Should I buy a flat?

by Laurence Rowe — published Jan 07, 2008 01:20 AM

Despite the gloomy outlook, buying a flat still looks like a good investment to me.

At first glance, it looks bad:

Speaking on BBC One's Breakfast programme, Merryn Somerset Webb, editor of MoneyWeek, said he could not "understand why anybody would get into a buy-to-let investment right now."

"It was a brilliant idea five years ago when the numbers added up. But if you were to invest in the average buy-to-let flat today you would be losing money on a monthly basis because your yield wouldn't be as high as your mortgage payments.

"So there is no compelling investment reason to do it unless you are convinced that property prices are going to go up indefinitely. And we know that they are definitely slowing at the moment and are much more likely to fall than rise over the next few years."
(via this site)

Indeed. But what this analysis misses is the rising cost of rents. Over the past ten years (data from DCLG) rental rates have increased in line with average earnings, 50% in ten years or 4.2% pa. While this has been much lower than the increase in house prices, it also seems much more secure. Land is a positional good. In a city such as London supply is restricted. Even if the Government's target of 3 million new houses is met, I can't see it making much of an impact on the rental market here. With a 100% interest only mortgage, rents will have increased sufficiently in 10 years to cover the repayments.

So lets make some assumptions:

This is a buy-to-let property. Though it will be more favourable to calculate this as my home, I can't imagine staying in London forever.
Average price of a flat in London: £240,000 (Nationwide, Q4 2007)
Average rent in London: £843 (DCLG, 2006) -- these are the latest figures availabe. Though their estimates put London purpose built flats at £241,000 in 2006 and London flats saw a price increase of 15.5% in 2007 according to Nationwide, if anything £843 pcm seems a little low for a £240,000 flat to me.
Rental prices increase at 4%
Mortgage rate is 6%, on an interest only mortgage.
Deposit £20,000
Stamp duty £2,400 (1% on homes under £250,000)
Other costs are another £2,400
Captial gains tax is 18%
I could get 5% in a savings account
but would pay 40% income tax on any interest earned
and on rental income, but after deducting mortgage interest and carrying over the initial losses.
Price of the flat increases at 2.6% pa, in line with the RPI average over the past ten years. Nationwide in fact shows a long term trend of 0.7% above RPI.

This seems to show break even after 5 years and a £116,000 profit twenty years down the line.

Even if I pick a 7% rate for savings income / mortgage cost and a 1% pa captial rise (in other words a price fall in real terms), rental income covers mortgage payments in 12 years and the overall account reaches break even 26 years down the line.

This does all rather assume that the era of stupidly high interest rates is buried though. That would though likely lead to higher inflation rates for housing too. Leave that model for another day.

Update: All this assumes a (share of) freehold, which are rarer than hen's teeth. Not sure how to price the decline in value as a leasehold runs out.