Build-To-Rent vs. Buy-to-Let: The Investment Case

The chief executive of Grainger, the UK’s largest residential rental company, has advised buy-to-let landlords pressed by the changed tax regime to sell up and buy shares in her company instead. Helen Gordon warned that the private buy-to-let model that has worked so well for property investors over the past few decades has had its time. She thinks that the government removing the tax breaks landlords benefited from means the returns will no longer be worth the trouble.

Is she right? Is the traditional rental sector’s days numbered? And if so, is investing in build-to-rent companies that first custom build and manage whole apartment buildings or even small neighbourhoods, a viable alternative?

Changes to Buy-to-Let Tax Regime

Buy-to-let landlords used to be able to offset their mortgage interest payments against taxable rental income. Other costs such as an annual ‘wear and tear’ budget were also deductible. However, that is being progressively phased out, starting from the 2016/17 tax year with the process set to be complete by next year and replaced by a 20% tax credit.

Wear and tear also can’t be deducted as a fixed annual budget but has to be claimed for with supporting evidence. Other changes include limiting the value of deposits that can be asked for to no more than 5 weeks rent and an upcoming review of the rule that means tenants can be evicted within 8 weeks of their contract expiring. There is also now a 3% stamp duty surcharge added to the purchase expense of investment properties.

The impact is being keenly felt by buy-to-let landlords. Especially those in higher tax bands who can now lose 40%-45% of rental income to tax, minus the 20% tax credit. That’s being borne out by surveys and buy-to-let mortgage data. A recent survey conducted by the Residential Landlords Association reported on by consumer website Which?, saw a quarter of 2500 landlords who responded say they were considering selling at least one investment property over the next twelve months.

Trade body UK Finance also recently reported that over February, the number of buy-to-let mortgages issued was down 8% on the year before. That’s despite the most attractive terms in history being offered to tempt buy-to-let landlords.

It’s hard to argue that buy-to-let sector sentiment isn’t currently low. But does that necessarily mean the investment class is dead and landlords would be best advised to immediately sell up and instead buy shares in Grainger, as Ms Gordon advises?

Let’s take a look first at the new but quickly growing build-to-rent sector and the investment opportunities it represents. We’ll then return to buy-to-let and ask whether there isn’t still life and investment opportunities in the old favourite.

Build-to-Rent And How You Can Invest

Build-to-rent is a model that has long been a major industry on other international property markets such as the USA and Germany but has only recently started to gather traction in the UK. It is dominated by institutional investors, listed companies and residential-focused REITs with the finances to invest in the construction of entire buildings or complexes. Grainger is a FTSE 250 company and its most recent build-to-let development is Clippers Quay, a 615-home complex in Manchester.

Build-to-let developments typically consist of compact one and two bedroom apartments, complete with fixtures, fittings and furnishings ready to go on to the rental market. They also usually offer community facilities which, especially in the case off larger complexes, can be impressive. Clippers Quay, for example, boasts communal living and co-working spaces, a 24-hour gym, Amazon delivery lockers, high speed wifi, an onsite handyman and even a cinema room that can be booked for a modest fee. The companies behind build-to-let developments also usually have their own in-house property management arms which deal with rentals, maintenance, upkeep and administration.

Gordon, and others in the industry, argue that private landlords can’t practically compete with the quality of the accommodation and service that build-to-let specialists are able to provide tenants. And the result, combined with the changed tax environment for buy-to-let, will inevitably lead to an evolution of the UK’s rental market towards built-to-let as prospective tenants vote with their feet.

An argument in favour of considering an investment in the built-to-let sector is that even if buy-to-let is becoming less attractive because of tax changes, demographics are generally very much in favour of the property and rental sectors.

Experts say the UK needs 250,000 new homes a year but we’re managing to build around 150,000 a year. That means there is a significant deficit of housing building up which can only be good for rent levels. That’s compounded by the fact that renting is generally becoming more common in the UK. 21% of private homes are currently rented and experts such as Knight Frank expects that level to keep on steadily rising over the foreseeable future.

The UK rental market has a different make up to the rest of Europe. Small private landlords dominate here, while institutional build-to-rent landlords currently own just 3% of rental stock. But institutional investment in the sector is growing quickly, up an average of 17% a year over the past ten years. Well over £7 billion will be invested by build-to-rent landlords over the course of 2019.

If institutional landlords provide a better product and service than small private landlords, the market will swing in their direction. Many expect that is exactly what will happen over the next decade or so.

Another aspect in favour of an investment in the build-to-rent sector is that rental levels and demand tend to prove more robust than house prices and sales activities during economic downturns.

Risks to Build-to-Let Investments

Of course, there are also plenty of risks that an investment in the build-to-let sector could entail. Investing in a listed company or through a fund means less direct exposure to the property market than actually owning residential property.

Share prices and dividends, and so returns, are impacted by general stock market and financial markets sentiment and trends, the company’s management, long term strategy and many other factors. It’s a bit like the difference between investing in a bar of gold or a gold mining company for exposure to the price of gold.

Changes to tenant rights, both in forms being suggested by the present government and a possible future Corbyn Labour government could also have a major impact on the industry. Tenants may be better protected in future with rent hikes strictly limited for existing occupants of rental properties and evictions harder for landlords. Some market observers see this as a major risk to the market while others are more relaxed, pointing to Germany where laws protecting renters are very strict but the market remains healthy. Build-to-let companies that focus on social housing would also likely benefit from a Corbyn government and provide a hedge.

Build-To-Let Companies

Grainger has already been mentioned. Other companies and vehicles that can be invested in and offer direct exposure to the build-to-let sector include:

• Hearthstone’s TM home investor fund
• Civitas Social Housing Real Estate Investment Trust (Reit)
• Residential Secure Income Reit.
• Telford Homes

Buy-to-Let: Is There Life In The Old Dog Yet?

But of course, many investors also believe that there is still an investment case for buy-to-let done right. It really all depends on the individual property, the yield it is able to generate, the owner’s tax bracket and other factors that will impact the bottom line.

And it also makes a big difference if a buy-to-let property is currently already owned and how much of a mortgage, if any, is currently outstanding. Many buy-to-let owners are choosing to move their properties into a limited company structure which can, depending upon the particular circumstances, be more attractive when it comes to the tax burden.

There are also companies springing up that are in the ‘build-to-sell-to-let’ sector. These enterprises also develop buildings or complexes purpose build for the rental sector and furnish and equip apartments ready for the market. They then sell these apartments to investors, often within a company structure, and deal with renting the apartment out, property management and even filing annual tax returns.

Of course, all that eats into rental returns but in areas where yields are high it could be an option worth considering. And at the end of the day, the investor does actually own the property, even if the ‘let’ in buy-to-let is fully managed.

Plenty of traditional buy-to-let landlords have no intention of taking flight from the sector despite the recent tax changes making the environment more challenging. They are adopting a ‘wait and see’ mentality with the belief that the right properties correctly managed will still provide solid returns as well as the security that has always made bricks-and-mortar investments attractive.