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

As investors reflect on a turbulent period for financial markets, the stability of property as an asset has considerable appeal. While the stock market has fallen back and even safe haven assets such as government bonds experienced double-digit declines in 2022, rental property maintains its attraction as a source of income and capital growth within a portfolio. Still, there are pitfalls for the unwary that should not be glossed over.

The residential property market in Luxembourg has enjoyed heady growth over the past decade, with home prices increasing by 131% between the beginning of 2010 and the first quarter of 2022, according to Eurostat. However, inflation, rising interest rates and the impact of war in Ukraine have taken their toll on economic activity and investor confidence since the beginning of 2022, and real estate prices have softened in recent months.

Nevertheless, the price of housing in Luxembourg has been among the most stable in the EU. The country has only experience one period of decline – in 2009, in the wake of the global financial crisis, and it proved to be brief. Prices continued to rise strongly during the Covid-19 pandemic, boosted by extremely 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 long into the future. It can also represent a cheaper way to access Luxembourg’s extremely expensive property market than buying a family home.

Luxembourg has a buoyant rental market, with strong demand for short-term accommodation.

Luxembourg has a buoyant rental market, with strong demand for short-term accommodation. Almost half the population (47.1% at the beginning of 2022) do not have Luxembourg nationality; the country is home to citizens of 170 countries.

Buy-to-let property also represents a diversifier of investment portfolios from shares and bonds. Fixed income and equity markets have proven highly correlated in 2022, both affected by rising inflation and interest rates. Alternative options could help investors to create a more balanced and resilient portfolio of assets.

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 will be 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. Markets are 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 been seen in a sharp slowdown in property price growth over the course of 2022.

There is no guarantee that home prices will continue to rise just because they have proved extremely buoyant throughout the past decade – thanks in large part to exceptionally low interest rates since the global financial crisis, which now seem to be history. Also, rental prices in Luxembourg have not kept pace with the cost of property, rising 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 as a long-term investment.

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

Investors considering buy to let need to do their sums carefully. It is tempting to take a simple calculation of rental income less mortgage 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.

It is also important to consider tax. Rental income will 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 lead to deductions, it still leaves a significant portion of income liable to tax. In addition, buy-to-let investors who sell the property will be liable to pay capital gains tax on any profit.

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 sit empty for a couple of months than it would do to lower the rent. 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 be variable.

The key decisions regarding buy-to-let property are different to those involved in buying a home to live in. The economic factors are not the same, which buyers must 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 thought and attention the returns may be disappointing.