The heat has left the property market and average price growth figures for the past year have fallen from the 26 per cent high enjoyed during the property boom. Both commercial and residential markets are taking some punishment, with the result that investors’ faith is shaken, particularly the growing number of pension investors who have been putting more funds into property, either within a self-invested personal pension (SIPP) or as part of a general portfolio.

One eye on the horizon
Property can have an enormous emotional attraction as a solid investment because people can see and touch it. It is familiar because many have already bought their own homes. And property offers two income streams – capital gains from property price growth and a monthly rental income.

Buy-to-let residential property has become an increasingly popular alternative for investors looking to diversify the investments they make with a view to funding their retirement. However, one thing you can guarantee with an investment as political as buy-to-let is that you need to keep a weather eye on any changes to the tax rules governing investment properties.

There was frenzied speculation following Gordon Brown’s proposed tax changes to allow SIPP-holders to invest tax free in residential property back in 2005. Evidence suggests that thousands of businesses and investors moved to take advantage of the tax loophole but, four months before they were due to come into force, the Government withdrew the plans after considerable criticism.

Investments in a SIPP, whatever the asset class, remain exempt from capital gains tax (CGT) like any other pension vehicle. But this time, Alistair Darling’s proposals for a flat 18 per cent CGT rate could offer a small advantage to SIPP investors investing in commercial property, says Andrew Tully, marketing technical manager at Standard Life.

‘It is still a little unclear, because the Government proposals are under discussion right now,’ says Tully, while Malcolm Kerr, a director with accountant Ernst & Young, adds that ‘The changes may impact property transfers into the SIPP, but it is only likely to involve “marginal” tax savings’.

Putting property into SIPPs
However, the tax-efficient nature of SIPPs means that with the right advice there can be real benefits, especially for higher-rate taxpayers, regardless of how the underlying asset performs.

Hyman Wolanski, head of pensions at Alliance Trust, points out that ‘People with their own share-dealing accounts, or those who are interested in a certain fund-management group not offered by other pension providers, tend to take the next step into SIPPs.’

The management charges for SIPPs are higher than for stakeholder and personal pensions, and so tend to appeal more to those with larger pension funds. Standard Life, one of the larger SIPP providers, says the average SIPP fund size is roughly £170,000, compared to the UK average annuity of roughly £18,000 from standard pensions.

But SIPP-holders can only borrow funds worth up to 50 per cent of the value of their pension pot to buy a property through a SIPP, which is likely to make buying property in a SIPP more of a rich man’s game. These investors, often guided by an IFA, have often been able to consolidate several pensions into one pot, which can be filled with a wider-than-average variety of asset classes, sometimes including property. But property is still considered a specialist investment, and investors need to check if their SIPP provider allows commercial property into the wrapper, because many do not.

Commercial property
You can invest tax efficiently in property via three routes and, unlike buy-to-let, direct investment in residential property is effectively excluded. The punitive CGT
levied on investing in residential properties inside a SIPP takes away any financial incentive to do so.

The most attractive route is commercial property. Lee Smythe, a partner with Killick & Co, says, ‘For small-business owners, business finances and their own personal finances can be intimately entwined. Holding your own business premises in your SIPP can be a very efficient method of organising finances as, while the business still needs to pay a full market rent, this is going into the business owner’s pension fund, rather than being paid to an external landlord or to service debt on bank borrowings to fund the ownership.’ He adds, ‘Ownership of the premises in this way can offer a certain degree of protection from creditors, but you should always take professional advice before considering this.’

Property funds
Alternatively, property funds buy properties and allow investors to buy units or shares in the fund. Property funds need to borrow to offer fund managers liquidity to buy and sell properties, and this degree of gearing makes these funds higher risk.
There are roughly 1,500 commercial and residential property funds available, which
you can research through an IFA or a financial publication such as What Investment.

‘Be careful when researching individual providers,’ warns Wolanski. ‘I don’t know a property fund manager that doesn’t claim his fund is the best performing in the sector. So, always seek more top-down advice from your IFA or elsewhere before you invest.’

Lastly, investors can use a property investment vehicle, such as a company or unit trust often created specifically for the purpose, to invest in residential property indirectly, but such an investment must meet strict conditions, says Wolanski. At least three investors must participate to create a vehicle – for example, a unit trust with at least £1 million in assets – and no single investor can own more than ten per cent of the investment.

One commentator gave the example of a client who wanted to buy a flat next to Arsenal’s Emirates Stadium, which he wanted to hold inside a SIPP. ‘It would have been possible if he could find 11 other investors to buy 11 flats between them, giving them less than a ten per cent share in the investment and, effectively, one flat each on a syndicated basis.’

But the risks are high on this type of investment. For example, if one investor dies or loses interest and wants to sell, you may not find another buyer on the same terms.

Buy-to-let
Buying a single investment property is far more accessible to the average investor than buying it in a SIPP. But from a tax point of view, buy-to-let is the clear loser.

Comparing these investments is like comparing apples and pears. SIPP investors, for reasons of tax efficiency, are more likely to be commercial property investors, whereas amateur buy-to-let landlords often prefer residential property.

Buy-to-let investors pay yearly income tax on rental gains and submit tax returns. Renting out a buy-to-let property is a long-term investment which, when you retire, may provide a good income, provided the mortgage is paid off. But when you sell a buy-to-let investment, CGT is payable on the growth (i.e. the price rise) the property has seen, which is not the case for a property inside a SIPP. However, some of the extra costs associated with buy-to-let are tax deductible, such as mortgage interest, legal fees and insurance, and repairs and maintenance.

In terms of funding, buy-to-let is more accessible. If mortgage lenders are satisfied that a property is a good rental prospect and an investor can provide a deposit of
15 to 20 per cent, some mortgage lenders will fund the rest. But the credit crunch has left its mark on the buy-to-let market. The number of loans has fallen in the past six months and lenders are far stricter in the criteria they impose. Unless an investor is a cash buyer, this an issue that affects both SIPP and direct property investors.

The outlook for property   
As with most investments, predictions for property depend on who you talk to. Tom McPhail, head of pension research at IFA Hargreaves Lansdown, reports that ‘It is not something we are necessarily encouraging clients to invest in right now. If you know what you’re doing, and that is a big “if”, and you want to pan for nuggets of gold, there could be money to be made.’

But if you already own your home, you may be overinvesting in a single asset class. Property can be quite illiquid, so anyone tying up large sums in a single investment should be cautious, unless they have taken advice.

Malcolm Cuthbert, managing director of financial planning at Killik & Co, says that ‘Over the past decade, we have seen a huge increase in buy-to-let properties, and as a financial planner I’ve become used to clients saying “my house is my pension”. But how practical is this? What are the upsides and downsides of using property as a pension?

‘You have to think about who administers the buy-to-let. The older you get, the less inclined you are to want to deal with running a property – including filing an annual tax return.’