January 2020 was a positive month for the UK property market, after uncertainty surrounding Brexit and the December 2019 general election - which caused house prices to drop and prompted potential buyers to wait for an indication of more stable ground before house-hunting - was eradicated.
According to Nationwide Building Society, UK house price growth hit a 14-month high in January - with property values 1.9% higher than in January 2019, at an average of £215,897.
This is all good news for residential property bond investors - after all, their high target returns are generated in part by the borrowers ability to sell the properties that their loans fund, therefore increased confidence for buyers and higher house prices provide a promising outlook.
The importance of property bonds within the UK property market
If you need a refresher on what a property bond (also known as a loan note) is, they’re basically a kind of IOU. An investor loans funds to a property developer as a means of financing residential or commercial property developments - funding the likes of land purchasing and construction costs. The investor then receives interest (coupon) payments, as well as the repayment of the original loan amount, which is usually repaid at the end of a fixed term (upon maturity). Keep in mind that a property bond is an investment product though, and these returns are not guaranteed.
You might be wondering why property bonds are necessary - why don’t developers just loan the money from banks? Often, they will. However, after the effects of the 2007/08 recession, banks tightened their purse strings, resulting in a lack of affordable mainstream finance available to property developers operating in sectors such as hotels, student accommodation and residential.
The UK is estimated to need around 340,000 new homes built each year until 2031 to keep up with demand - and in the year ending September 2019, only 177,980 were completed. Property bonds are a key consideration when looking for ways to tackle this housing shortage head-on, offering developers an alternative finance method that can often provide them with larger sums of funding, allowing them to take on more ambitious projects.
The advantages and disadvantages of property bonds for investors
We’ve covered why property bonds are important to the future of the UK property market, and why they’re advantageous to property developers. But what are the advantages (and disadvantages) of property bonds to you, the investor?
Some investors want to reap the benefits of investing in property - with the intention of earning a profit - without being responsible for the day-to-day duties of owning property outright. For these investors, property bonds are an attractive, hands-off alternative to the likes of buy-to-let.
First and foremost, they have the ability to offer high target returns of around 4% to 8% on average - though these returns aren’t guaranteed, and when investing into a property bond, your capital is at risk.
The lower minimum investment amounts attached to property bonds - when compared to the initial capital needed to purchase properties for the purpose of renting, or refurbishment to re-sell - means they’re often much more readily accessible to a wider range of investors.
Property bonds can also be held in an Innovative Finance ISA (IFISA) - the investment product introduced in April 2016 that has the benefit of a tax wrapper, meaning there’s no tax to pay on any interest or capital gains. So not only do property bonds offer high target returns, these returns could also be completely tax free.
Property bonds are usually fixed term, which means your funds will be locked away for a set period of time. Depending on you and your circumstances, this could either be a good thing, or a bad thing. Fixed term generally means you’ll also get a fixed interest rate, and this rate is often higher the longer the term.
Interest can be paid quarterly, and with a defined payment schedule and a predictable target return over the lifetime of the bond, they can provide a relatively dependable stream of income. Alternatively, interest received on property bonds can also be rolled up and paid upon maturity, at the same time the original loan amount is repaid.
The drawback of a fixed term bond for some investors is that they don’t usually allow for easy access to your funds - many providers won’t let you withdraw money at all, while others will charge a penalty. So before investing into a property bond, make sure you’re comfortable with the length of time your provider requires your money to be tied up for.
Though property bonds come with a mid/high risk profile and aren’t protected by the Financial Services Compensation Scheme (FSCS) - which protects investors for up to £85,000 if their authorised provider goes bust - they’re often asset-backed, with your investment secured against a property or development. This means that if something was to go wrong and the borrower was to default on their loans, you’re able to sell the asset as a means of getting some of your money back. If a property bond is being used to finance a group of projects, investors benefit from the spreading of risk across a number of sites. This gives the investor a degree of diversification, as well as additional security and peace of mind.
Investing in property bonds with an IFISA
The IFISA - which the government introduced in a bid to progress the UKs alternative finance market - has been booming as of late. In 2019, investments held within an IFISA hit and exceeded the £1 billion mark, and their popularity appears to be on a consistently upward trend.
The main, obvious benefit of an IFISA is the tax wrapper, making all income from investments held within the account completely tax free. When combined with the high target returns offered by fixed term property bonds, they can form quite an attractive partnership.
An IFISA isn’t the only way you can invest into a property bond - you can also invest directly or through your SIPP or SSAS (as long as your individual provider allows) - but it’s certainly the most tax-efficient way.
If - after careful consideration and, ideally, seeking advice from an independent financial advisor - you decide that investing into a property bond with an IFISA is a good investment choice for you, doing it is relatively simple. There’s a lot of choice online, and after you’ve found an IFISA eligible property bond that ticks all of the right boxes for you, you’ll have the option to continue with an IFISA. You’ll then open your IFISA online, where you’ll be able to use the platform to view the progress of your investment throughout the life of the bond.
The CARLTON Bonds product is available exclusively to experienced investors who are classified as either sophisticated investors, high-net-worth individuals or professional investors and have the knowledge and experience to make their own investment decisions. Investments are high risk and illiquid, your capital is at risk and returns are not guaranteed. Bonds are not protected by the Financial Services Compensation Scheme (FSCS).
Originally published 17th February 2020, updated 12th May 2020.