Should you invest in a buy to let or put more money into your SIPP?
Over the past 20 years investors have made large amounts of money from owning buy to let property. More recently the UK Government has made the asset class far less attractive by increasing taxes and changing wear and tear allowances. Here we explain why making payments into personal pensions are increasingly more attractive once tax rates are factored in.
Rising house prices have alarmed politicians from all sides of the political spectrum, with low interest rates and quantitative easing now recognised as widening the divide between the ‘haves’ and the ‘have nots.’ Over the past 20 years house prices (alongside prices of equities and luxury goods), have gone up much quicker than the official rate of inflation, making it increasingly difficult for first time buyers to get a foothold on the property market.
At present it is thought that four in ten people between the ages of 26 to 30 are privately renting from a landlord, compared to fewer than one in ten in 1987. At the same time the buy to let industry has grown in size, with the large number of investors entering the market helping to drive down yields and push up prices.
The perceived ease with which buy to let investors have been able to make money has seen them metamorphose in the eyes of the public from an investor that has improved Britain’s housing stock, while risking their own capital, to one seen in rather less favourable terms.
Not unsurprisingly the government has begun to act, making property a much less attractive place to invest.
- April 2016: introduction of 3% stamp duty surcharge on second homes
- April 2016: removal of the automatic 10% wear and tear allowance
- April 2020: mortgage interest relief set at 20%, rather than the marginal rate of income tax.
This last change is absolutely key. Whereas an investor could offset their mortgage financing costs against income, higher rate tax payers will now pay 40% income tax but only receive a tax credit of 20% on the cost of their mortgage. This means that if financing costs rise, landlords will have to shoulder higher costs and consequently receive a lower net of tax income on their properties.
While these changes are only being fully introduced in 2020, a chill wind has swept through the buy to let industry. Property owners with mortgages in the South East and London, where yields are very low, are already having to factor in making annual post-tax losses. For the investment to be profitable in the long run, they require more capital growth from an already expensive market.
But are SIPPs really a better place to invest?
Savers need to remember that every pound spent on purchasing a buy to let is paid out of net income. This means that for a 200k property, where the investor puts up £50,000 (ie 75% loan to value), with other initial costs amounting to £9,700 (see table 1), it has all been paid out of post-tax income. From a pre-tax perspective, a 40% tax payer could have contributed £99,500 into their pension instead.
Let’s say the buy to let initially lost money after tax, or there were unforeseen refurbishment costs, that shortfall has to be made up out of post-tax income. Therefore, a £1000 expenditure could instead have been a £1667 SIPP contribution, an effective day one uplift of 66.7%. This gives SIPPs an immediate head start in growing your wealth.
Additionally, as long as your SIPP is valued at less than £1 million when you retire (this will increase in line with CPI), 25% of it can be withdrawn tax free.
Table 1: Initial Costs
|Initial costs (£)|
|Total nect cost||£59,700|
To illustrate how this works in practice, we used the example above of the investor with £50,000 looking to buy a £200,000 property with a £150,000 interest-only mortgage over a 20-year time period (a loan to value of 75%). The buyer faces an initial total cost of £59,700, which in pre-tax income is £99,500.
We gave the property a rental yield of 3.5% (allowing for voids) and annual capital growth of 4.5% making a total return of 8% a year. If achieved this would represent a very healthy return.
To finance the purchase, we assumed a 3% interest-only mortgage could be possible based on best-buy tables, with annual running costs of 1.5% of the property’s capital value. This would include insurance, estate agent fees and annual maintenance costs.
In comparison we said that a do-it-yourself SIPP (or indeed a risk-seeking IG Smart Portfolio) might grow at 7% a year, with 1% in fees - a 6% total return. To put this in context the MSCI World Index grew at 7.5% annualised over the 30 years to 30 June 2017.
Table 2: Buy to let key assumptions
|Tax payer marginal rate||40%|
|Annual capital growth||4.5%|
|BTL mortgage rate||3%|
|Annual running costs||1.5%|
Over a 20-year time horizon, once the interest-only loan has been paid back and selling costs of 1.5% are taken into account, the investor would have a gross profit of £275,000. Net of 28% capital gains tax, this results in a net profit of £201,000, a percentage return of 237% over 20 years.
Table 3: Post-tax value after 20 years
|Capital gains tax||28%||£77,030|
|Cumulative income P&L||-||£3141|
In comparison the SIPP investor could get a day one SIPP contribution of £99,500 (assuming previous periods of unused allowance), for an equivalent net of tax cost of £59,700. If the SIPP grew at 6% net of fees for 20 years the investor would have a total pot worth £319,000, which is an effective return on the net of tax £59,700 of 435% or 8.7% a year.
Investors should also be aware that small changes in capital growth rates can make a very large impact on total returns due to the leverage effect of the mortgage. In our calculations a 1% fall in annual capital growth and a 1% increase in mortgage costs would see an investor’s total return fall from 237% over 20 years (6.3% annual growth) to 60% (2.4% annual growth), showing the sensitivity of the asset to modest changes in financing costs and capital growth.
With the tax advantages of a SIPP, and all the stock market listings available to investors to get property exposure, we would suggest that investors think carefully before setting aside money for a buy to let. It may well be that buy to let is no longer worth the hassle and the risk of getting into.
I’m not convinced – property is surely the place to be in long term
For those investors that really want property exposure, there are a number of ways to do so in a SIPP, or an ISA. On IG’s share dealing platform, investors can buy listed estate agents (eg Foxtons and Purple Bricks), housebuilders (eg Persimmon and Redrow), Real Estate Investment Trusts — REITs (eg Land Securities and British Land) and specialist investment trusts that invest in physical property (eg Picton Property Income and Standard Life Investments Property Income Trust).
You’ve persuaded me to look at a SIPP. Where do I start?
IG offers low-cost SIPPs to both share dealing and IG Smart Portfolios clients. You could invest in your best ideas in a share dealing portfolio from just £5, and manage the bulk of your wealth in an IG Smart Portfolio with management fees starting at 0.65% and falling as low as 0.1%. The only other fee to pay is a £205 annual charge to our SIPP administrator James Hay.