The article below is taken from Guardian.co.uk and will be of interest to buy to let investors.
Investors must use cash assets, avoid gearing and only pay a fair price for property to avoid an all out market crash
First-time buyers are the ‘plankton’ of the property market, on which the health of the entire ecosystem rests. Photograph: Philipp Assmy/Awi/EPA
Imagine for a moment that the housing market is an ocean and everybody involved in the property chain a different underwater lifeform.
Plankton, a minute microorganism without which the other higher life forms wouldn’t survive, would be the first-time buyer: a young couple who want to own their own home but have little capital to realise their dream. As in the ocean, once the plankton disappears other species die off.
As property value is all based on supply and demand, the continual rise in property prices would ease; unless the current homeowner has someone to sell his house to, he won’t be able to afford the new home he desires, and this has a knock-on effect all way up the property ladder to the owners of the most expensive homes – or the sharks.
At the minute, first-time buyers aren’t doing well. Despite the rush to beat the stamp duty holiday, creating a bit of a rush at the beginning of the year, they are now once again priced out of the market. So, if the first-time buyers are no longer feeding the housing market, who is?
That role is currently being fulfilled by the private rented sector. In the 90s, high interest rates led to repossessions, and this led to a flood of houses being brought on to the market, which pushed prices down. As it stands, the private rented market is playing a major part in both the supply and demand of houses in the UK. More and more people are in search of higher investment returns than just having their cash in the bank, so the demand for buy-to-let properties is constantly increasing.
However, house prices are unlikely to rise in the coming decade because of the lack of first-time buyers (the plankton have died off), and investors looking for capital growth in the private rented market could be in for an unhappy time – and investment demand will also start to fall.
New investors are too optimistic about the returns they expect; according to the property website Zoopla, 65% of people believe that house prices are going to rise in the next six months despite the fact that house prices and asking prices are falling in both nominal and real terms, and the mortgage market is as tight as ever.
Property investors may derive hope from the fact that more people are looking to rent, yet tenants are struggling to pay rent in the current climate. Templeton LPA estimate that 9% of all rents are in arrears. As a result, house prices are set to plummet, with thousands of owners facing negative equity and an all out market crash.
There is a solution to the problem. Firstly, investors must purchase within their means, using the cash they have available. Those who have over-geared are in trouble, the fault, at least in part, of irresponsible lending.
Secondly, buy-to-let investors must pay the right price for the property in the first place, protecting their investment and generating higher yields by ensuring the stability of the entire market long term.
In the last quarter of 2011, 5.6% of borrowers were in negative equity. The figure is far worse in the north of England, where 8.5% of homeowners are in negative equity. But, if people paid the right price for the property in the first place, they wouldn’t be in negative equity.
So how do you ascertain the true value of a property? A lot of investors simply rely on the price given to them by the developer, but developers overcharge and are often forced to do so just to break even.
Experienced investors should use sites such as property-bee.com to see how properties have been amended, re-listed, re-valued since their original posting. Also look at mouseprice.com to see what similar properties in the area have sold for.
But there is only one way for investors to ascertain a property’s value that is truly safe – find a property’s residual value. The residual value is based on the amount of net rental income it can generate, and anything above 6% looks like a good investment. For example, if a property brings in £6,000 rent per year after all costs have been taken in to account, that £6,000, based on a 6% net yield would give the property a value of £100,000.
By working out the 6% net yield using below-market-value rent, the investor will not have to contend with tenants struggling to pay rent. As rent continues to rise, there will always be a demand for properties charging below-market-value rent.
It also means that there will always be savvy investors looking to purchase a property residual value because they are not only purchasing a strong income stream, but they are purchasing a property at a price that will not be affected by market fluctuations or crashes.
The UK will have the dangling sword of overpriced property above its head for some time, but, if inflation is to bring house prices back in line with earnings quickly, then wages have to start rising more rapidly than they are now. If that happens, then the Bank of England will have no choice but to raise interest rates, which in turn will hit house prices.
The sword will fall and it will burst the property bubble, but the investors in residual value will be protected from any fall in house prices.
In the end, everybody will be relying on residual property valuations – it’s an inevitable future.