plonkee money an english-er's thoughts on personal finance

January 8, 2008

planning for retirement: pensions vs buy to let part 1

Filed under: investment — Tags: , , — plonkee @ 12:00 pm


I recently compared pensions and ISAs as investment wrappers after being inspired by a reader’s comment. In response to that post, Nick said:

It’s been suggested to me that a good option is to buy property to let over the same period I would normally be pay into a pension plan, then use that to fund a retirement plan instead.

Buy to let investments have been very popular over the last few years, and certainly a really comprehensive asset allocation plan would probably include property. How could you incorporate them into a retirement plan, and how would this compare to investing in the stock market via a pension?

In theis first part, we’ll look at one way of using a buy to let investment to fund a retirement. Tomorrow, in the second part, we’ll compare the results here to a standard pension.

what is a buy to let?

A typical buy to let investment is a small residential property in high demand in the rental market. Three of the most popular segments to aim at are:

  • young professionals – typically 1 or 2 bed flats
  • housing benefit recipients – inexpensive 2 or 3 bed houses, often in ex-council estates
  • student housing – 3 to 6 bed houses, close to a University, preferably in a student ghetto

upfront costs

To buy a property, you need a deposit, money for fees and stamp duty, and a mortgage. For a buy to let investment, you usually need a deposit of at least 15% of the value of the property. In addition to the set-up costs, there are ongoing maintenance costs, tax to pay, and fees.

For the sake of argument, let’s assume that the we’ll be investing in a property selling for £175k – about the average price of a flat in the South East of England. On this property, the deposit required is £26,250, and a mortgage rate of 6% would give you interest only repayments of £750 per month (these are tax deductible).

Your other buying costs I’ve estimated as stamp duty at £1,750, and (putting a finger into the air) conveyancing and legal fees at approximately £2,000. So you need an upfront investment of £30,000.

ongoing costs and income

A typical rental yield is about 5%, which means that the property could be rented out at around £725 per month.

You need to budget that the property won’t be rented out all the time, a 10% void rate is probably appropriate. Then anticipate that around 10% of the rental income will be spent in maintenance, and another 10% on letting agents fees. This means that the average monthly income from the property would be £522, leaving you with a net deficit of £228 per month.

capital gains and cashing up

Since the 1970s, the rate of increase in house prices in the UK has averaged about 2% above inflation. We’ll assume that will continue over the 30 years between now and retirement and that inflation will average 3%.

This means that on retirement, the property would be worth about £756,000. We’ll estimate that the selling costs would be 5% of the value of the property, and we’ve still got the £150,000 mortgage to pay off. This leaves us with a profit of £543,200, which will be subject to capital gains tax of approximately £114,200 – assuming that exempt amounts increase with inflation. This leaves us with a net profit of £429,000.

The profit can then be used to fund a retirement income, with 4% being a reasonable assumption, so it would give a retirement income of £17,160 (approx £7,070 in today’s money).

what about the rest of the money?

What? What extra money? Yes, in the first draft of this post I made a basic schoolgirl error in the calculations. I assumed that the rent would stay constant for 30 years. What an idiot. On the bright side, I realised in time to correct my post.

If we assume that the rent increases by 5% each year (the same as house prices, keeping the yield the same), and that any profit made (including the £228 per month) is invested in the stock market with returns of 7% per annum, then after 30 years, there will be an extra £141,000 in investments. This can then be used to fund additional retirement income of £5,640 – which is about £2,320 in today’s money.


In summary, for an initial investment in a buy to let property of £30,000 and a further constant £228 per month invested in cash-flowing the property, or in the stockmarket could give a retirement income in today’s money of £9,390.

Please note that I’ve done all these calculations from scratch, so I may have made errors in my assumptions, chime in if you’ve got better suggestions. I’ve tried to make all them all as reasonable as I can, but it’s certainly not guaranteed that any investments will perform in the way described above.

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