ETFs are better than buy-to-let flats

by , 18th February 2018

Investing in UK buy-to-let flats has been highly lucrative for many investors for the last 20 years. But there are no guarantees that will continue. Personally, I’m much happier putting my money in ETFs than residential property.

Before I go any further, I should stress that it makes total sense to own your own home if you can afford to do so. My issue is with investing in a second (or third) residential property as your main investment for later life.

I should also stress that I understand that residential property has performed very well over a long period of time. And it hasn’t just performed well in the UK. Recent research* shows that equities have delivered an annual return of 5.56% in 16 major countries since 1950 whereas residential property’s return is 7.85% a year. These figures are real, so they’re showing growth on top of inflation. The figures for equities include dividends and the figures for property include rent, so they compare apples with apples.

It’s a big victory for property and I admit I was surprised when I saw the figures.

And many property investors have generated much better returns – thanks to gearing. If you buy a £400,000 flat with a £300,000 mortgage, your initial investment is £100,000. If the value of the flat then rises to £600,000, you can turn your £100,000 investment into £300,000, assuming you haven’t paid off any of the mortgage while you own the flat.

What’s more, property returns have been less volatile than for stocks and shares.

Downsides

So why don’t I own a buy-to-let flat myself?

Well, it’s partly because the gearing can go against you and boost your losses if house prices fall. I also think that a lot of UK property is overvalued. The average UK house price is now 7.6 times the average salary, and that ratio is much higher in some parts of the country, especially London. That high valuation reduces the chance of strong returns over the next 10 years. I’m not ruling out strong returns, just suggesting that they’re less likely than some people think. For what it’s worth, I suspect that UK residential property will deliver modest positive returns over the next decade.

Then there’s tax. In his last couple of years as Chancellor, George Osborne announced several tax grabs affecting landlords. If Labour win the next election, there’s a strong chance further increases will follow.

There’s also the hassle of being a landlord. When I did briefly own an investment property a few years ago, I found there was much more bother than I was expecting. I could have paid my estate agent to do more of the admin, but that would have reduced my returns.

On top of that, residential property is an illiquid asset that normally takes time to sell. Transaction costs are high and it’s absolutely not an efficient market. And we shouldn’t just compare buy to let flats with equities. You could argue that commercial property is a better bet than residential property because its yield tends to be higher.

But the big point for me is concentration of risk. If you put a big slug of money into one property, there’s a risk that something can go wrong with that one property even if house prices continue to rise. It just makes no sense to put all your money into two or three properties one where you live and one or two investment properties. Yes, your concentrated investment may work out fine, but it may not and I’d much rather have some diversification. And that’s what ETFs can provide. Big time.  

It’s not just the obvious assets that ETFs can invest in – stocks and shares in the UK and US. You can access stock markets from all round the world – emerging markets, europe, or Japan. There are even single country ETFs that can give you surprisingly precise exposure. Korea for example. iShares MSCI Korea UCITS ETF. If you invest in a range of stock markets around the world, you may be pleasantly surprised to discover that the markets won’t always rise together in the same direction or by the same amount.

You can also add to your diversification by investing in factor-based ETFs. These ETFs follow particular investment strategies such as value investing and do so in a rules-based way. (So if  a stock becomes sufficiently cheap according to the rules of the ETF, then it’s included in the fund.) Because these ETFs don’t employ expensive stockpickers, they have relatively low charges. Crucially they also offer extra diversification. For example, ‘low volatility’ ETFs should perform relatively well when share prices are falling.

Commodities and bonds

Commodities is another area where ETFs are very strong. ETFs that invest in gold are perhaps the best known, and gold is a great way to diversify to your portfolio as it tends to perform well when times are tough or we’re in the middle of a major crisis. There are more generalist commodity ETFs as well, and you can also invest in a wide range of single-commodity ETFs: copper, aluminium and coffee are just three examples.

Bonds is another option too. Bonds are traditionally seen as low risk investments but I don’t think that’s the case right now with interest rates set to rise and the great unwinding of QE just beginning. Give it a couple of years though and bond ETFs could be another great way to diversify your portfolio.

Bluntly diversification helps me sleep at night and ETFs help me do that at low cost. I accept that buy to let flats may carry on delivering great returns for the rest of my life. But I don’t want to take the risk. I’d have rather have eggs in several baskets.