Property versus pension: the conclusion

My last blog considered whether property or pension was the better investment choice. The below case study may help you decide.

It has been a little trickier to answer the question than I thought, when relying on all the facts and figures. I researched the returns from residential property and discovered that during the last (almost) 30 years, capital prices have increased by a staggering 444 per cent (source: Halifax House Price Index, Jan 2003 to Nov 2011).

So, if you paid £9,000 for a house in 1983, it would be worth around £49,000 today (a return of approximately 5.8 per cent per annum, on average). If you paid a 10 per cent deposit, let it out and the rent covered all the mortgage repayments and costs, you would have turned £900 into £49,000.

So far, property wins by a mile. But I then looked at the UK stock-market performance - arguably, the most likely place to invest your pension - over the same period and was surprised to discover that even with the dire returns and volatile markets since 2000, the stock market has still returned 1846 per cent (source: MSCI UK Market Index, Jan 2003 to Nov 2011), which is around 10.4 per cent per annum on average, smashing the 444 per cent from property.

I then realised that the property return excluded the rent. So in the interests of fairness, I decided to exclude dividends from the stock-market return, which brought it down to 619 per cent, still comfortably ahead of property.

However, these figures are about comparing the average growth of equity and property sectors over a period. They do not reflect the answer to the question, which can be affected by other factors. For instance, the majority of property investors 'gear' their investments by getting a mortgage and most pension investors benefit from tax relief plus they can get the benefit of matched contributions from their employer.

Simple sums

To take these matters into account and demonstrate the point, I need to over-simplify the issue. My client had £10,000 to either invest into a pension or pay as a deposit on a buy-to-let property. First, let's assume that the £10,000 pension contribution receives basic-rate tax relief and is matched by the employer - then it instantly turns into £25,000. Alternatively, the £10,000 can be used as a 20 per cent deposit on a property with the balance funded by a mortgage.

The mortgage cost is £213 per month on a repayment basis, assuming 4 per cent per annum interest. The rental income at, say, 6 per cent of the value would be £250 per month. So, on the face of it, this investment would appear to work well and produce positive cashflow of £37 per month.

However, there three snags to this approach:

1. Tax. Only the interest element of the mortgage can be offset against the rent leaving £23 per month tax to pay (assuming a basic rate taxpayer).

2. Fees. Agents costs could be up to 10 per cent, reducing the rent by £25 per month.

3. Vacancy rate. It is safe to assume that the property is empty for one month out of 12, reducing the income by another £20 per month on average.

Therefore, it is likely that the owner may need to pay more than £30 per month just to keep the property ticking over. Also, they will be responsible for repairs, which are likely to be about 1 per cent of the property value. So, in total, it could cost nearly £900 per annum in negative cashflow.

Taking stock

However, let's simply assume that the rent covers all costs and that the mortgage is repaid in 25 years. Also that the average annual returns from both property and the stock market seen during the last 30 years (that is, 5.8 per cent and 10.4 per cent respectively to November 2011) are repeated over the next 25 years. Then, the property would be worth almost £190,000, which is pretty impressive, but the pension would be worth around £290,000.

At that point, assuming a 5 per cent yield from both 'investments', the property would provide £9,500 per annum, but the pension would yield £14,500 - an increase of over 40 per cent. The pension fund also has the flexibility (under current legislation) for the client to take 25 per cent of the pension fund as a tax-free lump sum. The gain on the property would, however, be subject to capital gains tax.

So, it seems to me that a pension is less hassle and more tax efficient, with the potential for higher returns. It is also possible to establish a pension for no (or very little) cost, whereas the property transaction will incur legal fees, mortgage arrangement fees, etc.

I'm pleased to conclude, therefore, that for me, if you have the benefit of a matched contribution from an employer or you are a higher rate tax payer, pension wins every time.

Colin Lawson is founder and managing partner of Equilibrium Asset Management

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