9 – PROPERTY INVESTOR (PENSION)

I Vital Statistics

Introduction

Let me tell you the key findings of a major investment bank’s survey:

• Only 1 in 4 workers are set to retire on a pension greater than half their salary
• This means that 3 out of 4 workers will retire on half their salary or less and,
• 1 in 2 workers will retire on less than 40% of their final salary

Can you afford to live on half your salary in today’s terms?  Or even 40% in today’s terms?

The reason for this is that the stock market has not performed as expected.  Annuity rates have declined due to people living longer and the situation is only going to get worse with the increasing quality of health care.

I initially invested in property to provide me with a pension 13 years ago at the age of 24.  The main reasons why I did were because:

• I didn’t trust anyone handling my hard earned cash apart from myself
• I thought it was morally wrong for a pension company to take my money and not allow me to have access to it until I was of retirement age

The funny thing is that even though I invested in property initially to provide me with a retirement income, I found that my property income was in excess of my salary so I retired at age 27!  Now I own a portfolio of 200 properties that will earn me an income now, in to retirement and beyond.

When you contribute to a pension fund you are investing in to a business (by way of shares) that you have no control of.  If the managing director decides to go on a mad shopping spree and bleed the company dry you have no recourse.  Okay, the director may go to jail but you won’t get your money back.  Just have a look at some of the high profile cases – WorldCom, Enron etc.  These are the ones that hit the press.  There are companies that you probably won’t of heard of that a pension fund company invest in that may have suffered the same problems but on a smaller scale.

Property is something you do have control of.  It yours!  You don’t own a piece of paper called a share certificate.  You own something you can see, touch and do with whatever pleases you.  But simply owning property is not your route to retirement bliss.  You need to know how to exploit the opportunities that ownership brings.

The difference between property and any other investment is the ability to borrow.  You can borrow to purchase the property and let the tenant pay your interest payments by way of rent, hence it’s a self-funding investment.  Now you can borrow to buy shares but the dividends receivable are rarely sufficient to cover the loan repayments.  Also the maximum any bank will lend to you will be up to 50% of the value of the shares and the interest rate is much higher than a typical mortgage because shares are riskier than property.  This begs the question - if shares are riskier than property why do people invest in shares rather than property?

Well there are some answers to this.  Apart from the tax breaks you get which make investing in pension funds seemingly tax efficient we invest in shares because:

• We are lazy! Its easier to simply pay over some money and let someone else do the hard work.
• Other people do! We act like sheep sometimes and follow the crowd.  If others are doing it we’ll do it too.
• We are too trusting of these big pension companies. We fall for their mock caring TV adverts, glossy spreads in the national newspapers and magazines and impressive head offices and branches.

So its time to take up the profession of becoming a landlord and start enjoying the rewards that have been enjoyed by the middle class for centuries - its time to build that property pension!

I wish you the best of luck with your future property purchases.

1. Traditional Pension v Property Pension

Pensions are a numbers game.

But its not about how much you put away for retirement.  You can heavily contribute to an pension investment fund and it can return you very little in the long term – no matter how many tax breaks, frills or top-ups you receive.  There is no come-back or guarantee – it’s your loss!  There are tax breaks, frills and top-ups there to entice you in to investing in companies which prop up our economy but have no real strategy in providing you with a real long term income that is related to your lifestyle or even your contributions.

I can already hear you say – what a cynic!  But if you understand the principles involved you may change your opinion.  I am going to show you in words, pictures and numbers how property is a better way to invest for your retirement than any other method suggested by below.  Its important to understand why:

1. The Government, Pension Companies & The Banks cannot deliver you a guaranteed long term income sufficient enough to live a comfortable life and,
2. Property can deliver an income for you, your family and your subsequent family members that is far in excess of what any of the above can do.

You may think this is a tall order.  But if you take the time to really understand how long term income is created you will realise that what I first say, that pensions is a numbers game, is a true statement and you will laugh at what is currently offered to you as a ‘pension’ from a traditional pension provider.

Traditional Pension Providers

There are three broad categories of traditional pension providers:

• The Government
• Pension Companies

3.The Banks

Okay, so what is so bad about the traditional providers?  Well lets look at what they offer:

How A Traditional Pension And A Property Pension Work

The only real competitor to a property pension is a pension offered by a pension company.  So it makes sense to look into how both these pensions work and how they compare.  Can I warn you that the numbers get quite complex if you’re not that numerate.  I’ve tried to keep it as simple as possible so bear with me.  I guess the reason why so many people have been duped by the pension companies is because of this very fact!  It is easy to get blinded by the science.

Lets look at a traditional pension.

Traditional Pension

Joe is 41.  He works in an office earning £30,000 per year and is a basic rate tax payer.  He decides to take out a private pension.  He comes across a reputable firm offering:

Management Fee         1%

Estimated Growth       5%

A management fee is the charge a pension company charge to you for managing your money.  This seems reasonable from their side as no one would do this for nothing.  They invest your money in so called ‘safe’ investments such as cash deposits, bonds and shares.  Some pension fund managers are very good at what they do (even though they are an exception) and are well worth their charge as they can out perform the general market.

Estimated growth is how much the fund manager thinks he can make your money grow.  If current rates offered by building societies are 2.5% then a 5% growth is very attractive as it is double what is being offered from a bank or building society.  If you took in to account the tax breaks then it seems even more attractive.

Lets assume that the pension company actually achieve their estimated growth target of 5% year on year.  If Joe invested £100 per month, increasing his contribution by 4.25% year on year his personal contribution, government contribution and fund value would be:

So Joe’s pension fund at his chosen age of retirement, 65, is £111,814.  Then Joe has to purchase an annuity, which is a guaranteed annual income till his death, with his pension fund.  AXA Sunlife offer £45.78 annual income for every £1,000.  So Joe’s annual income in retirement is:

£45.78 x £111,814/1000 = £5,118.84 p.a. (say £5,119)

Now let me draw your attention to 2 key figures – what you put in and what you get out:

These should really be the only 2 figures you should be interested in.  These 2 key figures can only ever be the most important figures in the whole pension equation.  In fact, these 2 figures are always the key indicators whenever a business person appraises the likely success of a potential investment.  A pension fund is an investment so there should be no other way to look at the performance of it.

What you put in is totally within your control.  Therefore this number is known.  It is for you to decide how much you should put away for your retirement.  You can be advised on how much you should put away but no one can guarantee what you’ll get out of it.  However, you can be assured that most sane people want to put the least away for the most gain.

What you get out is totally out of your control.  Unless you have taken out a guaranteed benefit pension (which guarantees a fraction of your final salary, usually two thirds) which is hugely expensive and normally only available to executive directors, you will have no idea what your pension fund and thus your annual income will be.  You can only ever estimate what you’ll get out with the accuracy of your estimation increasing as you get closer to the maturity date.

So in the above traditional pension Joe put in £51,692 and he’s got out £5,119 p.a.  He may get £1,000 p.a. or he may get £10,000 p.a. depending on the performance of his pension fund.  But at 5% growth rates he has got roughly 10% of his contributions as an annual income, being £51,692 contributions and £5,119 annual income.  Now we can’t say that’s good or bad unless we have an alternative to compare to.

Now lets look at a property pension.  More importantly – what you put in and what you get out.

Property Pension

So what’s a property pension?  Well the name suggests it all!  It’s a fund invested in property that delivers an income from the rent derived from these properties.  In other words retirement income from rent.  But why is a property pension better than a traditional pension?  It has nothing to do with the past.  Its to do with the present and the future.  If we were to get in to a game of how  pension funds have out performed property or the other way round then we would go nowhere.  The reason for this is because its historic.  Look at this table:

Both have done well but it depends on which time frame you look at.  Over 15 & 20 years pension funds win but over 5 & 10 years property win!  So it depends on what time frame you look at.  The only common thing between these figures are that they all happened in the past.  The only people that benefited form these are the people that made these investments.  The key to understanding how you can always win with property is to understand the concept of gearing.  Or in other words having the ability to borrow.

The mortgage market has changed dramatically.  It is now possible to buy a property with the lender’s money based on the rental income only.  So you are not expected to earn a certain salary to obtain a buy-to-let mortgage of up to £500,000.  The only problem is you need a larger deposit compared to the traditional 5% deposit for a residential mortgage.  The least you need is 15% deposit but in some cases you need 30%.  Due to the introduction of the buy-to-let mortgage house prices have risen way above wage inflation rates.  This is because property prices are now determined by the rental value of the home rather than its desirability.

So lets look at the cashflows.  Jill is 41. She works in an office earning £30,000 per year and is a basic rate tax payer.  She decides to build a property pension.  She can afford to save £100 per month to build a deposit and buy a property costing £30,000.  She can rent it out for £2,400 per year which equates to 8% of the purchase price i.e. 8% yield.  She decides to buy a property every time she saves up enough for a deposit.

Now I’m going to have to hold your hand through these figures!  Jill buys 4 properties over the 25 years with property values rising 5% every year (the same growth rate as the pension fund).  She rents them out and allows a 20% loss of rent due to agent’s fees, void periods and repairs.  Allowing for this she gets an annual profit rising every time she buys a property and allowing for rent inflation (applied every 5 years).  So the annual profits after tax (basic rate 21% - average used) are calculated from the following table:

Now having calculated the figures above we can derive the key figures in building a comparison with a traditional pension.  The key figures being:

• Deposit & Fees put down to acquire the properties
• The profits from these properties
• The purchase price of these properties
• The value of these properties at retirement
• The debt outstanding on these properties at retirement

So Jill’s property pension fund is £181,721 being the value of the properties less the mortgage debt.  But just like the traditional pension fund we have assumed a 5% growth in property prices.  Now, I am not a fortune teller, so I have no idea what the growth rate will be averaged out over the next 25 years.  Even though a property pension fund is greater than a traditional pension after tax at the same growth rates (£181,721 v £111,814) - the great thing is that IT DOESN’T MATTER!

So why doesn’t it matter?  The 5% growth is nice and probably realistic but it doesn’t provide us with an income.  What we’re interested in is the rental income.  The key figures you should be looking at are the 2 key figures I talked about earlier.  Let me remind you – what you put in and what you get out!  So here’s what we’ve put in and what we’ve got out:

So with a property pension you actually get money back!  What you put in is a negative amount.  Your investment in property by way of deposits and fees are replenished by the profits made in property and more.  Being prudent, lets assume that the profit just covers the deposit and fees only.  This means that over the 25 years what you have put in is still only NIL!

So what have you got out of it?  Well a nice income of over £10,000 p.a.  which is twice as much as what a traditional pension can offer.  And this income is not just for your life but for your descendents after your death as the properties pass to your beneficiaries in your will.

If you do want a risk free pension and want to purchase an annuity then the net value of the properties does matter because you have to sell the properties.  The beauty of property is that you can sell when you want to.  So you can sell when the market is high or hold when the market is low.  The market could be high enough to sell within 15 years of you making the first property purchase or you may have to wait 30 years.  Assuming the property portfolio does perform at 5% growth p.a. then the net fund after tax will be:

Proceeds of Property Sales                 £334,316

Purchase Prices                                   £179,523

Profit                                                   £154,793

Tax Relief                                            (£61,917)

Chargeable Gain                                  £92,876

@40%                                                 £37,150

So net proceeds will be:

Proceeds of Property Sales                 £334,316

Tax Bill                                                           (£37,150)

Net Proceeds before Mortgage Debt   £297,166

Mortgage Debt                                                (£152,595)

Net Proceeds                                       £144,571

Using the same annuity rates as above of £45.78 per £1,000 the risk free pension till death is:

£144,571 x £45.78 / 1000 = £6,618.44 p.a.

Comparison Tables

So lets look at a proper comparison table of the figures:

I hope that you can clearly see that property pensions out perform traditional pensions quite astronomically even with all the tax breaks.  This is because you essentially put no money in and get more out!  Even if the traditional fund did return you a higher income the property pension would win as you haven’t put anything in!

This is why traditional pensions are a joke.

But it doesn’t stop there!  Its not only the numbers that make a good case for a property pension.  There are other factors that make a property pension superior to a traditional pension which are in part drawn out from the figures above.  Look at this table:

Assumptions

Now there have been a number of assumptions made in deriving these calculations.  These are necessary otherwise we could not build a picture of your future income.  Here are a list of the assumptions I have taken for each type of pension, how reasonable they are and how relevant they are to the overall performance of each.

Traditional Pension

Property Pension

Its up to you to think are these assumptions reasonable and/or relevant?  Try flexing the numbers to see what other results you get.  Do whatever it takes for you to come to a decision on whether what I’m saying has some basis or is fundamentally flawed due to very relevant omissions.  Until you do this you will always be waivering between traditional pension funds or property pension funds or even something else! - and always kicking yourself for not making the right decision when one of them booms.

Risks v Returns 

So we have established the returns to be had from a traditional pension and a property pension but what are the risks and are they worth it?  Lets look at the risks for each one.

The Risks Involved In Investing In Property

They’re a number of fears that people have which are fully justified.  They are not dissimilar to what business people face when appraising a potential investment.  These are called risks.  The difference between the ordinary person and a business person is that a business person:

1. Identifies all the risks involved
2. Mitigates each risk as best he or she can
3. Considers the overall risk based on how well he or she can mitigate each individual risk
4. Makes a decision based on the overall risk

So to build a property pension you need to:

1. Identify all your fears involved in building a property pension
2. Think how you can overcome each fear involved in building a property pension
3. Consider the overall fear factor based on how well you can overcome each individual fear
4. Decide whether you want to build a property pension or not based on the overall fear factor

Fortunately for you I’m not going to ask you to think up all the fears involved, how to overcome these fears and calculate the overall fear factor.  I am going to tell you this!

Unfortunately for you I am not going to decide for you whether to build a property pension or not because I am not you!  However, I will present a very strong case to you and I will recommend that you build one - but the ultimate decision rests with you.

The Fears and How To Overcome Them 

With every fear you can take what I call Countermeasures which overcome each fear.  A countermeasure is an action you take to counteract each fear.  No countermeasure is fool-proof otherwise the fear would not be a fear purely by its definition as it could be fully overcome.

There will still always be an overhang of fear albeit a lot less than the starting fear.  This is what I call Residual Fear.  The residual fear is therefore still present even after the countermeasure and thus is a real fear.  You can take further countermeasures to reduce this residual fear but it depends on how far you want to go.

There will always be residual fear however.  An example of residual fear that cannot be eliminated is the destruction of your property if there was a war.  No insurance company will take on this risk.  The only way you could mitigate this risk would be to build a bomb proof shell around your property – but this would be impractical and probably cost more than your property itself!

The fears, countermeasures and residual fears in buying a property are:

Overall Fear

To calculate your overall fear is to gather all the residual fears that remain.  To do this you:

1. Decide which fears listed above 1 to 6 are fears that you actually have
2. Decide what countermeasures you are willing to take for each fear
3. Calculate the residual fear for each fear applicable.

So for example if you had the following fears and were willing to take the following countermeasures then your overall fear is all the contents of the residual fear column:

So the overall fear is the total of the residual fear column being:

• Not finding a tenant even though you have bought a desirable property and you can reduce the rental price asked
• You buy a property that goes falls into negative equity and you have to sell
• You get stung for a repair that you never thought you’d get

You have to make an estimation of how likely these fears will materialise and are the rewards in investing in a property pension are compensatory enough.  If you are happy with this overall fear then you will invest in property.  If you are not then you won’t.  If you are not happy with the overall fear then I suggest you take more countermeasures so that your overall fear is reduced.  Reduced to a level that you are happy with so you are comfortable in investing in property.

The Risks Associated With A Traditional Pension Fund

Because you transfer a lot of your control over to the pension fund manager there are only two real risks:

So in summary you can either add to your fund or wait.  These are the only two strategies you have!

So Are You Convinced?

Well I’ve laid out both arguments for you but its for you to come to a decision.  Do you think property is better than traditional pension funds?  I really want you to study this chapter as this is key to your motivation to build a property pension.  Once you are convinced the motivation to build a property pension will be there.  This is because you understand the uniqueness of property and how property is a superior investment to virtually any of the other investments out there.

The illustration above is only one strategy to achieve a property pension.  There are many strategies you can adopt to achieve a retirement income but this all depends on YOU.  It depends on how much you are willing to contribute, how much you want and when, your attitude to risk and your level of involvement.  Lets look at this in more detail in the next chapter.

2. YOUR PROFILE

Objective

If you want to build a property pension you need a strategy.  A strategy is a method to achieve an objective.  So in this scenario the objective is to:

‘have an income sufficient enough to meet all your needs in retirement’

This is what a pension aims to do but often fails.  This is why there are so many charities to help pensioners such as Age Concern and Help The Aged.  So to achieve this objective you need a strategy!  The first stage in constructing a strategy is to really think about the objective.  The objective throws up some obvious questions you need to ask yourself.  The obvious questions that need answering, why and how to answer them are:

So an example of someone’s objective would be:

What’s Needed From You To Achieve Your Objective

Your objective is not going to land in your lap!  It requires the following from you:

1. Time
2. Money
3. Acceptance Of Risk

All these factors are correlated.  That is to say if you don’t have much money to put in then be prepared to put in more time and accept a higher degree of risk.  If you increase the time you put in then you won’t have to put so much money in or accept so much risk.  Lets look at exactly whats expected from you.

1.Time

 Your time is needed in the following ways with ways to reduce them:

2. Money

You need money to buy a property!  Here is why you need money and ways to minimize the amount needed:

3. Acceptance Of Risk

In chapter 1 we dealt with the risks in property.  There are always risks of owning an asset but there are also benefits!  You can mitigate against these risks and they cost but there will always be a residual risk remaining.  So you will always have to accept a degree of risk.

You need to decide what risks you are willing to take as this will determine the strategies open to you.

The Relation Between What’s Needed From You & Your Objective

Now these three factors, time, money and acceptance of risk have to bear some relation to your objective.

• If your objective is to have a retirement income of £100,000 p.a. at today’s value in 5 years and you earn £20,000 p.a., have no savings, no time and willing to accept a very low level of risk then it won’t happen!
• If your objective is to have a retirement income of £100,000 p.a. at today’s value in 5 years and you earn £20,000 p.a., have no savings, willing to contribute, little time and willing to accept a high level of risk then it might happen!
• If you wish to earn a retirement income of £20,000 p.a. at today’s value in 15 years and you earn £20,000 p.a., have no savings but the discipline to save, have a bit of time, and willing to accept a medium level of risk then it probably will happen.

So how do know what won’t, might or will happen?  This is best explained by looking at two extreme cases and what’s in between.

So, in my professional opinion, as long as you are willing to earn a retirement income that is what you are earning now, that is 15 years away, have the time, can save and have savings, accept a medium level of risk then it WILL happen.

Deriving Your Profile

Based on the above you should be able to build a profile of yourself and your aims.  Your profile should follow the answers to the above prompts.  A profile would be made up of the following:

So a typical profile may be:

Based on this profile we can match it to the strategies available.  What’s your profile?  Take your time to really think about what you want.  Is it realistic?  Will it be enough?  Do you earn enough to save and/or contribute?  Can you take a higher level of risk?

Based on your profile we can match a strategy or even a number of strategies based on your profile.  Chapter 3 has all the answers.

3. THE STRATEGIES

The Three Core Strategies

There are 3 core strategies to a property pension:

1. Buy & Then Hold
2. Buy & Then Sell
3. Buy, Then Part Hold & Part Sell

There are variations within these strategies but every strategy will fall within these core three.  Remember from the last chapter the definition of a pension, being the objective of a property pension:

‘have an income sufficient enough to meet all your needs in retirement’

Well the 3 strategies above can meet this objective.

In more detail:

Choosing The Right Strategy

You need to choose the strategy that’s right for you based on your level of time, money and acceptance of risk.  Here’s how these strategies could work with the level of time, money and risk a potential investor has:

So think about whether you want to own and run a property or properties pre and post retirement.  Think about how much money you want to put away for saving up for a deposit and ongoing pre-retirement.  Think of the level of risk you want to expose yourself to – Do you want only one property or a few? Do you want repayment or interest only mortgages? Do you require a risk free income in retirement?

Based on your own profile and personal preferences you should come up with a strategy you want to go for.  To help you decide lets look at some examples.   I have decided to ignore tax consequences in these examples to keep the figures simple.

Buy & Then Hold

Richard has the following profile:

He has decided that he wants to Buy & Then Hold so he can pass the properties down to his children.  But he also doesn’t want to pass any debt on so he intends to own the property outright.  He works full-time so he doesn’t want to manage the properties and he wants desirable properties that are easily let out.  He has the ability to save and a willingness to contribute on an ongoing basis if need be.

The strategy would to be buy one or more properties that give a rental income of £24,000.  As he is a low risk investor he would buy a low yielding property, such as 8%, on a repayment mortgage.  This could be 3 properties costing £100,000 producing an £8,000 per year income.  He will also have the property managed by a letting agent.

Using Your Own Home To Provide A Retirement Income

Some people do use there personal home to provide for themselves in to retirement.  The theory is that you downsize to a smaller property due to the kids leaving and purchasing a bungalow in a quieter area and rent out your own property.

The key things you need to consider are:

• Is the rental value of your home equivalent to your desired income in today’s standards?
• Will the property be paid in full when its time to retire?
• Will you have saved enough to buy a property for yourself to live in?

You can always sell your own home and buy two cheaper properties and live in one and rent out the other.  This falls in to the strategy of Buy & Then Sell.  But the key things you need to consider above still apply.

Buy & Then Sell

Susan has the following profile:

Susan doesn’t earn that much money.  She earns £15,000 and cannot afford to contribute anything on a monthly basis.  But she does have savings of £15,000 left to her by her late grandmother.  Susan want’s twice her annual income in real terms in her retirement within 20 years!  Funnily enough this is possible due to her attitude to risk.

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