Your Life in Property - Chapter 8

Paying Regard to Competition

One of the key activities of CEOs in successful companies is to keep a key eye on competition. What are others doing well or not so well? What are your competitors charging? Where are they buying or selling? In the market of property investment, the marketplace can be very fragmented with no clear market leader or player with huge market share (other than social housing provided by the government). This is true to more or less of an extent depending on factors such as owner-occupation levels. Typically, the lower the owner-occupation levels resulting in the presence of larger investment institutions. Perhaps surprisingly, it is very infrequent for a "brand" to exist in the market that clients (tenants) are aware of and are drawn towards. This provides the obvious advantages of ease of entering the market as a small player, perhaps investing in just one studio flat and making a profit. Just imagine trying to break a market such as the soft drinks industry and compete with market leaders such as Coca Cola. Huge capital and risk is required. Notwithstanding this feature, it surprises me the lack of business approach that is adopted by property investors, even the so called "big boys" who I have seen make huge mistakes (by having just a broad overview of a market and investing in perhaps a lazy fashion). The big boys can be beaten by very small investors that employ more competitive tactics and strategies. Equally, smaller players looking merely to "provide a pension pot" or some other vague notion based on capital appreciation display a very loose attitude towards monthly cash flows and growth strategies (perhaps they are busy people!), providing the business-focused investor huge opportunities for competitive advantage.

Analysing the competition will reveal an abundance of factors that can be used to align your business approach. For example, what are your competitors charging for their rentals? Have they kept rent levels static for years and fallen behind the market rent (a common mistake) or is your competition attempting to achieve unrealistically high rents based more on the return they seek than the market will bear. This is a common mistake of investors that have paid at the peak of a property cycle and attempt (badly) to cover the costs of a doomed investment. Analysis of pricing, available from letting agents and the media, will guide you to price your property at a level which is competitive and achieve a successful letting. Perhaps inventive pricing structures can be implemented, beyond the flat monthly payment to induce potential tenants and keep them. Not seen often, offering low monthly costs at the beginning of a tenancy and providing incentives to stay (including managing their property well!) could pay dividends. This process is of course ongoing as the market develops. So that's the income side.

What about costs? Again, careful analysis of your costs versus typical costs of your competitors will increase profitability. Statistics are more difficult to reveal, your competitors are less open and willing to show your their balance sheets. Perhaps a good approach is to make good relationships with the suppliers of your services and attempt to achieve low costs (perhaps as low as the big boys do through their scale) by "win win" negotiation or by teaming up with other investors to present a stronger front. Typical costs in the business will include:

• Property management fees
• Property buildings insurance
• Finance
• Routine property maintenance
• Non-routine maintenance
• Furnishings and fittings

Maximising Cash Flow

The positive flow of cash in any business is key to its ongoing success and your property business is no different. Hopefully you will achieve good purchases at high yields to ensure a good cash flow exists. By making efficiency measures as detailed above, your expenditure should be reduced to a minimum and so should the periods that your property stands empty. It is a good idea, once a property has "settled down" after a few months of ownership to capture the cashflow it brings and what this contributes to your overall cashflow across your growing portfolio.

By listing individual properties against monthly income and outgoings, each property can be analysed for its benefit to the portfolio and highlight potential "stars" or "dogs" within your portfolio. It is inevitable that some properties will out perform others in a given month, but is this a continuing trend? Tracking such flows of cash will help make decisions such as taking streamlining measures or making further acquisitions of a certain property type / location or disposing of under-performing property.

Planning for Acquisitions and Disposals

In growing a portfolio, regular decisions should be taken to whether to acquire or dispose of particular property or types of property as time passes. Analysis of cashflow as outlined above will provide a clue to which properties you should consider to add or reduce from a income perspective. Additionally, the trends of capital growth of properties in your portfolio and property on your "watch list" should be researched on an on-going basis to help make crucial decision regarding timing of buying and selling.

Thinking "like a CEO" will encourage you to use the data you build on your portfolio and the market conditions to make decisions, just like at a monthly board meeting (perhaps just with yourself!). It maybe for example that a particular property in your portfolio was purchased some time ago and was purchased at a good yield-level, a fact you are proud of. Over the length of ownership, the property has performed well and produced a regular positive monthly cashflow. However, by regular analysis of the market, it is revealed its capital value has increased and the yield on present value is now much lower. A decision should be taken by the active CEO. Should this capital be released through sale of the property or refinance to invest in other markets that are performing well? It is very easy when less actively managing a portfolio to miss these crucial buy and sell triggers and it could hold you back in growing your portfolio to a size that will achieve your overall financial objectives.

Financial Planning

The most significant aspect to most property businesses in terms of financial planning is the conditions under which you raise mortgages to acquire and support your investments. Again, this could be an "agenda item" at your regular board meetings. Properties held with finance should be examined regularly for their payments and terms of the finance. Aspects such as incentive periods when rates are kept low may expire and rates revert to a higher "standard variable rate" may occur. This should be regularly reviewed and action taken as appropriate within a few months of the product reverting to the higher rate. Additionally, the mortgage market should be regularly analysed to discover any changes in lending terms or rates and thereby keep you one step ahead of the game. Decisions should be taken about which lender to use for new purchases based on their loan-to-value levels, arrangement fees and product types available. Finally, a view should be taken on when to opt for a particular product in the financial cycle. Is it best to go for a tracker, suspecting rates will trend downwards over your product term or has the market flattened out and a long-term fixed rate becomes more attractive. A key eye on national bank rates, inflation and predicted GDP growth or contraction rates will give some guidance in informing these decisions. I use the following rough guide to determine which way rates go:

Bank Base Rate Level (tends towards):

GDP growth(or contraction) rate + current inflation rate

So, for example, in Q1 of 2008 the UK:

Bank Base Rate Level (tends towards): a GDP of 2% + 4.5% inflation = 6.5%

At the time base rates were 5% and increased to 5.5% during this time. The view could be taken that bank rates were set to increase, GDP and inflation figures remaining as they were. If fix rates were available at around 5% (which they were) this could have been a good bet.

Taking the current position in the UK in Q1 of 2009:

Bank Base Rate Level (tends towards): a GDP of -1.5% + inflation 3% = 1.5%

Indeed the current bank base rate was 1.5%.

The bank rate maybe 0.5% currently but investment mortgage pay rates are still usually above 5% for investment finance. So should a fix rate be more suitable or a tracker / variable rate? Well looking once more at the equation, with the 6 month forecasts for GDP and inflation, we would get (October 2009):

Bank Base Rate Level (tends towards) – GDP of 0.2% + inflation 1.6% = 1.8%

We live in strange times, but the current bank rate is unlikely to drop below 0.5%, if the above is followed, and should drift upwards as long as GDP and inflation predictions hold. When the margin that banks charge over base rate reduces, perhaps a fix in the medium term at these historical lower rates would be prudent.

It is a judgement call of course, but by using this guide provides a system to inform the decisions which are made. I have used this system and currently have 60% of my finance arranged on a tracker basis as we speak. These products were mainly set up in 2007 when deals that tracked below the bank rate (between 0.25 – 0.75%) were not uncommon. My current payrate across my UK portfolio is now around 2.3% as a consequence which allows for a substantial monthly cashflow, even as voids have now started to creep in as the economy worsens.

Tax Planning

A crucial aspect to your planning of your property investment business right from the outset. Four aspects of the local tax system should be considered for you to be efficient in retaining profit generated.

Purchase Tax

Tax rates made at the point of purchase (sometimes to referred to as Stamp Duty) can vary wildly both between countries and within a countries tax system. If a flat tax across the piece is applied, there are very few decisions to be taken – you will end up paying it regardless. However, if you are analysing different countries in which to invest then if all other factors are equal this could be a critical factor if the purchase tax rates differ greatly. The purchase tax must be paid for by you, at the point of purchase, out of your cash holdings. Therefore, the payment of this tax reduces your working capital and potential to make further acquisitions.

It is very common for purchase tax rates to vary between locations within a country and depending on the purchase price paid. Governments do this to encourage the purchase of particular types of property or property in a particular location which usually could benefit from the inward investment. This research is easily carried out on a country's tax website or by taking advice from a tax consultant. It maybe that your research shows that buying a number of smaller properties rather than one large property ensures that you stay beneath the tax threshold and therefore pay zero purchase tax. Nice. Or you may find that a particular city or part of the city is designated for lower purchase tax rates for a limited period. Again, you can take good advantage of this, as long as the investment stacks-up in every other regard.

Income Tax

Strangely, although the least popular of taxes for the poor old employees who are taxed direct from their payslip each month, this tax need not affect the property investor unduly. Why? Most countries with developed tax regimes allow many deductions to be taken from the gross income to reduce the income tax liability. Firstly, these allowances broadly cover any expenditure you make in running your property business, such as:

• Property maintenance (including items replaced on a like for like basis)
• Travel connected with the property
• Professional expenses (such as letting agent)
• Finance interest payment (not including capital repayments)
• Property insurance
• Provision of furnishings

In fact the list goes on and on. To restate, in the usual case any expenditure related wholly to the property business can be offset against the income received. Of perhaps greatest impact is the offsetting of finance interest payments. The finance payable to service a loan can be considerable in relation to gross rent and so offsetting this element can reduce your tax liability considerably. Of course, it affects your cash flow in an equal measure! However, this point should be considered carefully if you are in a position to either buy a property with cash or raise finance against the property. Buying with cash will clearly give you a better net cash flow on the individual investment but your income tax liability will be high. Taking finance will reduce this liability and leave you with more working capital with which to make more acquisitions, if that is the plan. It is important to remember that the repayment element of the finance (if a repayment mortgage is taken) is not allowable against income. Perhaps for this reason, around 90% of investment finance in UK is taken out on an interest-only basis.

Additionally, some tax regimes will allow for further deductions against income such as:

• Depreciation of the building, at a notional annual level.
• Cost of re-finance if funds used solely in the property business.
• An annual percentage of the income is exempt from tax.

Tax regimes differ considerably and change regularly so research should be conducted at the very outset of your venture.

Capital Gains Tax (CGT)

Although difficult to predict and therefore plan for with any real precision, the capital gains are likely to dwarf the monthly net income from property ownership. Therefore, the tax take on this potential profit should be considered. Questions posed should include:

• What are the CGT levels?
• Are capital gains levels the same of individuals and companies or do they differ greatly?
• Does CGT reduce over the time a property is held? This is the usual case.

Double-Taxation – the rule of residence

Double Taxation treaties exist between all major economies to ensure that tax is only levied once, unless the taxation made in the country of your investment is lower than your country of residence. For example, if a income tax rate of 30% exists in your country of investment and 20% in your country of residence, only tax will be payable in the country of your investment. In the usual case, this higher level of tax must be paid and cannot be offset in your country of residence. Conversely, if a zero rate of capital gains tax exists in your country of investment and say 20% in your country of residence, you will be liable for the 20% tax in your country of residence.

Finally, a word on the structure of your business. Another common feature amongst developed countries are the various structures of business and how these affect all types of tax discussed. These structures generally include:

• Individual or Partnership – property is purchased and held under an individual or partners name.
• Limited Liability – a company is formed with shareholders and appointed directors. The persons within the company have limited liability to defaults for example.

In the general case, to encourage the establishment of business enterprises, tax regimes often favour the formation of a company and charge a lower rate of tax as a reward. This is not always the case and treatment of income and capital gains may differ. Additionally, the ability to finance purchases may be affected by the structure of the property business you form. Careful research is therefore essential.

To be honest, the subject of taxation deserves a book longer in length than this one in itself. And it is important to note that tax regimes change frequently, so basing an investment purely on tax benefits may not be prudent. Hopefully I have done enough to get you to research fully the taxation of the area that you wish to invest within and take professional advice.

Activity 7

Imagine you are the CEO of your business and you have called a monthly meeting to analyse performance and make decisions on future growth and management. What aspects will be on your agenda for the meeting? How would you gather the data to present to the meeting?

Agenda Points: