The nations obsession with home ownership seems to be continuing unabated, despite growing evidence that the housing market has stabilised and double digit house price inflation has had its day. Over 223,000 people took out buy-to-let advances in 2005, borrowing a record £24.5 billion in this sector. This lending accounted for 8 per cent of the total UK mortgage market in 2005, while increasing the overall number of outstanding buy-to-let mortgages by nearly 50 per cent to a record 701,900 – worth a total of £73.4 billion.
Before examining the relationship between rental cover and client income, it’s worth looking at how the buy-to-let market has changed over the past few years and what drives property investors to reduce or increase their portfolio?
Changing trend
Before the 1998 Housing Act, a significant minority of private landlords owned just one property, while companies tended to own more residential properties – often in order to house their employees. In the early 1990s this trend changed slowly, and private landlords began to invest in multiple buy-to-let properties as they benefited from the wider prosperity in the housing market due to double digit house price inflation.
The vast majority of part-time landlords still regard investment in property as part of their overall retirement planning as numerous people in the investment market feel rental income is preferable to a traditional pension.
Landlords’ sentiment very often reflects the prevailing conditions in the property market itself. For instance, according to a Council of Mortgage Lenders (CML) report, in the last property recession, during a period of marked decline in residential property prices, about a quarter of property investors thought their total portfolio would decrease in size in the short term. In contrast, over the past few years, a minority of landlords have anticipated that the property market conditions are particularly favourable and typically planned to acquire more property in the coming years.
Some market commentators argue that buy-to-let landlords, acting as dispassionate investors rather than emotionally involved owner-occupiers, may decide more quickly than a home owner to dispose of property in the event of a downturn in the housing market. They further wonder whether this could potentially destabilise confidence in the wider housing market. However, there is no compelling evidence or statistics by any survey or research study over the past decade – during which investment in residential property has become mainstream in the UK market – to suggest that investing landlords tend to decide to sell their properties more quickly than regular homeowners.
Today the buy-to-let sector is ever growing and the outlook for this year looks promising. After a period of uncertainty in the property market, investors seem to feel that the time is right to buy property as they believe the prospects for capital growth are good. A survey of more than 1,000 property investors visiting the recent Home Buyer Show in London found that 81 per cent of investors believed that the private rented sector would provide good returns, with 72 per cent saying they are planning to buy more property over the next 12 months.
Strong and healthy market
There are certainly signs of a strong and healthy rental market, as first-time buyers continue to find getting on the housing ladder a financial challenge. More young people are also choosing to rent rather than buy for lifestyle reasons, as well as the availability of high quality rental accommodation in fashionable areas or good city centre locations.
According to a recent survey by Paragon, the overall trend in yields is upward and a growing number of professional investors are willing to pay higher prices. This demonstrates that they are confident that levels of demand are sustainable and, in some cases, set to increase. The results of this survey also show interesting variations in profitability. For instance, at the beginning of 2006, Wales saw its strongest monthly increase in gross yield from 6.90 per cent to 7.75 per cent, while other regions saw yields rise from about 6.50 per cent to just under 7.50 per cent. Greater London has remained at just over 6 per cent, reflecting a greater rise in property prices that typically erodes rental yields. The average rent in Greater London stands at £17,555, or just over £1,400 a month, according to Paragon.
As far as brokers and consumers are concerned, the key issue in considering an appropriate investment mortgage is the rental cover required by a buy-to-let lender. Rental cover is essentially the relationship between the rental income required to service the loan repayment on an investment property and the actual interest payments on the mortgage expressed as a ratio. For example, if the rental income of a property is £10,000 per annum and the servicing cost of the buy-to-let mortgage is £7,000 per annum, the rental cover ratio is 1.43.
Diversification
An increasing number of banks and building societies have diversified from the prime residential market and are making a significant impact in the buy-to-let sector as it grows ever more mainstream. This is great news for new and existing landlords, as headline rates on products are becoming more and more competitive, while lending policies and criteria are becoming more sophisticated and flexible.
Increased competition has also driven down margins and forced many lenders to re-examine their lending criteria to allow them to be more flexible to a greater number of customers, while maintaining their quality of lending. Margins on buy-to-let mortgages, which historically ran at about 1.5 per cent higher than prime residential mortgages, have reduced significantly in the past two to three years and average margins are now in the range of around 0.45-0.65 per cent.
Until a couple of years ago, rental requirements had made it difficult for many potential investors to get a mortgage. Many lenders have responded by either reducing the percentage of rental cover required, or by basing the rental calculation on the pay rate rather than the revert rate. For example, one lender recently gave borrowers the ability to choose their own level of rental cover. Their standard requirement is for the rent to equal at least 125 per cent of the mortgage interest but, for a higher arrangement fee, only 100 per cent of cover is required.
Similarly, over the last year, a number of buy-to-let lenders have changed the basis of their rental yield calculations. A number of mortgage lenders are changing their criteria to base the rental yield calculation on the actual product the investor has chosen rather than the standard variable rate (SVR). For instance, a two-year buy-to-let fixed rate at 4.99 per cent chosen from a lender means that the rental calculation will be based on 4.99 per cent rather than their SVR, which is invariably higher. This enables investors to increase their borrowing potential.
Most lenders tend to ignore the client income when assessing a buy-to-let loan and the key criteria tend to be as follows:
- Location of the property
- Tenant demand
- Indicative market rent
- Rental yield calculation
- The maximum LTV
While full-time landlords are primarily motivated by the rental income from their portfolio, many will value capital growth as it allows them to expand their portfolios through remortgaging to raise deposits for new acquisitions. In contrast, among investors for whom being a landlord is not a full-time occupation, buy-to-let is also being used as a form of pension planning. Most are intending to live on the rental income when they retire.
The prospects of the buy-to-let market look very good indeed – against the backdrop of low inflation, low interest rates, low unemployment and a higher demand for renting. However, it is unclear how investors may respond to different economic conditions, such as a rise in interest rates, nor how more recent investors entering the market are performing due to the tighter margins that are currently available as a result of rises in capital values.
Mehrdad yousefi is head of intermediary mortgages at Alliance & Leicester
