Is the buy-to-let investment bubble finally about to burst?

The housing market slowdown is worrying investors but it may really be good news, says James Daley

Small investors may be on the verge of another disastrous mistake, taking their cash out of buy-to-let property investment at the worst possible moment, financial experts warn. Figures from the Investment Property Databank show returns from rental property lagged the stock market last year - with the two sectors producing average gains of 9.1 and 12.8 per cent respectively. And with the ongoing slowdown in house prices, confirmed by Halifax yesterday, many investors are pulling out of buy-to-let.

Small investors may be on the verge of another disastrous mistake, taking their cash out of buy-to-let property investment at the worst possible moment, financial experts warn. Figures from the Investment Property Databank show returns from rental property lagged the stock market last year - with the two sectors producing average gains of 9.1 and 12.8 per cent respectively. And with the ongoing slowdown in house prices, confirmed by Halifax yesterday, many investors are pulling out of buy-to-let.

Some investors fear a collapse in the stock market, similar to the way the technology share bubble burst at the end of the Nineties, sparking a three-year nose-dive in European equity markets. But buy-to-let experts say the slowdown in house prices has presented a buying opportunity. Those who sell out, having bought housing in recent years, could face losses, just as shrewder investors cash in.

Paragon Mortgages, the specialist lender, and Landlord Mortgages, the buy-to-let broker, say the recent fall-off in demand from regular investors has been offset by an increase in transactions by professional landlords, who believe conditions are perfect for adding to their portfolios. Lee Grandin, the managing director of Landlord, says a cooling off in the housing market has increased demand for rental accommodation, driving a slow but steady increase in rental yields during the past few months.

Although, year on year, rental yields are down, he says this trend has now reversed, and that this has been the main attraction for more experienced investors. "It's been the professional landlords - with at least two or three properties - who have been buying more recently," he says. "The worst time was last year, when interest rates were rising and mortgage outgoings were increasing, but rents weren't going up that quickly. Since then, interest rates have stabilised and there's been fewer buy-to-let properties going to market. But there's still people out there needing to rent. So rents have begun to increase."

The National Landlords Association (NLA), in a recent poll of its members,found that more than a third of landlords were optimistic about the market and were planning on buying new properties during the next five years. This contrasts with other recent polls, which show private investors are much more guarded about the market's prospects.

John Heron, the managing director of Paragon, says a move away from more speculative property investors who are trying to make a quick buck is a positive development. "Buy-to-let is not an investment, it's a business," he says. "If you buy the right property in the right location and manage it well, you will have a good business."

David Salusbury, the chairman of the NLA, insists that some two million tenancies in Britain are a success every year, but he admits there are many landlords who do not treat their tenants with the respect that a business would treat its clients.

A change in pensions legislation next April - which will allow investors to hold buy-to-let properties within self-invested personal pensions (Sipps) - may renew interest in buy-to-let. Although existing properties will not be transferable into a Sipp without paying tax on any capital gain you have made, properties purchased after April will qualify for inclusion. All income and capital gains will remain tax-free, while the property is within the pension.

Given the limits on how much can be held in any pension - even after the forthcoming regulation changes - the Sipp option may be lessy attractive for professional landlords. But Sipps could prove the ideal tax shelter for smaller investors.

Even so, Heron believes that while the new regulations may encourage some people to consider buy-to-let for the first time, it is unlikely to spark a significant market rally. Moreover, given that most people have exposure to residential property through their own home, pundits agree that a move into the buy-to-let market, even when prices are rocketing, must be a carefully considered move.

Ben Yearsley, of Hargreaves Lansdown, the financial advisers, says investors should spread their savings across a mix of equities, bonds and even commercial property, before they turn back to the residential market. "If someone owns their house, why would you want to invest more in residential property, before you've provided some diversification?" he says.