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Buy to let: locked out of london

Would-be landlords are being priced out of the capital’s property market – but with plenty of value on offer in the regions they shouldn’t be too concerned. Jonas Crosland reports
November 21, 2014

The private rented sector has been seen as a classic way of making money on the back of a housing shortage, low interest rates and spiralling capital values. It still is, except there are now two buy-to-let markets: London and everywhere else. And it’s important that you understand the differences, because they affect how you best manage your exposure to residential property.

London calling

Certainly, the days of easy money from London property are long over – at an average price of over £400,000, buying a flat in London with a view to generating a rental income is an expensive business, prohibitively so for most.

True, the rents are the highest in the country, but with capital values galloping away, rental growth simply hasn’t been able to keep up. In fact in terms of yield, or the rent as a percentage of the cost of buying a flat, London delivers just 4.4 per cent gross yield. Take away from this any maintenance costs, agency fees, mortgage and tax, and there’s not much left. To generate an attractive rental income – the raison d’etre for many buy-to-let investors – London is not a very attractive place.

Of course, this doesn’t matter all that much if capital values continue to accelerate, and a brief glance at the market shows that demand continues to outstrip supply by a country mile, a factor that would suggest there’s plenty of life left in London property. It’s calculated that London needs 42,000 new homes to be built each year to meet the shortfall.

But less than half that number were delivered last year. But those imbalances have arguably been fully ‘priced in’ to the rampant house price inflation of recent years. In fact, property price growth in London is starting to flatline, with price falls seen in one borough this month, a 3.7 per cent fall in values in Kensington & Chelsea, playground of the uber-rich and an area at the heart of the foreign buying boom that many argue has had a huge knock-on effect on property prices in both the capital and commutable regions in the south east. Mortgage approvals are slowing, more generally, too. According to the Bank of England, the number of mortgages approved for house purchase in August fell to 63,371, reversing the gains seen in the previous two months and marginally lower than a year earlier.

Subsidence

It remains to be seen, though, whether the pillars of support that have carried the market to its dizzy heights are about to be fully demolished. The most obvious threat is a change in government next May and the introduction of some kind of mansion tax should there be a Labour victory – potentially even on one-bedroom flats in some parts of the capital, such has been the level of price appreciation. And the strength of feeling towards the increasingly two-tier housing market means there could be some kind of additional tax on higher-value properties regardless of the outcome of the next general election.

There is also the inevitability of an increase in interest rates, although at present sentiment is more vulnerable to this than reality. Around 90 per cent of mortgages are on fixed rates covering a number of years, and interest rates still look some way off – consensus expectations of a rate rise have been repeatedly postponed over the course of 2014 on moderating inflation and fears that economic recovery around the world might not be quite as entrenched as previously believed. Besides, any increase in rates would be relatively small – current expectations are that the UK base rate won’t reach 1.75 per cent until late 2017 a significant downward revision from the forecast of 2.25 per cent given by the Bank of England in August.

Reading too much into slowing mortgage approvals is also ill advised – the slowdown in demand for houses to buy could be a temporary consequence of unfounded fears over imminent rate rises and a belief that prices will moderate as more properties come on to the market. In fact, approvals did bounce back slightly in September. Houses could also become more affordable as income-to-price ratios are reduced by the return of modest real earnings growth, which could also breathe life back into transaction volumes.

There is little evidence from housebuilders that demand is running out of steam either. East London focused builder Telford Homes (TEF) said back in May that all targeted output for the year to March 2015 was secured, nearly three-quarters for 2016 and 25 per cent for 2017. These latter two figures will certainly have been improved upon since then, and it’s also worth noting that around two-thirds of all sales are made to UK-based and overseas private investors, and not owner occupiers.

Mortgage approvals still lag prices

Catch up

Areas outside London, meanwhile, are also still playing catch up, and a long way from the excesses of the UK capital’s market. Most regional cities do have mini hot spots similar to (but cheaper than) London, but for the most part capital growth is less pronounced, and yields are consequently that much higher.

Looking at that in terms of real money rather than yields serves to show just how different the markets inside and outside London are. Estimates tend to vary, but LSL Property Services (LSL) estimate that London rents in July averaged £1,143 per month, (even higher in Central London), while those in the North West were just £594. In yield terms that means a 4.4 per cent return in London and 7.2 per cent in the North West. In previous cycles, London rents have led the way higher, but regional rents have continued to play catch-up long after London rents reached their apogee.

What’s more, buy-to-let lending still has a long way to go before resuming the levels seen before the financial crash. From annual advances of less than £4bn in 2000, buy-to-let lending peaked at over £45bn in 2007. It fell sharply after that, but between 2009 and 2013 advances more than doubled to nearly £21bn, still less than half the pre-crash peak though.

The underlying strength of the market can be gauged from second-quarter data compiled by mortgage lender Paragon (PAG). This showed that void rates continue to decline, while nearly 40 per cent of those surveyed described tenant demand as growing or booming. According to Countrywide, there are now five tenants chasing each rental property, up from 4.2 a year earlier, a figure borne out by the fact that 99.6 per cent of all landlords are achieving the asking rent. What’s more, these figures remain well below 2012 levels, after which the rental market took a knock from the introduction of the Help to Buy scheme. Although the scheme has been extended to at least 2016, the effects on rental demand are likely to be less pronounced than the initial surge of renters wishing to get their foot on the first rung of the housing ladder.

It’s also worth remembering that there is an army of potential renters living with their parents, who may never be able to afford a house – the so-called ‘generation rent’. Not all, of course, will choose to rent, but the trend could prompt a significant shift in the makeup of the UK’s housing market – the Intermediary Mortgage Lenders Association reckons that by 2032 more than half of the UK’s housing stock could be rented out compared with 17 per cent at the moment, a major reversal of a long-term trend towards wider home ownership and good news for the nations growing army of private landlords.

How to be a landlord

There is no typical landlord – anyone can do it. Official statistics are notoriously slow to be updated, but the latest numbers from the Department for Communities and Local Government, show a significant shift in the make-up of the housing stock and the providers of rented accommodation. From 2001 up to 2012, owner occupancy as a percentage of the total housing stock has fallen from 69 per cent to 64 per cent. Over the same period accommodation rented from local authorities has halved to 7 per cent, while private rentals have doubled to 19 per cent. Housing associations have increased their stake from 7 per cent to 10 per cent, but it is clear that a lion’s share of the demand for rented accommodation is coming from private landlords.

Professional landlords with up to 10 properties represent around 17 per cent of all landlords, with over one third comprising an investor with one or two properties designed to generate a revenue stream. Unlike professional landlords, few in this latter category plan to use capital appreciation as leverage to expand into more properties. Most landlords are over 46 years of age, which is logical, since these people are more likely to have achieved surplus assets such as cash payments from retirement or surplus property through inheritance.

According to the Association of Residential Letting Agents, nearly a fifth of residential landlords have been operating for more than 20 years. This is important because it means that capital appreciation over that period has been more than enough to compensate for the cyclical downswings in house prices. It’s also interesting to note that new entrants into the market collapsed to just 1.5 per cent in the fourth quarter of 2010. Since then, this figure has recovered to just below 5 per cent, but has shown little material increase in the last three years.

Joining the growing ranks of landlords is easier now that more buy-to-let mortgages are generally available. The difference for landlords between the years leading up to the financial crash and now is that borrowing costs are significantly cheaper. And banks are belatedly starting to recognise that a typical buy-to-let landlord with 50 per cent to put down as a deposit on a house represents a far better risk than a young couple seeking a 95 per cent mortgage.

House price growth indexed to rental growth

Storm clouds

There are some potential storm clouds however. New EU regulations relating to lending must be in place in the UK by March 2016. The minute details are yet to be thrashed out, and much depends on how the Treasury elects to interpret the new mortgage credit directive. At the moment, it seems that those who have not actively acquired a property in order to be a landlord, and are not running a property-lettings business, will be affected. These include those who have inherited a property, or who have previously lived in a house but have been unable to sell, and which they may now let.

The proposals state that member states are required to meet standards in order to protect consumers taking out credit agreements relating to residential property. This captures residential mortgages secured against the borrower’s home and also any other lending where the purpose is to acquire or retain property rights. The UK government has rightly taken the view that the UK mortgage market is already well policed, and is trying to minimize the effect on the UK market. But uncertainties remain.

Generation rent: UK home ownership rates by age

No pain, no gain

Being your own landlord may sound attractive, but the benefits can also be badly affected by a whole range of circumstances. Never play down the stress levels associated with being a private landlord. Research by Rentguard Insurance, whose products include residential landlord insurance, suggests that more than half of all landlords use some of their holidays to sort out problems. Around a quarter admit that being a landlord is more stressful than they expected, while two-thirds admit they are more stressed now than they were a year ago. That’s without considering phone calls to sort out tenants and discussions with letting agents. More than a third worry about voids, or having no tenant in place.

Even dogs are a cause for concern. Most landlords do not allow pets in their property, but 5 per cent have found that tenants ignored this, resulting in some dog related damage to the property.

Apart from voids, maintenance and agent fees, there is also the prospect of higher interest rates. This will take years to have a serious effect, and semi-professional landlords will simply maintain their portfolios. If they are well run, they will manage through the cyclical swings. But putting your spare cash into bricks and mortar only to see returns in fixed-rate investments rising above rental yields would be a difficult blow. It’s not easy to get rid of a tenant just when you want to. And if interest rates are climbing, it may be difficult to sell your rental property.

Beyond that, as property is a cyclical beast, landlords who survive as such tend to ride out the sticky patches. In fact, weak house prices provide an ideal buying opportunity, although the depths of a property cycle are usually accompanied by restricted lending.

Looking ahead, it seems likely that when interest rates rise, investors with spare cash may revert to more conventional and less risky forms of investment. However, there is little doubt that demand for private rented accommodation will remain. For the die-hard landlord, the secret will remain avoiding paying up too much for a property to rent, and buying in the right area.

Where to buy

There are plenty of publications highlighting the pitfalls of buy-to-let, but one aspect that is difficult to formulate is where to buy. The obvious choices such as central London and university towns are already pretty well known; it’s finding those up-and-coming areas that might offer an opportunity to enter the market closer to the ground floor. One factor to look for is transport. Rents in parts of Lincolnshire, for example, are relatively cheap because transport links with central London are poor. Moving much closer in, the principal game changer is Crossrail, the new railway system that will link up parts of Essex and Kent with central London and Heathrow.

Even here, it pays to be selective. One end of the new rail system in Shenfield in Essex, but this is already well served by trains into London. A two-bedroom flat would cost around £375,000 to buy and generate rent of £1,200 per month; that’s a yield of 3.8 per cent. Looking at another terminus – Abbey Wood in Kent – reveals an area ripe for improvement. Currently a two-bedroom flat would cost as little as £165,000, generating rent of £825 per month or a 6 per cent yield. The scope here for both capital appreciation and rental income growth is significantly greater. Areas once never even considered as attractive have been transformed simply because the demand for accommodation situated close to central London has been pushed further out.

And the opportunities for capital growth are considerable. Recent data from the Land Registry shows that taking out the buoyant Greater London area leaves average house prices still 16 per cent lower than they were in December 2007. Including London, average prices were £177,299, but taking London out of the equation leaves average prices at £133,538, back to where they were 10 years ago. The point here is that outside London, becoming a landlord is still relatively affordable, especially given the low interest rates at the moment.

Not surprisingly, the regions with the highest proportion of landlords saying they had bought properties in the last year were the North East (37 per cent), Scotland, Wales and Northern Ireland (32 per cent) followed by the Midlands (32 per cent) and the North West (30 per cent). The number of landlords buying in Central London was just 21 per cent. This suggests that the regions, where capital and rental growth look strongest are playing catch up because more than half of landlords in the survey said they have properties – including London – located in the South East.

Life tenancies: a halfway house

Interested in property investing but unsure about buy-to-let? How about choosing a life tenancy investment. Up until now these have been the preserve of institutions such as Grainger, the largest owner of residential property in the UK. But individuals can now participate, too.

This is how it works. A home owner looking to raise capital on his house, but unwilling to move, sells the freehold interest in the property. In return, he will receive a lifetime lease with no rent payable. The occupier maintains and insures the building which reverts to the investor on the tenant’s death or move into long-term care.

As an example, a property valued at £120,000 is sold to an investor for £54,000. The tenant lives rent free for life, and the investors makes a profit when the lease reverts. The downside is that the tenant could live for another 40 years. The upside is that the investment can be sold on before maturity.

Life tenancy investments can be bought through internet channels such as Rightmove and Trovit.