Chapter 14 Investing in Residential Property
This Version: 14 May 2002

If you are considering investing in residential property, make sure to check out the Askaboumoney Forum (http://www.askaboutmoney.com/forumdisplay.php?f=36) on Property Investment. You will be able to read in more detail about the tax issues and you will get tips from other investors.

Property is more like a business than an investment. If you buy a portfolio of shares, you can forget about them. If you buy a property, you have to manage it like a business to get the best return. You have to find clients/tenants. You have to chase them for the rent. If you have problems with them, you may have to take action to remove them. You have to maintain the property. You have to cut the grass every couple of weeks. You have to redecorate or refurbish the property every few years. If you enjoy this and you are good at it, then property might be the right investment for you.

The returns on property investment vary enormously. If you buy in the right area, get good tenants and manage your property well, you will do a lot better than someone who buys in the wrong area and gets bad tenants. It's just like a business - a well managed business will be more profitable than a badly managed business.

Borrowing to invest in property is generally easier. The rental income on property is generally higher than the dividend yield on shares. The rental income less costs on property is probably 3% a year, compared to a 1% dividend yield on shares. For someone who borrows to invest, this is very important. If you have a good tenant paying their rent on time, the steady rental income should cover a good part of the mortgage interest. This will be very comforting for you and for the bank.

While the return on property is probably about 3% lower than the return on equities, it is a lot more stable in the short term. Equities regularly fall in value by 10% or 20% in any one year. While property does fall from time to time, the falls are not as severe and not as frequent. However property investors should be aware that property crashes in other countries have bankrupted many investors and the same could happen here. Borrowing to invest in any asset is risky.

There are tax incentives for investing in some properties. Again this is part of the business of property. A good investment without tax incentives will usually be much better than a bad investment with tax incentives. A lot of investments are being made in holiday homes, town renewal and rural renewal schemes. Some of these will turn out to be terrific investments, while others will cost their owners dear.
The current tax incentives are dealt with in Appendix 10

RESIDENTIAL PROPERTY

Table 10 Returns on Residential Property compared with the stockmarket

Since 1985, residential property has provided a nominal return of 13.6% a year. Equities provided a nominal return of 19.8% a year over the same period. And while 16 years is quite a short sample, it would be the general opinion that equities outperform property by about 5% a year on average. The experience in other counties would also favour equities over residential investment.

No account has been taken of Income Tax or Capital Gains Tax in the above figures. As the rental yield is higher than the dividend yield, property investors who don't borrow will pay more comparatively more tax than equity investors.

PROPERTY IS PROBABLY MORE RISKY THAN THE STOCKMARKET

There are two types of risk facing property investors - market risk and specific property risk.

Market risk is the risk that there might be a crash or sustained depression in housing prices. It is a common misunderstanding that property prices must continue rising. This is encapsulated in the expression "Safe as houses". Again, as a long term investment, there is very little risk attached to property. But there is risk. We have not had a serious house price crash in Ireland recently, but prices are at a very high level at the time of writing May 2002. Lots of people have lost money investing in property in other countries - Japan and the UK would be recent examples.

Specific property risk is the risk that the property you own might not do well, even if the general property market does well. Unless you have lots of money , you will only ever have one or two properties. If you get a bad tenant or if the area in which you buy is affected by a local economic problem, then you will lose money.

It is much easier to diversify your risk in the stockmarket. You only need about €10,000 to buy 10 different shares.

SHARES ARE A GOOD DIVERSIFICATION IF YOU ALREADY OWN YOUR OWN HOME

If you own your own home, you already have a substantial stake in the property market. If the property market outperforms the stockmarket over the next 10 years, you will be doing quite well anyway.

If you own your own home and you own a second investment property, a slump in house prices will hit you badly. If half of your assets are in the stockmarket, you are spreading your bets.

PROPERTY HAS HIGH TRANSACTION COSTS

Buying and selling residential property is expensive. Second hand property will cost you up to 9% in stamp duty and perhaps another 1% between solicitors and other legal fees. Selling it will cost you about 2% in legal and auctioneers fees. So if you buy a property today and sell it in 6 months time for the same price, you could lose up to 12% on the round trip. A similar transaction in shares would cost about 3%.

PROPERTY IS ILLIQUID

If you want to sell a property, it can take months to vacate the property , find a buyer and do all the paperwork.

If you want to sell shares, ring your stockbroker and you will get your money within a week. If you need only some of your money , you can partially encash your shares. You can't sell a room in a house. It is all or nothing.

This can be important if you are nervous about the value of your investments. If you have €100,000 in the stockmarket and you feel the market is overvalued, you can sell half your investment and keep it in cash. You just can't do that with a house.

BORROWING TO INVEST IN RESIDENTIAL PROPERTY

Since 1985 the nominal return on property before tax has been 13.6%. The compounded commercial mortgage rate since 1985 has been 11.2%.

However, timing your investment has been very important. £10,000 invested in property in 1985 would have accumulated to £39,100 by the end of 1997. If you had accumulated the interest on your loan, the accumulated loan would have been £39,400. So you would have managed a property for 13 years and you would have got no return for your work or capital.

The situation improved dramatically over the past 4 years as house prices raced ahead and mortgage rates remained low, so your investment would now be worth £77,000 while your accumulated loan would be only £48,000.

Someone who borrowed £100,000 to invest in property at the beginning of 1997 would have a property worth £250k at the end of 2000. The accumulated loan would only be £131,000, so they would have got a fantastic return.

Table 10 B
Nominal return on houses Commercial mortgage rate Profit

We have estimated the commercial mortgage rate as the home mortgage rate + 1%.

What is the outlook for the years ahead? Over the long term, house prices should rise and will probably exceed the mortgage rate.

BUT BORROWING TO INVEST IN PROPERTY INCREASES THE RISK

If you buy a property without the need to borrow, you will be able to handle slumps in property prices or periods without a tenant. But if you borrow to buy a property, you will be badly affected by such slumps. Let's say you buy a property for £100k with a mortgage of £80k. A 30% price crash would reduce the property to a value below the size of your mortgage.

How likely is such a crash ? There must be a significant risk of a slowdown in the short term. And there must be some risk of a crash !

And don't forget the property specific risk. If you might buy the wrong property in the wrong area and get a bad tenant, you might lose money even if the general property market increases.

What stamp duty do I pay on buying a house as an investment?

The following rates apply to investors in new or second-hand properties:

What Income Tax and Capital Gains Tax do I pay?

You will pay income tax on your rental income after mortgage interest and expenses at your top rate - 20% or 42%.
You will pay also pay prsi at 5%.

When you sell the property, you will pay CGT at 20% on the increase in value after allowing for inflation.

APPENDIX 10 TAX INCENTIVES FOR INVESTMENT IN RESIDENTIAL PROPERTY

As we have already pointed out, property investment is a business and choosing the right property is essential to its success. If you choose a property, just because it has tax incentives and not because it is a good investment in its own right, you face a real loss. Rural and Town renewal schemes are encouraging a huge amount of building. But when the tax relief on these schemes runs out, will there be a glut of property on the market.

SECTION 23/27 RELIEF - RURAL RENEWAL

This relief is given on new houses in designated areas. It is also available for refurbishing but we will concentrate on buying a new house.

You get a tax free allowance of about 80% of the cost of the property against your rental income anywhere in the state. So if you buy a house for €100,000, you can get rent up to about €80,000 rent free. In other words, you won't pay any tax on the rent for about 15 years.

You must rent out the house for at least 10 years on genuine rental agreements. If you occupy the house yourself within 10 years, the relief is clawed back. If you sell the house to an owner occupier within 10 years, the tax relief will be clawed back. If you sell the house to another investor, they can avail of any unused tax relief.

The Rural Renewal Relief applies to parts of Cavan, Roscommon, Sligo, and all of Leitrim and Longford

A typical property would cost about €150k to which you should add stamp duty and the costs of furnishing it.

You will pay a management charge of about €600 a year and you will receive rental income of about €6,000 a year.

TOWN RENEWAL SCHEME 2000

(More information needed)

Investors may write off 85% of the cost against all rental income.

HOLIDAY COTTAGES

10% of the construction costs will be given as tax relief against the income from the cottage, so again the income should be tax free for a 10 to 15 years.

STUDENT ACCOMMODATION - Section 50 - 1999 Act

All the costs of building such accommodation may be offset against all Irish rental income.
It must be approved by the college
Only such investment in an urban area

DISCONTINUED SCHEMES

While these schemes have been discontinued, second hand properties come on the market and the buyer can sometimes avail of the tax reliefs.

SEASIDE RESORT - Section 48 1995

This scheme is finished but properties which were started before the expiry date of the scheme still qualify.

In the first year, you get an allowance of 50% of the construction costs against all your income - so you can claim it against your PAYE income as well. You get 5% a year for the next 10 years.

You must let it for 11 years or else the relief is clawed back.

A typical apartment would cost you £150k. You would get rental income of about 5k a year after letting fees. You would also have to pay a management charge of £500.

SECTION 23 URBAN RENEWAL SCHEME

This was the first and the most generous scheme. The cost of buying these properties could be written off against a person's entire income and not just their rental income.

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