Buy-to-let property: diversification, income – and mistakes to avoid

Amid repeated turbulence in financial markets over the past few years and continuing uncertainty over global economic prospects, the stability of residential property as an asset is enjoying renewed appeal among investors. Rental property has become increasingly attractive as a source of income and long-term capital growth within a portfolio. Still, there are potential pitfalls that should not be ignored.

The residential property market in Luxembourg has enjoyed heady growth over the past 15 years, with home prices increasing by 131% between the beginning of 2010 and the first quarter of 2022, according to Eurostat. Since then, however, inflation, higher interest rates and the economic fallout of war in Ukraine have taken their toll on economic activity and investor confidence, and on real estate prices. During the 12 months to the end of September 2024, Luxembourg house prices fell by an average of 2.4%, while the price of apartments declined by 5.3%, according to online real estate portal atHome.lu.

Hitherto, the price of housing in Luxembourg had been among the most stable in the EU, with only one previous period of decline in the 21st century – in 2009, in the wake of the global financial crisis, and it proved to be brief. Prices continued to rise strongly even during the Covid-19 pandemic, boosted by ultra-low interest rates.

Strong demand for short-term accommodation

Against this backdrop, it is easy to see why property continues to appeal. Investors can bank the rental income and historically have been able to rely on consistent capital growth far into the future. It can also represent for many people a cheaper way to benefit from Luxembourg’s extremely expensive property market than buying a family home.

That’s why even though the sale prices of homes in the grand duchy may have moved into decline, at least temporarily, the country’s rental market appears to be as buoyant as ever. The market has always been bolstered by strong demand for short-term accommodation; almost half the population (47.4% at the beginning of 2023) do not have Luxembourg nationality, and the grand duchy is home to citizens of more than 170 countries.

According to atHome.lu, the decline in home prices has been matched by a surge in rental costs, with apartment rents up on average by 4.9% year on year as of September 2024 and house rental prices by 6.0%. Overall, average rents rose by 3.4% to €2,149 per month in the central region of the country, which includes Luxembourg City, and by 2.5% in the south to €1,613 per month.

Buy-to-let property also represents a diversifier of investment portfolios from shares and bonds. Fixed-income and equity markets proved highly correlated in 2022, with both depressed by rising inflation and interest rates. This has stimulated the search by investors for alternative assets that could help create a more balanced and resilient portfolio.

There is also a hedging factor. Money passed on to the next generation is often used to buy a home, so investing capital in property offers protection against market fluctuation in either direction. It matters less if the capital value of the real estate asset goes up or down if it is used to buy a home whose value has probably changed in a similar way. With financial market investments, by contrast, there is no guarantee that assets will keep pace with the property market.

Illiquidity, and the interest rate conundrum

However, there are also drawbacks to real estate investment in general and buy-to-let property in particular. The property sector is not immune to the economic factors that affect bond and equity markets. Rising interest rates make mortgage loans less affordable, and the impact of higher repayment costs have already contributed to the reversal of property price growth between 2022 and 2024.

There is no guarantee that home prices will continue to rise just because they have proved extremely buoyant in the past. The decade more or less book-ended by the global financial crisis and the Covid-19 pandemic was particularly conducive to property investment because of the period’s exceptionally low interest rates – which are unlikely to return in the foreseeable future. And while rental prices might be buoyant at the moment, there is no guarantee that they will keep pace with the cost of property; rents rose by less than 20% between the beginning of 2010 and the first quarter of 2022.

Real estate is by nature illiquid, so buy-to-let property should be considered a long-term investment.

Real estate is by nature illiquid, so buy-to-let property should be considered a long-term investment. It can take months to sell a property, so it’s not an ideal destination for capital that may be needed in a hurry. Transactions also entail significant upfront expenditure, including a registration levy and notary’s fees, as well as the cost of arranging a loan, and potentially the need for refurbishment to bring the property up to a lettable standard.

Investors considering buy-to-let property need to do their sums carefully. It is tempting to take a simple calculation of rental income minus loan repayment costs, and assume that the rest is profit. But there will be ongoing costs including repairs, estate agents’ fees, insurance and service charges. Homes are subject to unpredictable events, and one expensive disaster, such as flooding or roof damage, could wipe out a whole year’s profit or even more.

It is also important to consider tax. Rental income may be charged at a taxpayer’s marginal rate – the highest level of tax they pay. While expenses including maintenance and repairs, interest payments, amortisation and management fees can be deducted from profit, it still leaves a significant portion of income to be taxed. In addition, buy-to-let investors who sell the property may be liable to pay capital gains tax on any profit. A taxpayer’s principal residence is free from capital gains tax in Luxembourg, but gains from other property are normally taxed at 21% (plus a 1.4% dependency insurance levy), if it has been held off at least two years.

Know your market

Buy-to-let investors need to consider the natural market for their property, which could be students, young professionals or expatriates. There is no point in buying a property and refurbishing it to a high specification, only to find there is no market at the rental level needed to make it a profitable investment.

Investors should have a clear idea of the level of rental income they can expect to receive and how much they will need to borrow. Buy-to-let loans are often subject to different conditions from those issued to owner-occupiers – not least because the lending multiple tends to be determined by the rental yield rather than the buyer’s salary.

Keeping tenants happy, and therefore retaining them for longer, will usually be money well spent.

The key with all rental investment is to avoid void periods – it costs far more to have the property sitting empty for a couple of months than it would do to lower the rent a little. Keeping tenants happy, and therefore retaining them for longer, will usually be money well spent. Letting agencies can be an option if owners lack the time or inclination to oversee the property themselves, although their quality can vary.

The key decisions regarding buy-to-let property are different from those involved in buying a home to live in. The economic factors are not the same, something which buyers should keep in mind when choosing a property. It can be a good option for reliable income while offering capital growth at the same time, but without sufficient thought and attention the returns may be disappointing.