The NOT so hidden costs of property investment in the UK – Part Two…

How lucrative is investing in property really?

We recently looked at the considerable upfront cost of buying property as an investment Once you have bought the property, however, the costs don’t stop there. In order to work out whether it is genuinely worth the investment, you need to look at the income you’ll earn, the taxes and whether investing the money elsewhere could in fact be more lucrative.

The impact of rising interest rates

Mortgage repayment - With rising interest rates in the UK and around the world, borrowing costs have increased by about 3% to 5% over the past couple of years. If the rent was providing a 7% to 10% return, the increased mortgage costs may wipe out a significant portion of the income, if not all the income after tax.

For an interest only mortgage of £375,000, the monthly payments at 5% would be £1,563, which is £18,756 a year.

Rent will have to be higher than this and rise in line with rate rises for the net income to remain the same. With the rising cost of living (before rent rises), this could see more renters falling behind on rent and a potential spiral of unpaid rents and defaults in the rental market.

Ongoing costs - Annual repair costs could easily be 1-2% of the property value, that’s £10,000 a year on a £500,000 property. And if you don’t want the potential headache of dealing with tenants, you could, like many property investors, outsource to agents. But this cost could be as much as 10% of the rent, which would be £4,000 in management fees, assuming rent is £40,000 a year (8%).

A mortgage wouldn’t be possible without insurance and not having it would increase the risk of ownership considerably, so costs of insurance need to be factored in. This could be many hundreds of pounds.

How will tax affect your return on investment?

If the property is owned by you as an individual, the rent is taxed as income (so 20%, 40% or 45% depending on your tax band). If a higher rate tax payer received £40,000 in rental income and was paying £18,756 on mortgage repayments then the net income would be just £5,244 a year (before any maintenance / management costs). If the rental income was less or the mortgage payment was more then the net income would be even less.

It’s no surprise then that some landlords are now in a position where their net income (after costs) is not now enough to even cover the mortgage. They are running at a loss.

The income is reliant on tenants paying rent on time. But if there is a gap between tenants, there will be no income, whilst having to pay out the various costs previously mentioned. Even a short void period could be the difference between making a profit and making a loss.

Capital Gains Tax - When it’s time to sell and realise the profit, HMRC (revenue and customs) will be there to take their share. Capital gains (just the value increase) on stocks and shares is taxed at 20% for a higher rate taxpayer, but for property gains you’ll be looking at 28%.

Property can be bought by a company, but corporation tax starts at 25%, and that is before personal tax on any distribution, so this approach won’t escape paying tax.

Yes, investing in property can be profitable, but you need to go into it with your eyes wide open. The growth of the investment after the above costs and taxes are taken into account is significantly reduced. What’s more, if the sale takes longer than expected, or costs over run or the sale price is lower than hoped, the annualised return could be much less than expected.

Other considerations

If all of your investible capital is invested in residential property, there will be tax wrapper allowances that will be missed out on.

Residential property can’t be bought inside a pension, but commercial property (i.e. offices or shops) can be bought with some pension products like a SSAS. These can be more expensive products than a simple pension but there are benefits to owning a property within a pension.

If you are considering investing in property via a company, you will need to get expert advice. Not all property companies are deemed to be ‘trading companies’ by HMRC. This is important because income (i.e. rent) generated by a non-trading company can’t be used to make pension contributions, meaning the £60,000 pension allowance and 40% tax saving will not be available.

You also need to think whether the money you invest in property could be better invested elsewhere from a tax perspective. For example, the current ISA allowance is £20,000. If this was invested in a fund that achieved an annualised return of just over 7% a year, it would roughly double in value over 10 years. While in the ISA, there would be no tax to pay on the growth or income each year or when the full amount is withdrawn. So that is £20,000 growth tax free. You can also withdraw and replenish an ISA within a tax year so funds are accessible.

What’s more, property is ‘illiquid’; it can’t be sold immediately. And in some cases, a sale can take much longer than hoped. If a different (better) investment opportunity comes along, or you need access to your capital, funds wouldn’t be readily available from the property. Other types of investment can be more liquid and would provide quicker and more flexible access.

Property investing isn’t for everyone. While it can offer the potential for substantial returns and can be a great investment choice, it is vital to consider the true costs involved. We’re very happy to talk you through your options and to see if property is the right way to go for you.