Buy-to-Let vs Equity & Bond Portfolio

I have never invested in a buy-to-let property although during my career as a financial adviser I have previously owned three commercial office premises, two of which were partially sub-let.

Over the years I have used various types of savings and investment plans and the majority of my investments are now held in equity and bond portfolios.

Need to choose the right investment strategy for you? Then you need to know how different investments work, the risk they expose you to and how they are taxed. You can then compare them with your investment objectives, your tax position and the risk you are prepared to take. This applies equally to a comparison of investing in a buy-to-let property and a portfolio of equities (i.e. shares in companies) and bonds (i.e. loans to companies).

Benefit of each

Buy-to-let: Investing in a buy-to-let property is appealing because it gives you the benefit of something tangible that you can see which can generate rental income and is a hedge against inflation.

Portfolio: A portfolio of equities and bonds is a highly liquid investment that can both build long-term wealth and provide income via dividends and interest.

Investment Required

Buy-to-let: Investing directly in property tends to require a reasonably large capital outlay or at least a 20% deposit and a mortgage. For those with modest means real estate investment trusts (REITs) are a way to invest in property without a large capital outlay.

Portfolio: You can make a modest investment into a portfolio of equities and bonds using websites such as those provided by AJ Bell, Fidelity, True Potential, Vanguard and Wealthify. If you are using an independent financial adviser (IFA) you will typically need to invest at least £80,000 to £150,000.

Return Expected

Trying to compare the returns from a buy-to-let property and a portfolio of equities and bonds is like trying to compare apples with pears. There are so many factors that have affected the historical returns, not least the timing of the investment and the level of risk assumed for the investment portfolio. All that can be said is that both have produced real returns over the long term (i.e. in excess of inflation) and to remind you that past performance is not a guide to future performance.

Initial Costs

Buy-to-let: Purchasing a buy-to-let property will involve you in solicitors’ fees. Stamp duty is also payable if your property is in excess of £250,000 (this reduces to £125,000 on 1 October 2021). You will also want to arrange a survey of the property.

If you are not going to purchase the property outright and need to arrange a mortgage then there will be additional costs for arranging the mortgage.

Portfolio: The initial fees for investing in a standard equity and bond portfolio offered by the type of companies mentioned would typically be very small. If you are arranging these on the advice of an IFA then their initial fee will typically be between 1% and 3% of the amount invested and will depend on the level of your investment although some IFAs will have a fixed fee menu.

Ongoing Management Costs

Buy-to-let: Various surveys have shown that general building maintenance costs for a buy-to-let property are typically 20% or more of the rental income.
Unless you are going to be responsible for finding your own tenants Letting Agents fees will be around 12% of the monthly rent.

You will need to take out Landlord’s Insurance and pay for various utilities

Portfolio: A portfolio of equities and bonds will involve an annual management charge (AMC) typically of 0.2% for passive (i.e. index tracking investments) or 0.8% for actively managed investments.

The investments will often be held on an online investment platform with a typical fee of 0.35% pa.

Unless you are an experienced investor you will need to use some form of discretionary fund manager (DFM) with a typical charge of 0.25% pa

If you are using the services of an IFA then their ongoing advice charge will typically be around 0.75% pa

Time and Effort

Buy-to-let: Property ownership can involve a lot of hands-on work. You have to deal with the midnight phone calls about water leaks in a bathroom, gas leaks and the possibility of getting sued for a bad paving stone in a patio etc. Even if you hire a property manager to take care of your property there will still be occasional meetings and oversight.

Portfolio: Owning a portfolio of shares and bonds requires little work on your part especially if you arrange this on a discretionary basis.

Income

Buy-to-let: One of the main attractions of owning a buy-to-let property is receiving the rental income it produces. According to Zoopla the average UK rental yield is 3.63%. This is the average, however, and rental yields can change from postcode to postcode. Certain postcodes in Birmingham city centre are hitting 6% because property is less expensive than London but the amenities and opportunities available are attracting residents.

It is important to factor in periods when the property may be empty between tenants. During the recent Covid pandemic with so many people not earning their full income landlords have been faced with tenants not able to pay the rent for several months.

Portfolio: An investment portfolio will produce dividend and interest income which can be taken as natural income or reinvested to increase capital value. If a fixed amount of income is required this can be taken as monthly withdrawals of capital and provided the percentage withdrawn is no more than, say, 3.0%, this will hopefully be within the long term capital growth of the portfolio. The advantage is that withdrawals within the annual capital gains tax exempt amount (£12,300 in 2021/22) will be free of tax.

Volatility

Buy-to-let: Property has traditionally been a good inflation hedge. Price fluctuations in property tend to happen over months and while property prices can fall for long periods in certain areas, most investors who see that starting to happen can sell their property and reinvest elsewhere.

Portfolio: In an equity and bond portfolio the price of units changes daily. Unit prices can experience extreme fluctuations in the short term although a well run portfolio should mitigate against the worst extremes. You can use dips in value to buy more units in your portfolio. Such highs and lows have historically been smoothed out the longer you remain invested.

Liquidity

Buy-to-let: A buy-to-let property is not considered as a liquid investment as it typically takes a number of months to sell a property and in some cases it can take years. This may not be a problem provided an investor has an emergency or ‘rainy day’ fund in cash deposits of at least three to six months of their average monthly expenses and ideally other forms of more liquid investments.

Portfolio: You can usually get out of your investment portfolio within 24 to 48 hours, although it will take up to two weeks for cleared funds to be received. There are situations when a particular fund will be closed to withdrawals for a period but this most often happens to property funds and occasionally to funds that get into trouble such as those most recently run by Neil Woodford. However, a portfolio will normally include ten or more funds and so you should still be able to access most of your money. Naturally, if markets have fallen substantially when you want to make a large withdrawal you may be advised to withdraw the money you need from elsewhere.

Diversification

Diversification is a basic concept of good investing as the more the returns from investments are uncorrelated (i.e. one is not affected through changes in the other), the greater is the overall reduction in risk.

Buy-to-let: If you have sufficient funds you can diversify your property investment by carefully choosing the locations and types of properties you buy. For many buy-to-let investors this is not financially possible and money will be tied up in one or two properties. The old adage about ‘not putting all your eggs in one basket’ then applies and such investors should try to build up investments in other assets.

Portfolio: In a typical equity and bond portfolio your money is highly diversified as it is held in a selection of funds spread across different world markets and types of assets.

Taxation of Income

Buy-to-let: The first £1,000 of your gross income from property rental is tax-free. This is your ‘property allowance’. When you receive rental income from a buy-to-let property you can make deductions from the gross rental income for ‘allowable expenses’ before the rental profit is liable for tax.

You cannot deduct any of your mortgage interest payment from your rental income before paying tax – instead, the entire sum of your interest payment will qualify for 20% tax relief. If you are a higher rate tax payer you will therefore only receive 20% tax relief on your mortgage interest rather than 40% or 45%. You can overcome this if you set up a limited company to arrange your buy-to-let as you will then continue to offset your mortgage interest against your profits. Your profits will also be subject to Corporation Tax of 19 per cent rather than the higher individual income tax rates. However, you will have just added a further layer of potential hassle to your life.

You must contact HMRC if your gross income from property rental is between £1,000 and £2,500 a year. You must report it on a Self Assessment tax return if it’s £2,500 to £9,999 after allowable expenses or £10,000 or more before allowable expenses. If you do not usually send a tax return, you need to register by 5 October following the tax year you had rental income.

Your rental profits are taxed at the same rates as income you receive from your business, employment or pension, that is 0% (if below the personal allowance), 20%, 40% or 45% depending on which tax band the income falls into.

Portfolio: The first £2,000 of dividend income from an equity and bond portfolio is tax free. After this dividend income is taxed at 7.5% (basic rate tax payer), 32.5% (higher rate tax payer) or 38.1% (additional rate tax payer).

Depending on other interest from bank accounts etc the interest produced by an equity and bond portfolio may be partially covered by the personal savings allowance which is £1,000 (basic rate tax payer), £500 (higher rate tax payer) or Nil (additional rate tax payer). The excess is then charged at 0% (if below the personal allowance), 20%, 40% or 45% depending on which tax band the income falls into.

As mentioned earlier it is possible to take regular withdrawals of capital from an equity and bond portfolio which will provide a tax free ‘income’ in certain circumstances. Whilst it would, in theory, be possible to do the same with a buy-to-let property it is not practical to arrange regular sales of small percentages of the property.

A major taxation advantage for investors in an equity and bond portfolio is that £20,000 (or £40,000 for a couple) can be transferred into a Stocks & Shares ISA Account each year using the same portfolio if required. The money that is built up in the Stocks & Shares ISA can provide income which is completely free of income tax.

Taxation of Capital

Your liability to capital gains tax (CGT) is determined by the tax year in which the date of your disposal falls. Capital gains are assessed over the tax year and the due date for the payment of CGT is 31 January following the end of the tax year. If you made a gain in July 2021, the end of the tax year is 5 April 2022 and so any tax due is payable by 31 January 2023.

There is an annual exempt amount of £12,300 that is not liable for CGT. This is per individual and so couples are often advised to own buy-to-let properties or equity and bond portfolios jointly to make use of two annual exempt amounts.

Buy-to-let: Buy-to-let properties are subject to CGT. This is charged at a rate of 18% (basic rate tax payers) or 28% (for higher-rate taxpayers) on any growth in value that the property has enjoyed. You should also be able to offset any capital improvements you’ve made to the property against your CGT bill.

From 6 April 2020 if you sell a buy-to-let property that gives rise to a capital gains tax liability you must send a new standalone online return to HMRC within 30 days of the completion of the sale and pay the tax due within this same period.

Portfolio: Equity and bond portfolios are subject to CGT. This is charged at a rate of 10% (basic rate tax payers) or 20% (for higher-rate taxpayers) on any growth in value that the portfolio has enjoyed.

As we have seen a major taxation advantage for investors in an equity and bond portfolio is that £20,000 (or £40,000 for a couple) can be transferred into a Stocks & Shares ISA Account each year using the same portfolio if required. In this case the capital gains on the money that is built up in the Stocks & Shares ISA is free of CGT.

Another major taxation advantage is the ability to ‘wash out’ annual capital gains by transferring sufficient funds each year from the general investment account (GIA) holding the equity and bond portfolio into a Stocks & Shares ISA Account. If these gains are within the annual exempt amount there will be no liability for CGT and this will reduce, or even remove, the eventual CGT liability.

Leverage (debt)

Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment.

Buy-to-let: Many investors in a buy-to-let property do so with the aid of leverage (i.e. by taking out a mortgage). This is a reasonably safe way of using leverage.

Let’s take, for example, the purchase of a buy-to-let property for £200,000 using a deposit of £60,000 and a mortgage of £140,000. Let’s assume that the property has now been sold for £300,000. Although the percentage capital gain on the property is 50% (i.e. £100,000/£200,000), the leveraged gain on your actual investment has been 267% (i.e. £160,000)/£60,000). Of course, if in exceptional circumstances the property had to be sold for £150,000 then although the percentage capital loss is 25% (i.e. 1 – [£150,000/£200,000]), the leveraged loss on your actual investment has been 83% (i.e. 1 – [£10,000)/£60,000]).

Portfolio: Replicating the same idea of leveraging an equity and bond portfolio by borrowing money to invest is an altogether different story and would be discouraged by any IFA worthy of the name. This is because of the much higher volatility of such portfolios against an investment in physical property and the fact that you can end up owing far more than your actual investment.