Property investors are in for a rude awakening

Propertyprices can only go one way. And this time it's down.

For years landlords in this country have been able to charge outrageous rents on commercial and residential property. But that is about to change in a big way. Landlords throughout the country are struggling to find paying tenants. And with house prices falling sharply in February, there is now a serious downwind for property prices in this country.

Many experts I read are expecting a gradual decline in house prices this year. But I think it will be a lot more dramatic than that. Everywhere I look I see evidence of gaping imbalances in the property market. And it only convinces me thatUK property is due a rude awakening.

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What are these property experts missing? Well let's start in my hometown...

Why landlords are resorting to charity

Let's just be clear about something. When I talk about falling property prices I am not talking about property everywhere. Given that Russians, Chinese and various international crooks choose London property as the means to launder their ill-gotten gains, I am not pessimistic about London property values either.

But take the place where I live, Oxford. My local high street is gradually becoming the preserve of charity shops. Why is this? It is because the landlord would rather see the premises used - and because he gets 80% relief from local rates by letting it to a charity. But this just disguises the fact that there is very little real commercial demand for high street premises. From April landlords will be even keener to woo charities, because they will no longer receive rate relief on empty properties.

How will the landlords react? Well nobody wants to be paying rates on empty properties. And over the next year landlords will become increasingly desperate to find paying tenants. They will have to lower their sights - and lower their asking rents.

One of the shops on my high street handles parcels and sells stationery. Chatting to the owner the other day he told me that he has to pay an annual rent of £40,000. £40,000! You have to sell an awful lot of rubber bands to get that back. Or take my cousin. She had a tiny shop in Chipping Norton, a wealthy market town with a good tourist trade. She was selling fashion accessories and other such knick-knacks but last year gave up the struggle of paying the £18,000 annual rental.

There is nothing supporting land prices in this country

Here is the point. Both of these businesses would be perfectly viable if they were not paying extortionate rents. For years landlords have been gouging their customers, especially retailers, but now the boot is on the other foot. With the greatest reluctance landlords are now cutting the rents. The consequence of this is that the value of the properties takes a hit. What that means is that the value of the land upon which they sit becomes worth less.

What about the housing market? I spotted an announcement from INLAND (LON:INL), a company that specialises in tarting up brownfield sites. It has recently sold 148 plots on a large site near Heathrow for £14.6m. That works out at close to £100,000 per plot. My guess is that the housebuilder will now spend perhaps £70-80,000 on the construction of each new home, before putting them on the market for £250-£300,000.

Now here is my point. The price of a house is not determined by its building costs. It is largely determined by the cost of buying the land on which it sits. Just consider the difference between what you pay to insure the structure of your house and the amount you paid for the property and you will get the idea.

House prices are not set by the cost of bricks and cement. They are really set by the cost of building land. But while the price of building materials and builders' wages cannot go down by much, there is nothing to support the price of building land. House prices are falling and are set to fall further. With rising prices and taxation the amount that we have left to service a mortgage is going down.

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How you can still make real profits in the years ahead

So house prices will go down, not because people want them any less or because builders will make any less money. They will go down because building plots will cost less. Investors in land and property will suffer. Ask ten people today whether they prefer to invest in property orshares and nine, conditioned by years of rising house prices, will answer property. They are in for a rude awakening.

Just look at all the empty, derelict and unmarketable homes strewn across the USA and you can see what can happen. Could it get that bad? I think it could.

But here's the real point I want to make today: to make real profits in the coming years you need to back wealth-generating businesses, not static wasting assets.

That means buying shares in successful companies. Right now there are a host of very exciting companies among UK penny stocks. In this month's issue of Red Hot Penny Shares, I told my readers about a great wave of excitement in internet stocks - pointing to two small companies that could become major parties in what are fast becoming multi-billion dollar industries.

And over the last year, I've also been recommending some stellar UK manufacturing stocks - part of a great recovery in manufacturing in this country that I believe has years to play out.

Of course investing in shares requires a bit of work and takes a bit of courage. But if you don't have the time to do the groundwork yourself, then take a trial with Red Hot Penny Shares. You can sign up for a three-month no obligation trial. And that should be more than enough time to recognize the wealth of opportunities there are out there - from internet stocks to manufacturing to biotech.

This article was first published in Tom Bulford's twice-weekly small-cap investment email The Penny Sleuth.

Red Hot Penny Shares is a regulated product issued by MoneyWeek Ltd. Forecasts are not a reliable indicator of future results. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Penny shares can be volatile, relatively illiquid and hard to trade. There can be a large bid/offer spread so if you need to sell soon after you've bought, you might get less back than you paid. This can make them riskier than other investments. Please seek advice if necessary. 0207 633 3780