Buy-to-let property used to be a surefire way to build a sizeable financial nest egg. Unfortunately, tax and regulatory changes over the past few years means this is no longer the case. As a result, I think buying a basket of cheap UK shares could produce better returns in the long run.
Today, I’m going to highlight the three reasons why I believe this is the case.
There are two ways investors can profit from buy-to-let property. Rental income and capital gains. Many investors rely on rental income to cover mortgage payments and costs, such as decorating and emergency repairs. The income covers the day-to-day expenses, and the real profit comes from capital gains.
However, over the past few years, rental yields have dropped significantly. The average rental yield in the UK is now around 3.5%, although it’s possible to achieve higher returns. At the same time, the lucrative tax breaks to that used to be available have been eliminated.
All of these factors have squeezed the amount of income buy-to-let investors received.
According to one study, after stripping out all costs and mortgage charges, the average buy-to-let investor receives an income of just £2,140 a year on a property worth £183,278. That’s a return of only 1.2%, excluding capital growth.
Over the long term, UK home prices have increased at a rate of around 2-3%. That suggests a buy-to-let investor can look forward to a return around 3.2-4.2% every year.
By comparison, over the past 100 years, UK stocks have produced an average annual return of around 7%. That’s one of the reasons why I reckon a basket of cheap UK shares could be a better investment in the long run.
Buying cheap UK shares
I think the best investments to buy instead of rental property are high-quality blue-chip stocks. Some examples include healthcare giant GlaxoSmithKline and tobacco giant British American Tobacco.
Both of these businesses have unique competitive advantages and economies of scale. They also currently offer significantly higher dividend yields than the average rental return on property.
Glaxo supports a dividend yield of around 5% right now. Meanwhile, British American yields around 8%.
Owning these equities in a Stocks and Shares ISA could also produce significant tax benefits. It’s impossible to own rental property in one of these tax-efficient wrappers.
If you are not interested in picking individual equities, owning a tracker fund could be another alternative. For example, the FTSE 250 has produced an average annual return of around 12% over the past three-and-a-half decades.
To replicate this return, all you would need to do is buy a low-cost FTSE 250 tracker fund. There would be no extra costs or charges, and you can buy the fund inside an ISA.
The bottom line
So those are the three reasons why I’d ditch buy-to-let property and buy cheap UK shares instead. Stocks have the potential to produce higher returns, can be owned inside a tax-efficient ISA, and are generally easier to manage.
By comparison, rental property can be expensive to manage, tax-inefficient, and returns have collapsed over the past few years.
Rupert Hargreaves owns shares in British American Tobacco. The Motley Fool UK has recommended GlaxoSmithKline. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.