Last month I gave a list of possible things you could do with your spare money, (if you’re lucky enough to have some) and I got a few other suggestions back to add to the list. Perhaps the least controversial was to pay of your mortgage. This actually comes with the first on my list – “Pay off any borrowings”, and for many people it’s an obvious thing to do.
However, there’s a useful variant – the “offset mortgage”. Personally, my wife and I found this route useful in the past. They’re not so common at the moment, in times of lower interest rates, but they’re still worth considering. Basically, you leave your spare funds with the same bank or building society that has your mortgage, and arrange for them to offset one account against the other, so that you’re paying interest on a lower net balance. However, the offset is temporary – the original loan still exists, so the money that’s being offset against it is still available for use. For example, someone’s salary can be used, even though the balance is probably reducing as the month goes on.
Other people suggested riskier investments such as gold, art and fine wines. Gold is traditionally seen as a “safe haven” in times of uncertainty, whether you buy it directly in ingot form (but you probably have to pay someone to store it safely) or indirectly as shares in a gold mining company. However, gold itself is much more volatile than many people realise. Five years ago, 23 September 2011, it cost £1,029 per ounce; today, 23 September 2016 it’s virtually the same, £1,022 (having given you no income in the period). However, in the meantime, it got up to £1,094 on 18 August 2012 but spent much of the period well below £900, getting as low as £700 on 4 July 2015.
So I’m sceptical about gold, and I’d need an even longer bargepole to consider touching art or fine wines as investments. The latter, particularly, are the subject of many scams. There are some marvelous stories about art collectors who amassed valuable assets, but they seem to have almost always done this primarily through a love of the works rather than through consideration of their potential value.
Last month you may recall that I wrote something about buy-to-let residential property as an investment, and I said that now I might talk about commercial property as an alternative. Most of us, rightly or wrongly, have a reasonable idea of what’s involved in houses and flats, but we’re not so comfortable about what to do with office blocks or shops,
The model is rather more complicated than for residential property, not least in the initial costs, and again you have to make some assumptions, but let’s say that the property costs £300,000 (like last month). The first difference is that the stamp duty is much lower (because of the extra 3% on residential) so it’s just £5,000 instead of £14,000. However, other costs will be rather more – solicitors, mortgage fee, survey, asbestos report, fire risk assessment etc. – perhaps another £7,000, so it costs a total of £312,000. (Residential was estimated as £317,500, due to the higher stamp duty.) If you can manage one-quarter of the original £300,000 plus the extra £12,000 (total £87,000), you could perhaps find a commercial mortgage of 75% “loan to value” at 4% at the moment. So the lender puts in £225,000 and you put in £87,000.
Monthly income could vary considerably – the commercial market is not so fluid as the residential market – but we could perhaps assume a yield of 7% for a property of this sort of value. We’ll assume that there’s no lease premium or rent-free period – otherwise it gets too complicated – but of course you’d need to consider these in real life. However, you may not find a tenant for a while, so it would perhaps be wise to allow for an average of two months empty each year, giving you income of £17,500 for the remaining 10 months (still better than last month’s flat). But there are quite a few expenses against this each year: mortgage interest £9,000, agent’s collection fees at perhaps 5% of the income (plus VAT), plus an initial 10% charge for finding a tenant. In addition there’d probably be a surveyor’s fee for rent valuation and a solicitor’s fee for the lease.
This gives first year costs of perhaps £16,200, leaving a meager £1,300 profit, or £1,040 after tax at 20%.
Thankfully, so long as it’s occupied, the tenant will normally pay maintenance and service charges. But the first year gives a yield of only just over 1% after all the costs – less than the 2.4% in the residential model. The saving feature of commercial leases is that they tend to be longer than for residential property – typically for 5 years at the moment – so the initial expenses are not repeated. Also, the full amount of loan interest is allowed as an expense against the rental income, unlike the restricted allowance for residential which is moving to be only allowable at the basic rate of tax.
If you’d like to see how all these figures work, please get in touch, and I’ll show you.
In future years (again assuming only average occupancy of ten months but no repetition of the initial costs for the start of the lease) the profit after basic rate tax is £5,900, a yield of 6.8% on the £87,000 investment. This begins to be rather attractive – but, as with any property investment, there are quite a few unknowables that could make it worse. Interest rate rises, problem tenants, local redevelopments, periods with no tenants, etc. And there are a lot of variables and assumptions. However, Tariq Phillips, a solicitor who does a lot of commercial conveyancing, has had a look at my figures and assures me that they’re not unreasonable.
But as with residential property, it’s the longer term gain that has interested property investors. If we assume an annual increase of 5%, it’s worth £315,000 after one year (just above what you paid for it – but that’s before selling costs) but £330,750 after two years and £347,288 after three. If you can sell it for that amount, there’d be estate agents fees at, say 2% plus VAT and solicitors fees etc. of perhaps £2,000 (all including VAT). After two years, that only leaves about £8,800 so there’s no tax unless you have other capital gains. In other words, unless you need to sell it, you should probably keep it for longer. After three years, the gain after basic rate tax is about £24,700 and of course it increases as time goes on (still assuming the 5% annual increase in value.)
At this level there’s still only a little capital gains tax, because of the annual exemption of the first £11,100 of the gain – and it’s less than for residential property. As from last April, capital gains tax is generally charged at 10% to the extent that the gain falls within your basic rate band and 20% thereafter. It was previously at 18% and 28% – and it stayed at those levels for residential property.
So after three years you’d have had net income of about £37,600 after tax – on an investment of £87,000 – an annual return of nearly 13%. Better than you’d get from most other investments at the moment and better than the return in our model for residential property last month – but of course it’s based on a lot of assumptions. Whereas there’s a general shortage of residential property, for commercial property the market seems to be much more variable, and values may rise more slowly.
As with residential property, it looks as though you can get useful income from a commercial property investment – particularly once the lease is under way, although the stock market might still give you more if you managed to invest in the right things. Capital growth can be attractive, provided you’re able to leave the money invested for several years – but property prices are unpredictable, and how long will it take to sell the property when you want to?
The main tax differences between the two investments are that there’s less stamp duty on commercial property, capital gains tax is at lower rates, and loan interest is fully allowable against the income. Another point in its favour is that your pension fund can invest in commercial but not directly in residential properties. That all sounds positive for the commercial side, but caveat emptor (buyer beware): the market is less liquid and there are many factors to consider.
As I said last month for residential property, if you’d like me to go through some specific figures, please let me know. The scenario can change significantly based on your other income, whether you’re investing alone or with someone else, whether you’d plan to manage it yourself rather than via an agent, the planned length of investment, etc.