Worldwide: Property Investment Strategies

Many investors who put their capital into foreign property aim for high yields, but not all of them understand that greater initial yields imply greater risk and maybe even a long-term decline in returns. This article by Tranio expert, Yulia Kozhevnikova, analyses how to ensure the best yields when renting out property.

Investors that will benefit from rental property

Tranio's typical investment clients come from Russia, Brazil, Iran or China and are already operating successful businesses that generate their main profits at home. They prefer to gain passive income from their overseas property and take the least possible part in its management. They tend to invest in order to maintain their capital and protect it from political and economic risks in their countries rather than for income.

Most clients do not plan on selling their commercial property in the near future, instead they consider it a contribution to their personal wealth and a guarantee of their children's future financial well-being. Residence permits granted by investor visa programmes like in the UK and the US are another important incentive.

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Rental property is the best vehicle for non-core investors (i.e., for whom property investment is a side activity) because it is low-risk and the strategy is simple to implement.

Budget and property types

A successful investment starts with a budget of at least €200,000 because, excluding some minor exceptions, it is extremely difficult to buy good quality and well-situated property for less than this amount. These factors ultimately determine how easy and profitable your investment will be later on. With this budget, it's best to buy residential property, which is the object of high and steady demand.

If the budget is over €2.5 million, it's worth considering commercial property like retail premises or retirement homes straight away.

Up to 50–60% of the property value can usually be financed, meaning that €100,000 in personal funds is enough to start investing.

How to choose a location

Risks and yields depend directly on the property location, which is why we recommend investing in countries with well-developed economies and stable political systems. The markets in Austria, the UK, Germany, the USA, France and Switzerland present the lowest risks (e.g., hyperinflation, national currency devaluation and GDP declines).

Germany is a preferred location for Middle Eastern, Asian and Russian investors because it is easy to access and delivers slightly higher yields. It also has better lending terms and somewhat lower taxes compared to some of the other popular countries. However, some fear that the German economy will be weakened by recent political events and choose the USA, expecting higher capitalisation there.

In terms of location, it is better to opt for either metropolitan cities and their well-situated suburban areas, or the medium-sized towns with growing numbers of inhabitants, well-developed labour markets and potential for economic growth. We suggest looking at reliable locations where investors of the same nationality have already had a successful investment experience. Generally, western European capitals and big cities in western Germany are often a good option.

The choice of district depends on the property type. For instance, it is better to buy shops in central streets with lots of foot traffic and warehousing facilities on the outskirts of big cities near major transport routes like motorways.

Tenants and rental contracts

When renting out residential property, the best tenants are middle class representatives with good credit records and stable income. In terms of commercial property, it is better to choose real estate that has major corporate tenants that have been present on the market for decades. Such tenants are less likely to go bankrupt compared to small private companies. You can get the tenant's financial data from lawyers during the due diligence stage before an agreement is signed.

A property with many tenants (i.e., apartment buildings or shopping centres) is not adapted to the needs and requirements of non-core investors. From our experience at Tranio, anymore than five tenants and the management risks increase significantly. Additionally, properties serving multiple tenants require an extremely competent management company. For these reasons, we recommend choosing a property with only one tenant.

How the maintenance costs are shared with the tenant is the key to a successful rental contract as it determines who shoulders the taxes, repairs, utility bills, etc. We suggest mitigating the risks by choosing properties where tenants are liable for the maintenance costs. These contracts are called NN Lease (Double Net Lease) or NNN Lease (Triple Net Lease). The following table shows the different types of rental contracts.

Property that comes with a long-term (10-20 year) rental contract, no right of cancellation and fixed rental rates, regardless of the tenant's performance, is ideal. Keep in mind that such contracts bind both parties: they not only guarantee the tenant will make payments consistently during the whole period, but also that the owners have no right to evict the tenant before the contract expires.

Long-term contracts protect investors against price adjustments that can happen on even the most secure real estate markets. During 15–20-year contracts, investors will no doubt see rates decrease during the first decade of ownership because real estate market cycles alternate every 7–10 years, meaning that a long-term contract will be safe from price volatility because there is no way to cancel or negotiate the rate half way through the term. In fact, these contracts allow investors to exit the project under the most favourable conditions.

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Value growth potential

Low-risk assets come with 3–7% initial rental yields. At Tranio, we strongly advise against any property that promises initial yields over 7% because they are impractical to manage for foreign investors. There is a high probability that certain risks may materialise in 5–10 years and that the cost of solving them exceeds the risk premium paid upon entering the investment.

More importantly, property prices on low risk and low yield markets (generally located in upmarket districts of big cities) grow faster than in areas characterised by high initial yields and high associated risks. In fact, research by Tranio shows that, between 2001 and 2015, the price of property with an initial yield of 3% gained 5% in value per year on average. On the other hand, those with 4.7–7.0% had price gains of just 3.5% per year while 9% yields actually showed declining prices.

As a general rule, property with low yields is the least likely to lose value during the investment term, while property with higher initial yields is more likely to lose value (taking into account the probability of potential risks materialising). As a result, property with 3–7% initial yields is the optimal choice as it is the most secure and has better total revenue (yields and capitalisation).

Optimal yields depend both on the risks and the investment term. The shorter the term, the higher initial yield (i.e., 3–7%). For example, if the investment term is twenty years and you don't take any loans out, the highest total returns (including capitalisation) are about 3.8–5.8%, but if the investment term is just ten years, optimal initial yields are 4.5–6.5%. This is the conclusion of Tranio's investment analysts following the study of 100 "yield — capitalisation" correlations on the German residential and commercial property market.

Leveraging the investment

You can increase yields by getting a bank to finance your investment because the funds attracted are cheaper than the tenant's rent. For example, an investor in Germany can borrow up 60% of the property value at 2–3% interest per annum. If the rental yield is 6.5% then the return on investment, loans included, can be up to 8–10%.

In general, the cheapest loans come with floating rates and no early repayment option — the most expensive ones with fixed rates and an early repayment option.

Long-term loans (for 10–15 years) are more profitable. Even though longer terms come with more expensive rates, they reduce the risk of hitting a negative market cycle that could affect your ability to repay the loan. In the case of commercial property, we recommend taking out a loan that allows you to pay off the interest first and then the principal closer to term. It is always better to repay at least 40–50% of the principal before the loan expires.

Refinancing property and borrowing too much is not advisable. However, you shouldn't borrow too little either, as it would be strange not to use an opportunity to take out a loan that is cheaper than what the tenants are paying you.

Structuring the investment for taxes

Individuals in Europe and the USA pay taxes in proportion to their income, making it easier to register properties worth up to €1M to individuals. However, it is preferable to register more expensive properties to companies because legal entities usually have flat and lower profit tax rates. Also, companies are allowed to write off loans against their declared earnings, thus improving their tax situation.

It's best to organise the transaction in a way that allows the investor to pay taxes only in the country where the properties are located — but this option depends on things like where the investor is a tax resident, international agreements on double taxation, the form of ownership, etc. At Tranio, our clients work with tax advisors so as to choose the best transaction structure and take out loans under optimal conditions.

Exiting the project

Investors usually own commercial property for 5–20 years before selling it on and it typically takes at least 13–14 years to pay off the investment and start earning profits. In some countries, investors aim to own the property until they are no longer liable for capital gains tax (e.g., after 10 years in Germany).

The ability to sell the property at a profit many years later is one of the key investment risks that clients interested in high yields often forget. They are attracted by projects with 8% initial yields or more, such as car parks or student accommodation in remote suburbs, but these properties are hard to sell and have lower demand. Often, to sell them on, you have to drop the prices considerably, which levels out the high initial yields as a result.

With a timeframe of 10-20 years, we suggest considering commercial property that has the initial yields of 5% (following all the other recommendations in the article). Most often they grow in value by 2–3% per year together with the market or even faster. These are reliable properties you can sell at a profit and ahead of time if your plans change. And in case of market adjustment, high yield/risk properties face the greatest risk of value loss.

However, if you are going to sell the property in 1–3 years, it's better to choose the highest yielding property in a district with potential for growth. Spain, with its central markets of Madrid and Barcelona, is considered to be one of these locations in Europe. However, there is no saying that these markets will continue growing over the next 10–20 years, so it is better to choose more predictable locations for long-term investment targeting capital maintenance.

If you don't plan on selling but transferring the ownership to your heirs, it is important to choose the right ownership structure to optimise inheritance taxes. For instance, France does not charge inheritance or gift taxes if the property is registered to a property investment company (SCI). The UK does not impose inheritance tax on the properties registered to offshore companies.

Investment strategy recommendations

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.