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Income is the key to investment, including property

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We continue our investing for beginners series with an explanation of how investments are largely priced on the income they generate.

by Gavin Lumsden on May 03, 2012 at 10:03

Income is the key to investment, including property

Last week, when I talked about the 5 principles of investing, I said it was a good idea to spread your money around different types of investment.

In the next stage of the Lolly Investor Programme, I'm going to introduce three of the main ‘asset classes’ in the investment world. They are shares, bonds and property.

I will explain what they are, how they work and how they are different from one another.

But I will also focus on the thing that links them, which is income.

The search for income is a huge driver of stock markets and investments, as can be seen from this video, which looks at how property is priced on rental yields.

Visit our Lolly Investor Programme page to see more videos in the series.

Welcome to the Lolly Investor Programme.

Last time when I talked about the principles of investing I said it was a good idead to spread your money around different types of investment.

This time we’re going to start looking in more detail about three of the main different ‘asset classes’ as they are known.

They are shares, bonds and property.

There are big differences between them but I’m going to look at the thing that links them, which is income.

With interest rates stuck at an all-time low of 0.5% – way below the rate of inflation – almost everyone is looking for income from their investments.

Income is like cash in the hand for investors and in these troubled times that’s what they like.

Which investments they choose and how much they are prepared to pay depends on what kind of income they want and what kind of risk they’re willing to take.

Let’s start with property for that is the asset class most people are familiar with.

The funny thing about property is that, although we don't think of it that way, it is the investment category most closely tied to income, or rent in this case.

For example, most of us buying a property to live in don’t think about the price in terms of how much it would fetch in rent. Which is funny given that most of us tend to start off as tenants before clambering on the property ladder.

That’s not how professional investors behave, nor for that matter, private investors involved in buy-to-let.

Many of the flats in the housing development behind me have been bought by buy-to-let investors, who, if they were doing their job properly, will have thought a great deal about the rental value of the properties.

In the commercial and investment world rental yield is a key measure of the financial return from commercial property, whether it is an office block, warehouse or shopping centre.

(RENTAL YIELD = GROSS RENT – EXPENSES / COSTS OF BUYING A PROPERTY)

You don’t need to be a rocket scientist to see that the return – or yield – from a property investment is the rent – or income – minus the costs of maintaining the property and paying the mortgage, divided by the price paid for the property.

In other words, if as an investor I know what return I want and I have a good idea of what rent I can charge and I know what my interest payments are, I can calculate the price I should pay for the property.

Put simply, if my yield is 6% and my costs are 4% the property is worth buying. But if my yield is only 3%, because rents are falling, and the costs are still 4% then I am going to lose money unless the price of the property goes up. That’s unlikely to happen, however, if rents are falling.

That’s the trap that some buy-to-let investors fell into a few years ago. They assumed property prices would continue to go up and didn’t anticipate the income yield would fall below their costs.

So you see property is a good example of an asset class where price is fundamentally linked to the income it is expected to produce.

Next time I will look at how the income story applies to shares.

3 comments so far. Why not have your say?

Maverick

May 03, 2012 at 13:07

Someone needs to put the opposing view about income.

Assume you can find a bank giving you 5% net interest on a balance of £1,000. After a year your £1,000 has grown to £1,050.

Assume you instead buy £1,000 of shares in (say) Fenner plc. This gives a dividend of 2.6%. At the end of the year you have £1,026, you say. Ah, but the shares have gone up in value by 15%. So in fact you have £1,176.

After the next year your bank account balance is now £1,102.

The Fenner shares go up by a further 10%, with the same dividend. You now have £1,320.

Those of an uncharitable bent have been known to say that those who bother about income are unwilling to take the trouble to make capital gains. In the end it's all money - it doesn't matter where it comes from.

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Dennis .

May 03, 2012 at 18:09

Don't forget dealing costs, I bought £1800 of GSK shares this week and it cost about £20 in dealing costs and stamp duty ie about 1%. No doubt it will cost me the same when I sell them. So for small investors you are either in it for the long term (for income) so that dealing costs are spread over several years or you are expecting a large capital gain in the short term.

You need to have a large portfolio to make dealing costs indignificant. This is one of the points often overlooked with OIECs where dealing costs are part of the annual charge.

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Paul Eden

May 05, 2012 at 12:59

Stocks and shares ISAs have many charges attached...I am deterred by these charges. As shares do go down as well as up, charges can help lose people money. Cash ISAs have no such charges, only a fixed or variable rate of interest.

Shares bought in one go are seldom at a very good price when bought en bloc. I would like a stocks and shares ISA which allow people to choose the shares themselves without charges attached, other than nominal dealing charges. As things stand, the only certain winner is the provider of the ISA.

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