Houses are expensive.
But they’re still a fantastically popular investment. Data published yesterday says that the number of houses sold last year was the highest since 2007.
And yet another story doing the rounds yesterday from the Council for Mortgage Lenders told us that mortgage lending is still in a slump – and I mean serious slump. Consider that in 2007 the banks were lending (or should I say creating!) £350bn a year to pump into the market. But over the last few years lending has fallen off a cliff.
It’s down to less than half its peak value, at around £150bn last year.
So where’s all the money coming from to buy these properties?
Who’s buying up properties?
I propose that it’s coming from nervous investors. Investors that are fed up with a stock market that’s not sure of where it’s going. A stock market that shows no consistency and a financial industry that’s full of thieving incompetents.
Just last week, I was chatting to an old mate. He wondered why he shouldn’t just go out and buy another property to let out. Indeed, figures from the Association of Residential Letting Agents (ARLA) say that, over the last year, the average landlord’s portfolio has risen from seven to eight properties.
Well, I proposed one good reason why it wasn’t such a great idea. And that is if you look at it from an investment perspective, houses are just not good value – you’re better off in stocks.
Let’s compare houses with stocks
The sort of house my mate is looking at will bring in a gross yield of about 5%. That is, a £400,000 house brings in £20,000 per annum in rent.
But with his marginal tax rate at about 40%, for him the net income is more like £12,000. That puts the house on a price/earnings ratio of 33 times! Yes, a price earnings ratio is calculated after tax. And corporations have a much better deal than your average landlord when it comes to paying its dues.
Of course, you’ll have to pay income tax on stock dividends too. But in many cases this can be whittled down by diligent use of tax shelters. In particular Isas and Sipps. As we know all too well, an accountant can find other wheezes too!
Now, my rule of thumb is that an investment is cheap if it’s trading at less than ten times earnings. Historically, the average is something like 14 times and anything towards the 20s starts to look expensive. If something is over 30 times, then there’s got to be some compelling growth story if I’m to be a buyer!
Today the FTSE 100 trades at around 12 times earnings. Many decent international companies can be found hovering on multiples of around eight times.
From a pure earnings perspective, stocks come out on top. But there’s more to this discussion...
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The holy grail of investing
I guess one of the issues with stocks is that they don’t pay out all of the income they earn. Typically, a stock pays half as a dividend and keeps the other half for investment purposes. In technical terms, this is known as dividend cover... the FTSE 100 has an average dividend cover of two times. One half stays in the company and the other half pays the dividend.
To the uninitiated, this is why stock dividends probably don’t appear as appealing as rental income. They forget that the dividend you see is only half the story. Half the money is typically reinvested for growth. Now, going back to tax issues, it’s another feather in the cap for stocks.
You see, if the profits are channelled into growth and increasing the share price, rather than a dividend, then you’ll end up with a capital gain. And every year you can cash in up to £10,600 in capital gains tax free!
Of course, whether retained earnings are profitably deployed and achieve a rising share price is another issue.
I guess that’s the holy grail of investing. Finding businesses that make good earnings, and use retained earnings to consistently increase profits. My favourite firms are using retained earnings to invest in emerging markets, or expanding production of key commodities.
Now consider the growth potential for all that cash sitting in bricks and mortar. Not much room for profitable expansion there! Yes, rent increases have been keeping up with inflation – but I can’t get too excited about that.
It’s all about buying cheap
But don’t get me wrong – I totally accept that rental income has good visibility. That is, rents tend to be pretty consistent. Investing in a company is more of a gamble. During a downturn a company’s profits can disappear altogether.
But at today’s prices, is this (relatively) safe income stream really worth the money the landlord is paying for his investment?
In my opinion, putting your money into stocks is likely to produce better long-term returns and it’s certainly a lot less hassle.
Yes, houses have been a fantastic investment over recent decades. And yes, stock-market returns have been mixed. But past returns are no guide to the future. A more sensible guide to future returns is whether you’re buying cheap or expensive. Today houses are expensive and stocks are, well... about right.
I’d love to hear your opinion on this. You can leave your comments below.
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