Assessing the asset class: residential

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Direct residential property has many characteristics that set it apart from other, more traditional asset classes. For many it seems to be a very long-term investment that is measured over decades rather than years, although that may have been forgotten by some during the property bubble. It is tangible and, to many investors, its permanence offers a perceived security that they may feel is lacking with other asset classes.

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But there are significant challenges with holding residential property in a portfolio that can cause problems for investors. “People have a natural affinity for property,” says Rory Gilbert, Head of the UK and Ireland Private Bank at Barclays. “But investors need to be wary, as this is an inefficient market with low price transparency, illiquidity and high transaction costs.”

Asked about the main advantages of holding residential property in their portfolio, survey respondents point to the potential for income through rental as the biggest attraction. This was a finding that surprised many of the experts questioned for our in-depth interviews. In general, residential property offers relatively low levels of returns, especially when compared with commercial property. The consensus of the experts was that residential property is best seen as a source of capital growth, rather than of income.

Which of the following factors do you consider to be most attractive about holding property investments in your portfolio?

 

“Yields on residential property will never compete with commercial property,” says Willie Gething, Executive Chairman of Lennox Investment Management, an independent adviser that helps wealthy investors buy properties. “Today in central London, for example, you get yields of maybe 4 per cent for prime property. You don’t buy residential property for income. The yield merely helps you to service sensible levels of debt. Its real potential is for capital appreciation.”

Indeed, this is seen by survey respondents as the second biggest advantage of investing in property, followed by the long-term track record of residential property. Demographic pressures and demand for land will, over the long term, continue to support residential property as an investment, believe some interviewees. “People are always going to need somewhere to live,” says David Salusbury, Chairman of the National Landlords Association. “And they aren’t making land anymore, as the saying goes. So I personally don’t believe as a landlord, that if you do it properly over the long run, you’re going to go far wrong.”

There is no doubt that residential property does offer some diversification possibilities, but many experts believe that investors do not always think about this characteristic as systematically as they might with other assets. “We very often see wealthy investors who have portfolios with an unhealthy concentration of one or two prestige properties, a Manhattan penthouse or house in Belgravia, which often accounts for a large proportion of their real estate holdings,” says Basil Demeroutis, Partner at Capricorn Investment Group.“These investors would be better to spread their investment across different markets and asset types.”

He suggests that investors should consider low-income or student housing across a spread of geographical locations. “Your property investment doesn’t have to necessarily look like somewhere you would like to live. In fact, that can be a dangerous investment philosophy. There are big concentration issues when you invest in one very expensive property in terms of risks: fire, environmental, market and so on.”

A personal relationship

This highlights a broader point, whereby investing in property is about much more than a pure financial investment. Residential property has a special place in private investors’ hearts, as well as their portfolios. For a wealthy investor, residential property is seldom treated simply as an asset.

“Property is best seen as a composite good,” says Yolande Barnes, Director of Research at Savills. “It provides a range of different functions for a property buyer. Clearly it is an investment asset. And there is an element of utility as people live in these properties. But there are also elements of lifestyle, luxury and fashion that play a role in the decision. Buyers tend to have a strong, often intense, emotional connection with their houses, even if it is not their principal residence.”

This emotional relationship with property inevitably impacts the way investors deal with their property investments. There are several ways this can play out, according to Mr Gething. “Buyers may be inclined to buy somewhere they find very attractive to them personally which may or may not be a good investment. They may pay more for it than a dispassionate buyer. And they may not sell it when a return is offered that a dispassionate investor would be happy to take. The unshakeable rule maintained by the best property investors is never to fall in love with an asset.”

The risk of holding onto an asset too long is one that emerges from the survey. Asked how they manage property compared with other investments, just 33 per cent said that their willingness to sell would be greater than with another asset class should circumstances change. In other words, while investors may offload equities and other asset classes should the need arise, they are less likely to do the same with residential property – partly because it is a long-term, illiquid investment, but also partly because they develop an emotional attachment to it. Similarly, the survey found that just 18 per cent of respondents would hold property in their portfolios for less time than other asset classes, supporting the idea of property as a long-term commitment.

For most people, buying a house is one of the biggest financial investments that they make, yet investors often pay less attention to this decision than they would do with other comparable investments. The survey suggests that even highly sophisticated private investors may take a relatively simple approach to managing their residential property investments: they often make decisions independently of any advice or, if they do seek a second opinion, they rely on friends and family or estate agents. Professional, independent advice, according to the survey, is not always sought, which suggests that investors could do more to improve the rigour of their investment process.

For example, almost one-third of investors rely on advice from their family and friends (although they are not the most widely consulted source of advice). Friends can be very influential on buying decisions, if not always from a financial perspective. “For many wealthy property buyers, the opinion and values of their peers matter a lot,” says Ms Barnes.

Which of the following sources of advice do you turn to in order to assist you with your property investments?

 

The residential property market is a jungle populated by some rather wild animals: The developers, the agents, the owners.

Other interviewees suggest that investors may be being less than rational in their buying decisions. “I think property as an asset class is where the worst elements of behavioural finance rear their head,” says Mr Demeroutis. “Vanity is a huge factor in the purchase of residential property, although buyers are reluctant to admit this. There are clearly so many other reasons that people buy property besides as an investment, although they may say that it is an investment.”
 
Many investors will not take any advice at all when buying property, preferring to go with their own opinion and instinct. This is something that constantly surprises Mr Gething. “Not many people would spend £1m on buying a painting without taking any advice, but I have seen people spending £5m on a property without getting any advice,” says Mr Gething. “The residential property market is a jungle populated by some rather wild animals: the developers, the agents, the owners. Some are very good and highly professional. But many are not. It’s completely unregulated – it really is a case of buyer beware.”

Laurent Nouvion, head of the Rey/Nouvion family office in Monaco, highlights the importance of getting appropriate advice – and taking the views of some in the market with a pinch of salt. “You often find when your property is being sold that the agent tells you that the property is a mediocre one, but if you are on the buying side, it’s suddenly the world’s best,” he says.

There are interesting differences between men and women when it comes to residential property investments. Women are much more likely to rely on friends and family as a source of advice than men – indeed, it is their most widely consulted source of information. They are also more likely than men to say that they find investing in property more enjoyable than other asset classes, and are less likely to invest indirectly, through funds.

Knowing the risks

One of the lessons from the financial crisis is that, as an investment, property has certain limitations or disadvantages which many investors did not take into account, including the fact that its correlation with other asset classes may increase in times of stress. High net worth individuals should consider these carefully before making a commitment.

Which of the following factors do you consider to be the biggest disadvantages of holding residential property investments in your portfolio?

 

Cost of upkeep is cited as the biggest disadvantage of residential property. “There are all kinds of maintenance required when you come to residential property,” says Mr Gething. “You need to be willing to set aside up to 20 per cent of gross rents to cover this.”

Residential property’s relative lack of liquidity is also cited as a major disadvantage. During the boom years, this was a characteristic of property investment that many investors seemingly forgot. “I think many investors got used to the idea that you could have both high returns and high liquidity at the same time,” say Audrey Klein, Senior Managing Principalat Park Hill Estate, a subsidiary of Blackstone. “But that has always been anomalous. And what we saw was that a lot of the so-called liquidity that investors thought they were getting rapidly disappeared when there were problems.”