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Buy-to-let: 20 tough questions

Created:
1 May 2008
Written by:
Claer Barrett

In the UK's last recession, buy-to-let was barely a feature. Today, it's a £113bn industry, with more than a million buy-to-let landlords accounting for a 10 per cent slice of the UK's mortgage market.

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Private investors aren't the only ones to have profited from the buy-to-let boom - mortgage lenders and housebuilders have grown exponentially; now they are worried by the extent of their exposure. The lifeblood of cheap finance has evaporated, with more than 2,000 buy-to-let mortgage products pulled from the market since July 2007, and a rising tide of arrears and repossessions. For housebuilders, the valuation stigma surrounding new-build apartments - once so popular with buy-to-let investors - is a major worry. As fears of recession grow, economists worry that the prominence of buy-to-let could be the tipping point for a housing crash.

1) What is the extent of buy-to-let mortgage exposure in the UK?

Data from the Council of Mortgage Lenders (CML) shows that buy-to-let lending accounts for 10.3 per cent of the UK's entire mortgage market by value - that's £113.3bn.

At the end of 2007, the number of outstanding buy-to-let mortgages smashed through the million mark for the first time - a 23 per cent rise on the previous year - as buy-to-let investors gorged on cheap money.

The total amount of new buy-to-let lending in 2007 was £45.3bn, but the CML predicts that this will fall back to £22bn in 2008. This does not include buy-to-let remortgaging, which the CML expects to rise from £154bn in 2007 to £164bn in 2008.

It should be noted that the number of buy-to-let mortgages is not the same as the number of buy-to-let properties. For example, when couples move in together, the 'spare' property is often rented out rather than sold. These 'hidden' buy-to-lets could also end up flooding the market if the economy takes a turn for the worse.

2) How has the credit crunch changed the dynamics of buy-to-let?

The crisis in the wholesale money markets has dramatically inflated the cost of borrowing, and the number of mortgage deals on offer.'Riskier' lending - including buy-to-let, sub-prime and lending to new-build - has been hit the hardest.

Since July 2007, website Moneyfacts.co.uk says there has been a 62 per cent drop in the number of buy-to-let mortgages available - from 3,478 to 1,325 - and the figure drops further every day.

"The major difference is in the impaired credit sector, where there were 1,279 buy-to-let products in July 2007 compared with 82 today," says moneyfacts.co.uk analyst Julia Harris. "It seems ridiculous that it got to that stage."

Non-balance-sheet lenders such as Paragon, Capital Home Loans and GMAC RFC - who swelled their mortgage books off the back of buy-to-let - are effectively out of the market. Those who will still lend are rapidly reducing loan-to-value (LTV) to 75 per cent, and increasing rental cover (rent as a percentage of mortgage payment) to 125 per cent, which is clearing the amateurs out of the market.

3) How reliant are the big housebuilders on sales to buy-to-let investors?

New-build flats have proved particularly popular with buy-to-let investors, lured by expensive marketing campaigns, off-plan discounts and rental guarantees.

Berkeley Group declined to comment, but in December's half-year results, the company said 50 per cent of its sales reservations were to buy-to-let investors. A trading statement at the end of March did not update this figure, but revealed that overall sales were 20 per cent down on the previous year. The London-centric group has previously boasted about being heavily forward-sold, but it remains to be seen if buy-to-let investors who have laid down a reserve deposit will be able to secure a mortgage on the terms they are comfortable with.

Barratt reports that 15 per cent of sales in the July-December 2007 period were to buy-to-let investors, a fall from 18 per cent in 2006. "There are clear regional variations," says Patrick Law, director of corporate affairs at Barratt. "In that same period, the figures for buy-to-let sales in central London increased from 25 per cent to 32 per cent in 2007. Clearly, we build a lot of flats in east and west London. It's a very sophisticated market and there's a lot of buy-to-let in there. However, a lot of the buyers we're dealing with are not in the market for large mortgages, and have big portfolios they've built up over a period of time." Barratt reported higher levels of cancellations in the last six months of 2007 - rising to 30 per cent.

Taylor Wimpey business development director David Bridges says he is "not at liberty to say" what the percentage of buy-to-let sales has been. "Has there been a drop off? Yes. Has it disappeared completely? Absolutely not," he says.

"The death of the buy-to-let sector has been grossly exaggerated. We're still doing a material number of investor sales every week, but we're having to work hard to help them. We are pushing our regional businesses very hard to make sure they are the most solid sales possible."

Persimmon's chairman, John White, says only 8 per cent of 2007's completions were sold to buy-to-let investors, the lowest of all the listed housebuilders. "Only 2.5 per cent of our completions last year were high-rise innercity flats," he says. "The mortgage lenders' criteria for apartments, particularly high-rise, has changed dramatically in the past few months. I expect the housebuilding industry will see lower volumes this year, and a lot of the decrease will occur at the apartment end of the mix. I know the industry is putting the brakes on buy-to-let-type apartments more than any other product. We will see quite a lot of these schemes being mothballed, and the industry will be building a lot less apartments for some time."

4) Which lenders are the most exposed to buy-to-let?

The CML's table of the top 10 lenders to buy-to-let shows that Bradford & Bingley's Mortgage Express arm is the clear leader.

Its buy-to-let mortgage book totals £23.1bn - that's 57 per cent of all its lending - but nearly 100 buy-to-let products on offer in July 2007 has now shrunk to 41.

"We still believe buy-to-let is the fastest flowing bit of the river in the mortgage market," says Jeremy Law, head of buy-to-let at Mortgage Express. "It will rise to more than 10 per cent of the mortgage market in the future. The private rental sector is far larger than the buy-to-let sector, so there's huge headroom for growth."

HBOS has huge exposure to the mainstream mortgage market and, through Birmingham Midshires, it is the second biggest buy-to-let lender. Analysts refer to HBOS as "Britain's biggest housebuilder" due to its backing of private residential developers McCarthy & Stone, Crest, Gladedale, Miller, Countryside Properties.

"The future could be very difficult for companies like Bradford & Bingley, although I get the impression it tightened its lending criteria very quickly," says Alex Potter, banking analyst at Collins Stewart. Indexed LTV is all very well in a rising market, but in a falling market it's a different story. If prices slip, then up to 10 per cent of their book could be above 85 per cent LTV."

"If - and it's a big if - the buy-to-let market was to blow up, you'd expect to see problems concentrated across a relatively small group of lenders - Cheltenham & Gloucester, Bradford & Bingley and Paragon, and arguably HBOS as the parent of Birmingham Midshires," predicts Ed Stansfield economist at Capital Economics.

5) Are repossessions of buy-to-let properties rising?

The latest CML data shows a clear rise in arrears and repossessions of buy-to-let properties, although these are still very small percentages, and marginally below the figures for repossessions and arrears in the main market.

At the end of 2007, 0.73 per cent of buy-to-let mortgages were more than three months in arrears.

"Buy-to-let arrears are likely to remain lower than the rest of the market given the outlook for strong tenant demand and lower interest rates," says the CML. "This may not be the picture for some pockets of the market where there may be an oversupply of certain types of property."

As a whole, repossessions reached 27,100 in 2007, and they are projected to rise to 45,000 in 2008 - still a long way off the 1991 peak of 70,000.

"The danger area is sub-prime mortgage holders coming to the end of deals," says Lee Grandin, managing director of mortgage broker Landlord Mortgages. "There are no deals available for them, so they will be forced onto a higher rate, and are prime for repossession."

6) What is the extent of repricing in the buy-to-let sector?

Once repossessed by lenders, distressed buy-to-let properties are commonly sold off at auction. Research issued in March by Allsop - the UK's biggest residential auctioneer - shows an average price fall of 26 per cent on auctioned new-build flats, compared with their original purchase prices. Nationwide, distressed sales from mortgagees and receivers make up 22 per cent of all residential lots sold.

"Many developers specifically tailored apartments to attract the buy-to-let market," says auctioneer Gary Murphy. "Investors were offered incentives such as cash refunds of guaranteed initial rental returns. But with limited tenants available for the large numbers of units coming to the market, rental values were inevitably affected and many investors suffered voids almost immediately."

Analysts believe the situation will get worse. "The 26 per cent fall in values is almost certainly an underestimate of the situation for people who bought a year ago," says Alastair Stewart, analyst at Dresdner Kleinwort. "By the time those repossessions come to market, there will be more oversupply, and you could easily see falls of 40 per cent or more."

Once one flat in a development sells for a song at auction, this negatively affects values for the rest.

7) Are investors still in the market for buy-to-let property?

The housebuilders and lenders report that, while the amateur investors have been cleared out, experienced buy-to-let landlords are still in the market. Leveraging equity from long-held portfolios means they can still obtain mortgage debt, and bargain down prices.

‘Our portfolio lenders [landlords with multiple properties] are absolutely still in the market and looking to do business, says Mortgage Express's Mr Law. "As an investment for the long term, buy-to-let is still the right thing. More than ever before, you need to have done your research and understand the local market dynamics, the affordability of any loan you might be getting, and levels of rental cover."

"Professional investors are still out there, but they're looking for dramatic deals, and that's not something we're interested in doing," says Persimmon's Mr White. But as the speculation about price corrections intensifies, predatory landlords may well choose to wait for the bottom.

8) What legacy has been left by the buy-to-let investment clubs?

Tighter buy-to-let lending criteria has hammered investor clubs. One of the largest, Inside Track, was founded in 2001, and since then its clients have purchased nearly 15,500 new-build buy-to-let properties. Inside Track runs seminars promising how to "become a property millionaire". It has laid off 40 staff due to poor trading.

It is hard to estimate how many buy-to-let properties were acquired through clubs like this, as the industry is not regulated. However, the national press is awash with stories of amateur investors who bought properties off-plan through investor clubs, only to see their value plummet on completion, and rents achieved commonly fail to meet expectations.

The big housebuilders all claim they will not be adversely affected by investment clubs leaving the market, as they have used the power of their own brands and websites to attract buy-to-let investors directly. But when distressed amateurs start to dump properties, the effect on the overall housing market will not be pretty.

9) What areas of the UK are the most affected by 'buy-to-let blight'?

With buy-to-let investors retreating from the market, the northern cities of Leeds, Manchester, Liverpool and Newcastle are routinely held up as the worst examples of apartment oversupply, and therefore more likely to suffer from falling rents and capital values.

"There is a lot of concentration risk in buy-to-let," says Collins Stewart analyst Mr Potter. "Where there are gluts of available properties owned predominantly by landlords, there could be severe localised falls."

"In the north and Midlands, there are blocks of new-build apartments 'built for buy-to-let' where practically everybody who's bought one is a landlord,” says Mark Hughes, analyst at Panmure Gordon. "A lot of these will end up going to bulk discounters. Housebuilders outside London have pulled out of the city-centre market and have moved into suburban schemes."

"We've made some tough calls, like putting a major development in Leeds on ice," agrees Mr Bridges of Taylor Wimpey.

Although London is held up as being a market in its own right, it is not immune.

"Before Christmas, central London landlords were able to put rents up 15-20 per cent at renewal,” notes Neil Chegwidden, head of residential research at Jones Lang LaSalle. "Now, with the threat of unemployment in the City, they are no longer pulling the reins. For bigger landlords with 20, 50 or 100 properties, lots of voids could be catastrophic."

10) How can there be oversupply when there's a housing shortage in the UK?

One housebuilder sums up the problem succinctly: "In the North, there's too many flats, and not enough people. In the South, there's too many people, and not enough homes."

Figures from the NHBC show 46 per cent of new-build starts in 2007 were apartments, compared with just 21 per cent in 2000. Popular with developers and planners, the greater densities achieved squeeze the most value out of the rising cost of land. City-centre apartments have also proved attractive to buy-to-let investors - but, with many potential purchasers now forced out of the market, oversupply is set to increase, denting apartment values further.

11) Why are mortgage lenders so wary of lending to new-build flats or houses?

The short answer is worries over valuation. This sector's immense popularity with buy-to-let investors has sustained a boom in prices, which are now under threat from oversupply and distressed selling. However, the big mortgage lenders have particular problems with developer incentives.

Offers such as 'gifted deposits', payment of professional fees and rental guarantees are used to artificially maintain higher selling prices - the figures that end up as a matter of public record on the Land Registry. With lenders increasingly sensitive about LTV, the true cost of these incentives is coming under scrutiny.

"There's a complete lack of transparency with new-build, and there has been for a while," says Mortgage Express's Mr Law. "Developers have some fairly ingenious ways of providing discounts, which means new-build is harder to value, and valuers have become cautious. The Land Registry price is not the true price. If that person were to sell the next day, they wouldn't get that price."

The Land Registry is now working with the CML and the Royal Institution of Chartered Surveyors (Rics) on what can be done to rectify the situation.

"We have concerns, clearly, but we can only take the information from the application form we're given," says Mike Westcott-Rudd, head of legal services at the Land Registry. "What's happening is not unlawful - you only have to look at incentives offered by developers in newspaper advertisements - but we want all of our data to be accurate, and wouldn't want the implication that people were being misled."

Buy-to-let lending to new-build has an additional problem: "If too many of these properties become available for rent, it will drive down rental values, especially in any development where property clubs have bought significant slugs," adds Mr Law.

"The result is hardly anyone wants to loan to new build property in the buy-to-let sector," confirms Mr Grandin of Landlord Mortgages.

12) How will the stigma surrounding new-build affect the housebuilders?

Analysts keenly await first-quarter trading statements due from housebuilders who had a 31 December year-end.

"I expect that forward sales will be down vastly against fairly good comparatives from the year before, and I'm pretty sure someone will issue a profits warning before too long," says Dresdner Kleinwort's Mr Stewart. He believes forward sales held on reserve deposits are a burning issue. "Deposit holders who have laid down 5-10 per cent will take a view. If they complete the sale, a given development could be worth 30 per cent less than what they’ve paid."

If you don't need to buy a property to live in, the question is why buy at all.

"The market hasn't hit a brick wall, but we are having to work hard to help investors," admits Taylor Wimpey's Mr Bridges, who is offering buy-to-let investors four-year rental guarantees at a 6 per cent yield on selected developments.

"We have really got to work on relationships with lenders as an industry. The rental guarantee deal we're doing almost exclusively with HBOS. We've spent a lot of time explaining how and why it works to reduce that nervousness."

13) Do buy-to-let investments still stack up?

One could argue that the economic model of buy-to-let is no more than a bet on rising house prices. Buy-to-let investors typically take out interest-only loans, as interest repayments are tax-deductible, then rely on the rental income to service the loan.

Rental values have not grown at the same astronomical rate as house prices, but landlords don’t mind making minimal or zero profits on rents, as long as the capital value of their underlying asset is appreciating. They then have the choice of leveraging against their asset base to buy more properties, or selling out at a profit.

With house prices under threat, and mortgages becoming increasingly expensive to service, the model is rapidly becoming unworkable.

However, research conducted by the Association of Residential Landlords (Arla) shows that rents are rising - on average by 4 per cent for houses and 2 per cent for flats in the three months to the end of February. This has boosted average rental returns to 5 per cent - still less than the current Bank of England base rate.

Ironically, rents are expected to rise further as more first-time buyers are unable to get on the first rung of the housing ladder rent instead of buying. But that's hardly a compelling reason for new investors to get into buy-to-let.

14) What problems lie ahead for BTL investors who need to remortgage?

The increasing levels of buy-to-let remortgaging shown by the CML data brings a new set of problems for investors.

"Two-year fixed-rate deals were very popular with buy-to-let investors," notes Collins Stewart's Mr Potter. "We've seen elevated wholesale rates for eight months now. That means one-third of two-year fixes have had to re-price, but a further two-thirds have yet to do so, which signals more pain to come."

"The most favourable buy-to-let deals have been two-three-year deals, and we are now seeing a significant slug continually rolling off," agrees Mortgage Express's Mr Law. "I don't think remortgagers will suffer too much - there's been 20 per cent growth in house prices in the past two years to act as a buffer."

As previously noted, the value of some new build apartments sold at auction has dropped by a quarter - enough to question the LTV rates for remortgaging buy-to-let investors owning flats in affected developments.

"We will absolutely look after our own customers if they stretch outside of that LTV criteria," says Mr Law. However, with fewer lenders in the market for buy-to-let business, landlords with negative equity will no doubt pay extortionate rates.

15) Will we see a mass exodus from the buy-to-let sector?

Despite assurances from Arla and the CML that the majority of buy-to-let landlords are in it for the long term, analysts are not convinced.

"The proponents of buy-to-let say it is quasi-pension money, so investors will live with short-term negative equity concerns," says Collins Stewart's Mr Potter. "However, buy-to-let has barely been covering finance costs for a while."

The high numbers of buy-to-let mortgages taken out at the top of the market in 2007 is a future worry, but the recent introduction of fixed-rate capital gains tax charges on the sale of investment properties is an added temptation to take profits.

"The really spivvy stuff appears not to have been driven by the desire to own properties and let them, but 'buying-to-flip' off-plan to get capital appreciation," says Dresdner Kleinwort's Mr Stewart. "Investors were speculating on capital appreciation, and had no intention of being saddled with an asset."

And for those who find they cannot sell, repossession is the only way out.

16) Could problems in the buy-to-let sector lead to a full scale housing crash?

The prospect of distressed buy-to-let landlords dumping properties back on the market, or losing their assets through repossession could have a catastrophic impact on the wider market. The mortgage drought that has fuelled the crisis will also curtail would-be buyers chasing a bargain property.

"The buy-to-let market over the past couple of years has been a potential trigger for a major downturn in the housing market," argues Capital Economics' Mr Stansfield. "We are already seeing an exodus among newer, smaller investors. The astonishingly rapid growth of the buy-to-let sector has been concealing the fundamental problem - values couldn't go on rising forever."

Mr Stansfield believes the low levels of buy-to-let arrears in the CML data offer false comfort. "There's a considerable lag built into the system, getting through the hoops of court actions, and bringing properties to auction," he says.

Analysts believe the real tipping point will be employment figures; if a buy-to-let investor loses his or her job, the first thing they will do is dump the property to realise cash. Owner-occupiers finding themselves in negative equity will fight to preserve the roof over their heads, but buy-to-let investors have less incentive.

"If you have nothing in the house, you have nothing to lose," says Panmure Gordon's Mr Hughes. "You may as well walk away from it. It's the same for small private developers building innercity apartment schemes - they've borrowed a lot of money, and are going under and leaving the keys with the bank."

17) What will falling volumes do to land prices?

Falling sales volumes are bad news for housebuilders, but the effect a softening in land values could have on their land banks is what the analysts are now honing in on. Data from the Home Builders Federation (HBF) indicates prices are falling (see graph, below).

Long land bank holders which have acquired land at historically low rates are in a stronger position in a downturn. However, short land bank holders can work through any price differentiation more quickly, buying plots at lower prices.

"Barratt's model has changed to a longer land bank, and it acquired a lot of land at top dollar with the Wilson Bowden acquisition, so it should trade at a discount to NAV," argues Panmure Gordon's Mr Hughes. "Persimmon's premium is justified due to the hidden value of its older land bank, and Bovis has a 10-year old strategic land bank it bought for buttons years ago."

18) Should the Financial Services Authority have been regulating the buy-to-let market?

Many are surprised to learn that buy-to-let mortgage products don't fall under the FSA's remit; to argue they should is a case of closing the stable door after the horse has bolted. Horror stories concerning mortgage fraud and unscrupulous investor clubs clearly show the need for regulation of what has become a £113bn industry, but the future role of buy-to-let in the UK's private rental sector should not be underestimated either.

One alternative could be 'build-to-let'. Companies including Unite Group and Crest Nicholson are proposing to build 'branded residential' for lease. These assets could be sold into a fund for investors, similar to real-estate investment trusts in the US, giving investors a more balanced investment.

19) I am a buy-to-let landlord. Should I consider selling out?

"Long-term buy-to-let investors who have owned properties for seven years or more will lose out under the new capital gains tax rate, which has increased from 10 to 18 per cent," says Jones Lang LaSalle's Mr Chegwidden.

"The most experienced buy-to-let landlords could actually benefit from the current funding constraints," argues Landlord Mortgages' Mr Grandin. "The astute ones refinanced months ago, and have built up a war chest of funds available for when the market softens. There are people who need to sell. With 75 per cent loan-to-value, a lot of buy-to-let deals don't stack up any more, and a fall in house prices is inevitable."

20) My children live in a flat rented from a buy-to-let landlord. Should I be worried?

When buy-to-let properties are repossessed, precious little thought is given to the tenants. Landlords, desperately reliant on rental income, are hardly likely to warn tenants if they are struggling to meet their mortgage payments. If they go under, the tenants are at the mercy of repossessing mortgagees, who typically want to acquire vacant possession as soon as possible. Renters can protect themselves by going through a reputable agent, and ensuring deposit monies are held in a third-party scheme. Sadly, pursuing a case in the Small Claims Court for the breach of an assured shorthold tenancy is likely to be a case of throwing good money after bad.

See also: Landlords ride out the downturn

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