Fleeing from pensions to property

There is little that annoys pensions experts more than the old adage from members of the now retired ‘golden generation’ that “my house was all the pension I needed!” This much-criticised, old-school view – that investing in property instead of buying a pension was the key to a sound retirement – might well come back into vogue.

The reason property investment was such a runaway success for many people now in their 60s and 70s is that it is one of the few legitimate ways of investing in a high-risk strategy. Better still, the inherent leverage can act to significantly multiply gains. It is not really less volatile than investing in the stock market, but it feels that way given how infrequently bricks and mortar get valued.

For those who had stashed all their savings into a pension, leaving nothing left over to buy their own home or a second home, from April many will have the option to free up enough cash for a deposit, 25 per cent of it tax-free. Would buy-to-let be a sensible retirement income replacement strategy?

Firstly, a quick recap on the merits of the mortgage. If a fund manager were to amplify their performance by leveraging 100 per cent of their investment three times in a relatively high risk market, you would call them a crazy hedge fund manager, give them 1 per cent of your money at best, close your eyes and pray. But of course, this is precisely what happens when most people buy a house.

In reality

Let’s imagine buying a £300,000 property, which is close to the national average (although well below the current London average of £514,000 according to the Office of National Statistics in September last year) on a 70 per cent mortgage at 2.5 per cent annual interest, which is a broad current market rate for a buy-to-let. Your £90,000 liberated from your pension pot is, effectively, more than three times leveraged.

Then assume, perhaps heroically, that property prices rise 6.7 per cent a year – the simple average annual price rise since 2000 according to the ONS. Under this scenario your £90,000 would have netted you a £228,000 capital gain over 10 years – a total return of 242 per cent or 9 per cent a year, and that includes interest costs and stamp duty. Beat that, equities!

To cap it all off, if the house is rented out at a 5 per cent yield, or £1,250 a month, that adds a further £15,000 a year in income (£10,800 a year if netting off interest costs). Actual rental yields vary massively, from a paltry 2.8 per cent in Kensington (where the average house costs £1.2m) to a hefty 8.7 per cent in Southampton, according to HSBC.

Add in the income, assuming the rent uplifts as the house price increases, and after 10 years you can add £233,000 to your gain: that’s a total return of 501 per cent or 17.5 per cent a year.

Of course there are other costs that need to be factored in to get a full picture – estate agency and conveyancing fees on sales and purchase, rental agency and maintenance costs if renting out. But even making generous allowances for these, and the cost of one month’s rental vacancy per year plus mortgage renegotiation every two years, the total return on this model would be approximately 8 per cent a year unlet, 17 per cent a year let. There is, of course, capital gains and income tax to worry about too, but that is the case for any equivalent investment.

Rising interest rates could scupper this glorious plan though. If they increase at a rate of 0.25 per cent a year for the first five years (which would make the base rate still only 1.5 per cent by the end of the period), that cuts the profits to a total return of 200 per cent unlet, 460 per cent let – or 7 per cent and 16 per cent a year accordingly. A worst case scenario would be a significant hike in interest rates sparking a house price crash.

Let’s imagine after base rates hit 1.5 per cent in 2020, in 2021 they spiked to 3 per cent causing a 30 per cent fall in house prices, which failed to recover. What then? In that case, it goes rather wrong for our unlet hypothetical investor – after 10 years their house is worth less than when they first bought it, and they have paid out £81,000 in interest costs: total return -£111,000. With 11 months rental, however, a let property makes £164,000 in income, limiting overall losses; but still hardly worth the effort.

Weighing up the odds in such a complicated investment is tricky. There are many variables to consider, most of which are extremely unpredictable, such as tenant demand, ongoing costs and future interest rates. It can also be time consuming and stressful to manage.

In granny’s hands

But then again, many pensioners will have the time to spare. They may also have children or even grandchildren who would be happy to rent from them at least for a few years while they are students or in their first years of working life. In these instances, where a reasonable rent can be guaranteed for a period and the investment fulfils a wider social purpose, why not put Granny and Grandad’s hard earned savings to work?

For clients who need an income, 5 per cent or 6 per cent is not easy to come by outside of the annuities market and structured products. Even high yield equity dividend funds struggle to deliver this level of income net of fees.

Such a solution is unlikely to be top of an IFA’s list, given the typical focus on traditional liquid investment markets. But financial planners should not be surprised if the idea gets mooted when planning out a client’s retirement income. Even £90,000 will not buy much in the annuities market – and drawdown plans will struggle to deliver a better income or any better likelihood of capital growth.

Finding the ideal property, location and tenant could become a full blown project for a client – which may well be exactly what they need if they have just given up work for the first time. Pension experts will continue to look down their noses at anyone planning a retirement strategy based on property investment – but property has already worked once for our parents, couldn’t it work once again for them or even for the next generation?

Bob Campion is head of institutional business at Charles Stanley Pan Asset Capital Management