Everyone's got an opinion on house prices. And rightly so. For all but the lucky few, property is the biggest source of personal wealth. And looking at the UK's balance sheet – as we did – property makes up the vast majority of the UK's wealth.
Yet most financial advisers totally ignore residential property when it comes to structuring a portfolio. Irrespective of whether you have a mortgage, or own a property outright. Whether you live in it, or rent it. And even if you never intend to sell your property... a home should be considered as a part of your portfolio mix.
Now, before you start, I know what many going to say. "A house is somewhere to live, I don't care if its value goes up or down – I don't intend to sell it."
I don't believe a word of it. And what's more, whether you consider property a financial investment or not, its value is highly exposed to all the same things as other investments. Today I want to show you why not doing so could prove very costly...
The interest rate time bomb
The vast majority of mortgages in the UK are on a floating interest rate - that is, borrowers pay perhaps a few percent above a benchmark like Libor, or the official bank rate.
But of course, a floating rate leaves borrowers vulnerable to interest rate hikes. In 1980, rates rose to over 20% as the government tried to control surging inflation. And in 1992 they surged to 15% as the government battled with its European currency peg. Even before and after the ERM battle, rates were around the 12% mark.
That could happen again today. So you need to be ready.
I was recently talking to an old family friend that got caught on the wrong side of the 1992 spike in interest rates. Having just built a beautiful new home, his floating rate mortgage threatened to take him down. Believe me, this is a situation you don't want to find yourself in.
With a floating mortgage to pay today, your household expenditure could go through the roof. So make sure you have liquidity. Think about investing in Isas, rather than making overpayments into a pension for instance.
And consider a decent slug of assets that rise with rising rates. Cash would be a good bet – you've not only got liquidity, but returns will go up with the rising interest rate. Though I generally advise 25% fixed interest, arguably somebody exposed to a floating rate liability may want considerably less. Remember, bonds don't tend to do well when rates rise.
If you're highly exposed to a floating rate loan – be sure to balance the rest of your portfolio to accommodate it!
What if you have a fixed mortgage?
There’s no doubt that a fixed-rate mortgage (where repayments do not vary with market interest rates) leaves a borrower in a safer position. I could be sorely tempted by some of the longer fixes I see on offer today.
There are ten-year fixed deals at, or below 5% available from lenders like Britannia, Woolwich, The Co-operative bank (and more).
In many ways, the biggest danger with a long-fix is deflation. In a Japanese-style deflation, the real value of debt increases. Think about it as the opposite of inflation – where the real value of the capital you’ve borrowed is inflated away.
For every £1 you borrow, you’ll have to pay more than a pound back in real terms... and that’s on top of the fact that you’ll likely be paying higher interest payments than those on a floating rate.
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The good news is that bonds do well during deflationary periods. Depending on your age (and when you can start to draw down your pension), you may consider stashing a decent slug of bonds into a Sipp. Or you could consider stashing bonds in an Isa – where interest rolls up tax free. You could even choose some bond issues that mature at times when you want to make repayments on the mortgage.
Inflation-busting assets won’t be as important to you. I mean, if, for instance, two-thirds of your wealth is in property, then you’ve already got a natural inflation hedge. On that basis, it may be wise to use your other financial investments to hedge against a deflationary outcome.
Ownership is a bet, not an accomplishment
As we’ve just seen, whether you’re borrowing fixed or floating, there are considerations for how you structure the rest of your portfolio. But what if you own the property outright? Does that mean you are safe?
The point most people miss about a mortgage is that it is tantamount to shorting the currency you’re borrowing. Buying a UK property with a sterling mortgage is to go long property and short sterling. As such, there’s a natural hedge there...
If the UK hits the skids, (and crikey, our national finances are hardly in good shape), then one would expect the pound to take a dive. House prices too. Now, if you’ve got a mortgage, then you’re short the pound. The weak pound would likely cause inflation which would whittle away the real value of the debt.
A mortgage-free homeowner (long-only, as we’d say if we were talking stocks) could lose a fortune. It could put a spanner in the works for anyone planning to retire to sunnier climes off the back of their property.
What could you do to protect yourself?
Though it may sound crazy, taking out a mortgage on the property may not be a bad idea. Especially if that property is rented - since mortgage interest can be offset against rental income for tax purposes.
The cash raised by the mortgage could be invested abroad. How about a German rental property for instance? I even read that many properties in the US now look like a fantastic buy.
The more daring diversifier may consider foreign stocks – especially in emerging markets. Or hey – what about using a mortgage to short sterling and go long the ultimate currency - gold?
You need a plan
I’ve rattled through some of the things you may wish to consider if you own property, however it’s financed.
But it’s important to note that every one of us is different. We have different ambitions on what we ultimately want to do with our savings and we have different attitudes to risk. And though I make some assumptions as to how different assets may react to economic events, the truth is nobody can be sure.
The key point I want to get across today is that you should consider long and hard how your assets are protected given various threats – especially inflation and deflation. And because a massive lump of your portfolio is likely sitting in property, it seems unwise not to include it in your overall wealth plan.
Remember, in extreme cases, a poorly diversified portfolio could see you out on the street. At the very least it could make considerable inroads into your wealth. So when you plan your wealth, make sure you’ve carefully thought about your biggest asset!
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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