Using property to preserve – rather than create – wealth

By specialist property accountant Stephen Fay ACA

Most readers of YPN magazine are well aware of the power of property to create wealth – whether it be renting, developing, letting, finding, or selling property – you name it, property has the potential to generate big money for those with the talent and work ethic.

But, once you have made your money, what do you do with it, and how do you protect it? Specialist property accountant Stephen Fay ACA offers a different perspective on property investing …

Don’t you have to create wealth before you preserve it?

Most property magazines, forums, and meetings focus on CREATING wealth through property – and why not? Property allows huge leveraging of money and time, and offers the chance for an Average Joe to create wealth from virtually nothing. There are no qualifications required, you don’t need to pass an interview, and there is no restriction on how much you might make – you just need to know what to do, and how, to make money in property.

Whether you are a landlord, developer, prefer residential or commercial, are hands-off or hands-on – etc – all can offer fantastic rewards to anyone who works hard and smart.

BUT … allow yourself for a moment to assume that you have wealth already – whether created from a business, savings, a property development, or some other source. Once you have a chunk of cash, what do you then do with it? Most people, as their finances improve, are naturally keen to ‘lock in’ the profits and gains made to date – especially as they get older.

Why do I have to preserve wealth? Introducing the enemy of wealth – inflation …

A key long-term financial issue for wealthy people is the erosion of the buying power of that wealth by the ‘stealth tax’ known as inflation. In the UK, we have an actual goal to maintain inflation at 2% – not zero – so that the pound in our pocket is deliberately targeted to be worth less and less each year.

Put simply, £100 in 2014 is worth more than £100 in (say) 2044 due to the impact of year-on-year inflation. Your weekly supermarket shop that may cost £100 today, would cost £181 in 2044 with just 2% annual inflation.

Imagine how your finances would cope if your weekly food shop almost doubled – could your income and the capital that produces it keep up? What about when virtually every single item you spend money on costs a lot, lot more – and that’s without factoring higher than inflation prices rises – for example, in energy prices, which are set at least double in the next 30 years.

Cash – great, but not so great…

Cash is lovely – it allows us to get what we want in life quickly and easily. Imagine having to sell a property / car / asset every time you wanted to buy a pint, or go to Sainsburys! Cash is vital to the smooth running of the world – BUT, the problem with cash is that it has a low ‘investment value’ – in other words, it is guaranteed to go DOWN in value (note – not ‘might’ go down in value!). This is not the case with certain other assets, which are virtually guaranteed to INCREASE in value – more on that later.

This means that savvy investors carry just enough cash to manage their day-to-day operations, with most of their wealth invested into real assets that do not depreciate in value – rather than cash, cars, furniture, jewellery etc (yes, there are exceptions, but mostly these reduce in value, rather than appreciate).

How does property help to preserve wealth?

Residential property values tend to track wages over the years – and wages tend to track inflation. This means that house prices tend to increase over the long term, because wages increase, because inflation is a fact of life.

This doesn’t mean that house prices rise in a straight line, or that they don’t reduce occasionally (the 1990’s, 2008-2012 etc) – but that generally over the longer term inflation drives up house price values, which protects the value of the money invested in a house.

So, in our 2% inflation example earlier, a £100k property in 2014 would cost £181k in 2044. This inflationary protection is a key benefit of property, and to a lesser extent, stocks and shares (I say that, because the sheer volatility of shares puts off many investors).

The ‘double-whammy’ effect of mortgaged investment property …

Another feature of investing in property as a store of wealth – to preserve the buying power of wealth – is that inflation has a ‘double-whammy’ impact where borrowings are used to fund a property.

Simply, the asset value INCREASES due to inflation, AND the real value of the mortgage DECREASES due to the value of money reducing year-on-year.
This creates a double-benefit for mortgaged property investors – the asset value rises, while the real value of the mortgage reduces (Note – the ACTUAL value of the mortgage doesn’t reduce – just it’s real value compared to future prices).

For example, a £100k property bought with an £80k mortgage – @2% inflation over 30 years, the value of the property should be £181k. Inflation also acts to ‘erode’ the real value of the debt – so, although the balance may remain the same (£80k), the ‘real value’ will be a lot less than today because £80k in 30 years’ time is worth a lot less than today (to put that in context, someone earning £44k today would be earning £80k in 30 years’ time by only receiving inflation-pay rises).

The ‘sell-up and cash-out’ option – and why it’s a mistake …

A very common landlord temptation in the ‘later years’ is to sell property, repay mortgages, and ‘cash out’. Whilst every landlord who has had a lifetime of managing tenants can sympathise with this plan, from a financial view, it’s often not a great plan.

Simply, landlords have an inflation-protected capital base AND an inflation-protected income stream – since house prices and rents tend to track inflation and wages i.e. upwards. Compare that to a cash-only “investor” – whose capital base is guaranteed to reduce in value year-on-year, AND who is exposed to the interest rate environment (in the recent credit crunch, interest rates fell dramatically, whereas rents were maintained).

Summary

Inflation is the enemy of wealth – and the wealthier you are, the more that inflation is an issue that needs to be addressed. Residential property is a great store for wealth – it endures ups and downs, but has a long term upward value trend.

It’s always a good idea to maintain adequate cash reserves, but wealthy people invest their money into assets to protect the value of the funds – cash left on deposit may be liquid, and ‘feel nice’, but it’s a recipe for disaster over the longer-term. Shares of course offer a good long term inflection hedge, but suffer from volatility concerns, and of course shares can be leveraged far less than property.

Arguably, the ultimate in long-term wealth preservation is conservatively-geared property in areas of high yield or high capital growth.