Is residential property the Cinderella of the investment world?

Property is one of the four key components of a portfolio, but in investment circles, property means commercial. Residential, like Cinderella, is seldom invited to the investment allocation ball, perhaps because it is not seen as investment grade.

I understand the hesitation; after all, clients already own their own home so have residential exposure. Stories of clients who invested in city centre new build flats which quickly turned from buy to let to buy to regret only add to the negative sentiment.

So, is residential property an investment grade asset? The short answer is yes. Before we really get started I want to deal with the notion that a client’s home counts as investment exposure. In my opinion, this view is the same as saying my wife has exposure to gold because of her jewellery collection. Strictly speaking, it is true, but just because gold hits an all time high does not mean she will be selling anytime soon.

For most, investment in residential property is conducted outside the auspices of a financial professional with guidance and direction being provided by a TV presenter.

Perhaps herein lies the problem. Although buy to let has grown to over £200bn during the last 15 years, it is viewed by many as an amateur affair where investment decisions are, made with the heart and not the head. Interestingly this view appears to be unique to the UK.

Tony Keys, professor of real estate economics at Cass Business School, suggests that the optimum weighting of residential in property should be 40%.

On the surface this may appear excessive when according to Investment Property Databank (IPD), the UK only allocates a meagre 1%.

Things change when we consider that the eurozone average is 17% and that our Dutch and Swiss cousins allocate 47%.

Housing

Unlike commercial property, housing is seen as an essential where demand is stable. In addition risk is reduced because there is a large and diverse tenant pool whose income is largely stable. It also benefits from long term capital and income growth due to the correlation with wage inflation.

This is illustrated when we compare the sharpe ratio (a method of calculating risk adjusted returns, the higher the number the better) between 1999-2010. UK commercial property was 0.24 while residential was 1.15.

Research has also shown that direct investment into residential property acts as a hedge against inflation. With the latest dose of QE being injected into the economy, you will struggle to find anyone who does not think inflation will be an issue for years to come.

There are several reasons cited in the paper by Demary & Voigtanger, however one of them is the ability of landlords to make rapid adjustments to rents and therefore the income generated from the investment to keep in line or ahead of inflation.

The UK has a chronic shortage of housing. In 2010 we delivered the lowest number of new homes since 1923 and according to a report form IPD we could see a shortfall of 750,000 homes by 2025, 350,000 of those in London. If we combine all these factors, it becomes clearer why the asset class should be considered as investment grade.

To illustrate the difference in performance if you had invested in the FTSE commercial property index in January 2007, today you would be down 11.6%. During the same period, the Land Registry index for prime central & south west London increased by 28.6%.

There are downsides and risks to consider, starting with liquidity. Fundamentally, property (commercial & residential) is illiquid so if you need it, then property is not for you. I believe putting property into a liquid structure is like a square peg in a round hole, it doesn’t quite fit.

Not all residential markets offer the same opportunity for returns. Ideally the focus should be on locations with a finite supply, and global demand i.e. prime central and south west London. The conventional wisdom of spreading the investment and therefore the risk may have a negative affect on returns.

Strategy can make or break a fund’s return. I am a firm believer in adding value in order to minimise risk and maximise return. Be mindful if returns are solely generated by the market rising.

Finally most residential funds will be Unregulated Collective Investment Schemes (UCIS), because as it stands today it is impossible to put the asset into a structure that can be directly regulated.

But not all UCIS funds are high risk. The key is to understand the nature of the investment, knowing your customer and therefore suitability.

A fund investing in prime central London residential property is a long way from one trading Bolivian tree frogs. If you go for the latter, do not be surprised if things don’t quite pan out the way you had expected.

This article was first printed in Professional Adviser Magazine 17th November 2011

 

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