I won’t have to remind readers of Mortgage Introducer that interest rates rose eight times between November 2003 and January 2007. Even with one reduction during the period, the Bank of England Base Rate rose progressively from 3.50 per cent to 5.25 per cent. The typical mortgage holder with an interest only loan at a variable rate pegged to Base Rate might have seen their mortgage payment rise by 50 per cent or more – a fair chunk of anybody’s pay packet, and there’s probably another rise in
the pipeline.
What does this mean for the property investor? A crude layman’s analysis would suggest that, if gross yields are around 6 per cent and interest rates are 5.25 per cent or even 5.50 per cent, the investor will be losing money once he has absorbed running costs, repairs, tax and insurance; that he will be reliant on other income to subsidise his property investment activity and that the only reason to do buy-to-let is for capital gain.
The truth is rather more subtle.
A more subtle truth
For one, landlords do not borrow 100 per cent of the purchase price or value of a property. The industry standard maximum loan-to-value (LTV) is 85 per cent and, while there has been some degree of ‘creep’ whereby some lenders will go to higher LTVs, a ‘cushion’ is built into the amount an investor is permitted to borrow
Secondly, serious players in the residential property market own a number of buy-to-let properties bought at different times, which may be financed individually or on a portfolio basis. Often a landlord will cross-subsidise a lower yielding property, or one which may have been recently acquired with a relatively high level of borrowing, from other properties in the portfolio with established rental streams and possibly lower borrowings. In our experience, average gearing across a landlord’s portfolio is around 40 per cent.
It is also true that only a minority of landlords are exposed to variable interest rates. Over the past year, more than 70 per cent of investors have chosen fixed rate deals, so they are not exposed to the short-term fluctuations of interest rates and, more importantly, know exactly what their mortgage payments will be for the foreseeable future.
At the point when a buy-to-let loan is agreed, the lender will typically seek an interest coverage ratio of 130 per cent, requiring the rental income to exceed the monthly mortgage payment by 30 per cent. A property investor who takes a fixed rate mortgage deal knows exactly what his future mortgage payments will be, and has the potential to raise rents when a tenancy agreement is renewed or when a new tenancy is agreed on
the property.
Subject to market forces
Rents are, of course, subject to the forces of supply and demand in the local area, and indeed depend upon the quality and location of the property to be let. While there is no direct link between interest rates and rents – and indeed there tends to be a lag between rises in borrowing costs and repricing of rents – a higher cost of borrowing raises the cost of home ownership, which in turn feeds through into stronger demand for rented accommodation.
This creates upward pressure on rents, particularly when the impact of a growing population, expansion in the number of households and inward migration are factored in.
Our information suggests that rents rise at least in line with retail price inflation and, indeed, it is no coincidence that our Buy-to-Let Index has registered some particularly large increases in rents over the past quarter – rental incomes are up by almost 7 per cent since November.
The other key factor is that property investment for most landlords forms part of a diverse portfolio of investments, which include a cross section of other financial products such as equities, fixed income securities, bank or building society accounts, ISAs, pensions and life assurance. From a survey we conducted, landlords told us that on average only 32 per cent of their income is generated from buy-to-let, with employment and other investments representing the remainder.
This is important for two reasons. Firstly, rises in interest rates will have a positive impact on returns from the investors’ cash investments. Secondly, the diversification means that a landlord can use other income sources to cover any temporary shortfall where the mortgage cost and other expenses are not fully covered by monthly rentals, until such time as the rent can be adjusted to fit current market conditions.
I don’t need to tell an intermediary that diversity is a strength for an investment portfolio and that undue concentration can be risky. Buy-to-let is an excellent class of investment, generating good rental income and attractive capital gains over time. However, it is a long-term investment and requires a time horizon over five or 10 years.
Over the longer term, however, buy-to-let has an excellent performance record, and it is no surprise that, even in an environment of rising interest rates, there continues to be strong purchasing activity from investors who are adding to their property portfolios.
