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Buy-to-let comes of age

It's 18 years since the first bespoke buy-to-let mortgages were introduced, and landlords have done rather well.
May 9, 2014

It seems hard to believe that before 1996 there was no mortgage specifically designed for private professional landlords. It was thanks to the Association of Residential Letting Agents (ARLA) which, having recognised back then that rapid growth in tenant demand meant that letting agency members didn't have enough property on their books to meet this growing demand, first conceived the idea of a mortgage for landlords. Indeed, the private rented sector now represents 18 per cent of all households in England, and despite the pain endured through the financial crisis, nearly every mortgage lender now offers a buy-to-let product because history shows that these deliver a better credit performance and a higher return.

But let's be honest, a lot of individuals buying a single property in the hope of cashing in on the property boom came seriously unstuck on more than one occasion since 1996 by simply not thinking through the whole process. For example, someone using a high loan-to-value mortgage would face a multitude of risks from falling property values, rising interest rates, and income starvation between tenants. But for those with a sustainable business plan to take them through the tough times, what has been the return?

Recent analysis commissioned by buy-to-let mortgage specialist The Paragon Group of Companies (PAG) throws up some interesting highlights, suggesting that every £1,000 invested in an average buy-to-let property in 1996 would have been worth £13,048 by the final quarter of last year, a compound annual return of 16.3 per cent. The same investment in commercial property would have grown to £3,564, in equities to £3,082, with cash bringing up the rear with a return of just £1,949. And, despite the strength in house prices over that period, it's worth noting that as much as one-third of the average return came from net income, defined as rental income minus costs.

Mortgaging has been the key to growth. Those taking out a mortgage with a typical loan-to-value rate of 75 per cent would have seen their portfolio increase in size at a much faster rate than a cash buyer using all his capital to buy just one property, the idea being that once rental income reaches 25 per cent of a property purchase price, another house is bought using another mortgage. Following another route, someone buying a single property bought with a 25 per cent deposit and prioritising mortgage repayments, using all net cash flow to reduce debt would have paid off the mortgage in less than 12 years.

However, the greatest returns have come from using higher property values to maintain the LTV rate at 75 per cent. In other words, as house prices rise, landlords remortgage and use the extra capital to reinvest. Such a model suggests that starting with a single property in 1996 would mean accumulating 10 by 2013 and turning £1,000 into £33,051, a compound annual return of 22.8 per cent.

Perhaps the key point to make here is that these kinds of return may not happen over the next 18 years, but by making a long-term commitment certainly improves the chances of benefiting from conditions that currently look ideal. Even the tricky periods have been weathered by the long-term investor. The shorter the investment term, the greater the risk because there is a greater chance that falling house prices could push LTV rates above agreed limits. But the longer-term investor can take these in his stride simply because of the significant increase in long-term valuations.

So what do the next 10 years hold? Property prices are starting to recover towards pre-2007 levels, but mortgage availability is improving all the time and mortgage rates have never been lower. But investing now with a greater certainty of a profitable outcome has to have a built-in degree of flexibility to accommodate a certain rise in mortgage rates at some point. A highly-geared portfolio will obviously be the most risky, although, of course, this also offers the greatest return.

Paragon's take on the next 10 years has to make assumptions, and not surprisingly, these suggest that while returns are expected to remain attractive they will be more subdued than the average in the last 18 years. The company's projections are based on inflation staying around the targeted 2 per cent level, while average household income rises at the same rate, and assumes that house prices are slow to grow in tandem with nominal income growth, while rents rise in line with inflation. The two differences here are that, compared with past trends, this seriously under-estimates the performance of house prices, which have grown faster than nominal incomes over the past two decades, but overstates the performance of rents, which over the last decade have grown more slowly than prices.

But even with interest rates rising to 4 per cent by 2021, and buy-to-let mortgages costing 1.75 percentage points on top, this scenario would deliver an estimated compound annual return of 11.3 per cent for a landlord with 75 per cent gearing.