Soaring property prices, low interest rates and a dreary stock market have all boosted the appeal of buy-to-let over the past five years. New regulations - amongst other things - have made it easier for landlords to deal with sitting tenants, and ever increasing house prices and specialist mortgages, have cause the buy-to-let market to grow dramatically.

According to a recent survey of landlords, tenant demand for rental properties is at its highest rate ever, with almost a third of landlords stating that demand is growing or booming.

The recent rise in interest rates will prove to be a further catalyst. As borrowing costs rise, people will find it more difficult to afford mortgages and potential first-time buyers may be forced to postpone getting on the property ladder.

John Herron, managing director of Paragon Mortgages, said: “Demand for rental properties certainly shows no signs of declining. Tenant demand is fuelled by social and demographic factors, in particular the number of students, young professionals and immigrants that live in rented accommodation.”

Confidence among landlords about demand for rental properties is at its all time highest level and the average void period is down this quarter to three weeks a year, which with increasing demand is likely to continue to fall.

Why invest in buy-to-let?

Many buy-to-let landlords are investing in property to fund their retirement instead of taking the traditional option of making regular payments into a pension plan.

However, the burning question is, ‘is this sensible?’

Whether residential property is a better bet than traditional pensions is a long-running argument, but past records show that houses have not performed as well as shares or commercial property.

Those who invested in property years ago are sitting on healthy gains, but houses have not always been outstanding performers and there is no guarantee that they will be in the future.

Halifax has been a long-standing provider for consistent house price data, and their index shows that a property valued at £100,000 in 1986 would have been worth over £400,000 at the end of 2006.

It may seem that this is a decent return for any investor, but a similar investment in commercial property or a FTSE All Share fund would have almost reached the £1 million mark with all dividends reinvested.

However, the short-term story is different because over the past 10 years, residential property has outperformed equities by 28 per cent, while over five years house prices have doubled compared with the meagre 11 per cent return from shares.

The main thing to consider when deciding whether to place your hard-earned cash into property or into a pension fund is that pension contributions attract generous tax relief of between 22 per cent and 40 per cent - for a higher-rate taxpayer this means you pay £60 towards every £100 in your pension.

Plus, you are allowed to take a quarter of your fund as tax-free cash.

With property, any cash you realise from residential properties will be subject to 40 per cent capital gains tax, less your personal allowance and annual inflation indexation. On top of that, unlike being a landlord, holding a pension is virtually hassle-free.

Base rate effects

With economists predicting another increase in the base rate within 2007, the outlook for buy-to-let investors could be bleak.

If the Bank of England continue to surprise landlords, as they did at January’s Monetary Policy Committee (MPC) meeting, by increasing interest rates, buy-to-let investors could see themselves in financial difficulty.

It has been estimated that even a single percentage point could push many buy-to-let borrowers into negative cash flow – especially those who have bought with only a small deposit.

The overriding message is to think carefully before putting your faith in one asset class such as property. Balance is the key to any successful portfolio because cycles will dictate which asset class comes out on top; diversification reduces the risk of getting your timing wrong.