Join our community of smart investors

Will buy-to-let undo specialist lenders?

Concerns have mounted over a potential economic slowdown, slowing house price growth and the risk of defaults
December 13, 2018

The buy-to-let property market has taken a battering during the past three years, with the removal of tax breaks and stricter affordability tests for landlords. Despite that, writing buy-to-let mortgages has been big business for specialist lenders, which have carved a niche in catering to professional landlords.

Both OneSavings Bank (OSB), and more recently listed Charter Court Financial Services (CCFS), issued improved loan growth guidance for the year following strong progress during the first nine months of the year. In fact, for the former, the amount of organic lending during the third quarter – that’s new loans – almost doubled compared with the same time in 2014.

However, market valuations for these specialist lenders – along with many other financial services companies – are at near 12-month lows as uncertainty regarding the Brexit deal and the outlook for UK economic growth mounts. 

“I think part of the concern is, will banks that don’t have a history of going through a credit cycle withstand a recession?” asks Peel Hunt analyst Anthony Da Costa. 

So far this year, the three largest UK-listed specialists – which includes Paragon Banking (PAG) – have bucked the wider industry trend. New buy-to-let home purchase mortgage completions fell by almost a fifth in September, compared with the same time a year earlier, according to industry body UK Finance, while remortgage activity – which has benefited from home owners locking in their mortgages at lower interest rates – also dipped by 0.8 per cent. The gradual phasing out of higher-rate tax relief on buy-to-let mortgage interest by 2021 has played a large part in reduced activity. 

The market downturn has been exacerbated by the introduction of stricter affordability tests for borrowers in 2017, including minimum criteria for stress testing loans and tighter conditions on lending to those with four properties or more. However, some analysts argue that more rigorous tests – introduced by regulators concerned that buy-to-let landlords’ increasing share of the UK property market could worsen any volatility in house prices, should landlords sell in a falling market – may play to specialist lenders’ advantage.

Housing slowdown

UK house price growth slowed to its lowest level in more than six years in November at just 0.3 per cent, according to data from Halifax, compared with a year earlier. That also represented a reduction from a 1.5 per cent annual increase in October and marked the third consecutive monthly decline in the rate of house price growth.

A significant fall in house prices could have a negative impact on revenue performance, specifically as a result of lower volumes, a lower value of new business written, and higher impairments as lenders revise their models to reflect a higher anticipated probability of default, says Shore Capital analyst Gary Greenwood.

There could also be some adverse effect on regulatory capital levels. All three of the UK-listed buy-to-let specialists use the standardised approach for assessing loan risk, which is used to calculate the amount of capital to be held to back their loan books: “As you get house prices slowing, your loan-to-value ratios are going to migrate upwards,” says Mr Greenwood. “If the risk weighting of a lender’s overall mortgage book increases, that would put a squeeze on capital levels,” he adds.

However, the economic conditions around a slowdown in house price growth are an important factor in whether tenants can keep paying their rent or if they fall behind, causing landlords to default on their mortgage repayments. Private consumption may have been constrained by poor wage growth, but unemployment – which fell to a near historic low of 4.1 per cent between August and October – is benign. Whether that remains the case will partly depend on the UK’s economic growth outlook. The International Monetary Fund (IMF) has slashed UK GDP forecasts in 2019 from 1.7 per cent to 1.4 per cent, “conditional on reaching a broad free trade agreement (FTA) with the EU and a smooth Brexit process”.

But the introduction of the IFRS 9 accounting measure in January means any worsening in the outlook will be better reflected in lenders’ provisions, Mr Greenwood says. “What that means is they have got to take a more forward-looking view on what they think the economy is going to look like and where they think provisions are going to end up,” he adds. That could, however, result in more volatility in terms of provisions for bad debts.

A conservative approach to writing buy-to-let business should insulate lenders to some extent from large-scale defaults when house prices are falling. The loan-to-value ratios for these types of mortgages are typically between 60 and 70 per cent for the three major UK-listed players, with almost none at 100 per cent or more.

Regulatory capital levels are also robust, with all three lenders’ common equity tier one (CET1) ratios all ahead of target at the end of June. Analysts at Peel Hunt stress-tested five specialist lenders’ – including OneSavings Bank, Charter Court and Paragon – against the impact of a threefold and fivefold increase in impairments, based on the assumption of a hard Brexit and severe economic recession. After applying this to forecast 2019 capital ratios, Charter Court’s CET1 ratio remained at a sturdy 16.4 per cent, while those of OneSavings Bank and Paragon were estimated to be 14.3 per cent and 14.1 per cent, respectively.