Why pension freedoms won't trigger a property boom

The revolution has arrived. New rules came into force this week giving millions of pension savers the option to take their pension pots as cash from the age of 55, ending the effective requirement to use their retirement savings to buy an annuity.

Opportunities for investing the cash range from managed investment funds to a new conservatory, holidays and, in the memorable example of pensions minister Steve Webb, Lamborghini sports cars. But it is Britain's buy-to-let market that has generated some of the most intense speculation, with claims that a "wall of pension money" is primed to flood the sector.

In an era of low savings rates and volatile stock markets, many may find the lure of property hard to resist: in the past 20 years, it has provided a growing number of amateur landlords with a steady income plus a handsome capital gain on the back of soaring house prices.

But before they take the plunge, anyone mulling the idea of putting their life savings into a rental property should ask themselves a host of questions over costs, administration, taxes and their assumptions over future economic conditions.

As retirees start to consider their options under the new rules, should we expect to see a new generation of "silver landlords"? And would their investments have a broader impact on house prices?

FT Money spoke to property agents, buy-to-let specialists, pensions experts and mortgage brokers to assess the prospects of a pensions-led buy to let boom.

Some 29 per cent of people aged 55-64 are paying into a defined contribution pension - the type to which the reforms primarily apply - with a median pot worth £25,000, according to the Office for National Statistics. The figures equate to around £120bn in savings - half the £254bn spent on residential housing in 2013.

But while the potential impact on the market is theoretically large, there are reasons to think only a fraction of that total will work its way into housing. Research by property agent Savills found the distribution of pensions wealth was heavily skewed: after tax, only the top 7 per cent could afford an outright purchase of an average property, costing around £180,000.

The wisdom of diversification is another factor: wealthier pension savers may already own one or more properties, giving them pause when considering further investments in the sector. "Some people may instead use their pension wealth to pay down any debt held against existing investment properties and so maximise their income," said Neal Hudson, Savills associate director and author of the research.

Savills mapped the geographic distribution of potential investment to show the percentage of pension holders able to buy an average property outright. Only the top 2 per cent could afford to use their pension to buy a home in the southeast - whereas more than 10 per cent could do so in areas of the north such as Liverpool.

This implies a geographic mismatch between supply and demand: more of the country's pension wealth is concentrated in areas of least affordability, such as London and the southeast. Yet one solution - buying somewhere far from home - is not to be treated lightly.

John Heron, director of mortgages at buy-to-let lender Paragon, said experienced landlords tended to invest in property close to home because they were more familiar with local communities and property trends. "It's not necessarily the case but it's certainly less viable for a landlord to understand and manage property that's at some distance from where they live."

Key to any buy-to-let decision is tax. Typically only 25 per cent of savings withdrawn from a pension pot will be tax-free: the rest will be taxed as income. For some, this could mean a big lump-sum withdrawal to fund a property purchase catapults them into a higher rate of income tax.

"Taking tax-free cash from the pension freedoms to pay down a mortgage makes some sense. Taking taxable money subject to marginal rates of up to 60 per cent tax to invest in property is simply madness," said Danny Cox, chartered financial planner at Hargreaves Lansdown.

There are other ways in which the taxman makes inroads into a buy-to-let calculation: rents are taxed as income; selling a second home will generate capital gains tax; and passing it on to heirs may attract inheritance tax.

Estimates of these and other costs will be crucial to determining whether buy-to-let works, said Alan Higham, retirement director at Fidelity Worldwide Investments and someone with personal experience of the buy-to-let market.

Consider a retiree who decides to free up a £100,000 pension pot to buy a £150,000 property, with the rest funded by a mortgage.

Only £25,000 will typically be tax-free, leaving a total of perhaps £75,000 for a deposit after tax. Modest estimates of renovation costs, stamp duty of £500 and mortgage arrangement fees come to £7,000 in extra costs, reducing the pension cash available for investment and raising mortgage borrowing to, say, £82,000. That debt produces an annual interest charge of £2,900.

For many landlords, finding a tenant is another cost: around 6 per cent of the rent, reducing net income to £5,000. A typical one month void period every year - when no tenant is present in the property - reduces net income again. Maintenance costs might reasonably be expected to come to £1,000 a year. Agents' fees - should the owner choose to manage the property at arm's length - are around another £1,000.

After these costs and taxes are factored in, Mr Higham says, investors might be left with a net return of around 4 per cent. "It still stacks up as a reasonable investment but it's nowhere near as attractive as you might first think."

Buy-to-let returns are therefore comparable with those of more standard investment vehicles such as a portfolio of bonds and stocks or a multi-asset income fund.

But the advantage of the latter is that they are highly diversified, liquid and are free of the hassle and trouble of running a rented property. "Put it this way: Axa doesn't call you at 2am to say the taps are leaking," Mr Higham said.

Buy-to-let believers might retort that all of the above is overcome by a single factor: the performance of UK house prices over the past two decades. Research published this week by peer-to-peer lender Landbay found that buy-to-let beat all investment classes from 1996.

Those buying entirely with cash would have seen each £1,000 invested grow to £5,071 by the end of 2014, it said, a compound annual return of 9.4 per cent. Annualised returns on investment in a home bought with a 75 per cent mortgage were even higher, topping 16 per cent (although both these figures are before tax).

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But extrapolating future house price gains from past performance is a risky game, particularly as recent data suggests a cooling in the market. Mr Hudson of Savills says the risks of relying on capital appreciation are also greater now in view of the likely trajectory of increased interest rates over the next few years. "Betting your pension on house prices rising substantially is not the most sensible route to a secure retirement."

Will retirement savers put sufficient extra money into the property market to have an effect on house prices?

Simon Gerrard, president of the National Association of Estate Agents, said the particular needs of buy-to-let investors are likely to stoke demand, pushing up prices.

"Properties that could be considered for buy-to-let are hugely sought after, especially as this type of property is more often than not the same kind as first-time buyers and those moving to the second step on the property ladder are looking at," he said.

Savills estimates that around 1 per cent of pension wealth held by 55-64 year olds could find its way into the housing market every year, equivalent to £6.4bn or 23 per cent of buy-to-let lending in 2014.

However, Mr Hudson of Savills believes the effects are likely to be muted.

"These are not insignificant numbers and if all of it were to go into lower value markets you could definitely see localised upward pressure on prices. But across the country as a whole we're unlikely to see it have a significant impact on house prices."

Any large effects are liable to take time to show: not all pension providers are yet geared up to letting savers have their money; while some buyers may wish to take out money in tranches - delaying a house purchase - to avoid incurring a higher rate tax.

The pension reforms may also stimulate changes in the mortgage market, brokers said, with the emergence of a cohort of older buyers of property.

Ray Boulger, technical director at broker John Charcol, said increased demand for homes among the over-55s could reduce ageism among lenders.

He adds, though, that the buy-to-let market has traditionally been more open to older borrowers than standard residential mortgage lenders, which must test affordability based on the owner's income rather than rental potential.

"There is no logic in having an age limit in the buy-to-let market. In many ways once you've retired and have more time you can probably manage your portfolio more easily than when you're working," he said.

Andrew Montlake, director at broker Coreco, suggests lenders could also expand the range of products that carry lower or no penalties for early redemption - thus appealing to borrowers who wanted to pay off the loan in tranches of pension money over four or five years.

"If providers make available more products without redemption penalties then borrowers can have the choice of when to pay off the loan using their pension."

Buy-to-let remains a growing segment of the property market. But with small average pension pot sizes, concerns over taxation and diversification, and the potential for ruinous investment choices, brokers and pensions experts are sceptical about the idea of a buy-to-let bonanza fuelled by new pension freedoms.

A survey by Fidelity Worldwide Investment of 500 savers who were planning on retiring in this tax year found that just 4 per cent were thinking of using some of their pension money to do buy-to-let.

"There's no great wall of money we can see," concluded Mr Higham.

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