn’t necessarily the case. Property simply lacks a transparent, daily price, which gives it the illusion of stability as daily wiggles aren’t visible. However, as we’ve witnessed during numerous property crashes, the lack of daily pricing doesn’t mean real estate is actually more stable—it is just more difficult to value, which is another drawback for investors.
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