Diversifying Paragon too cheap

Paragon continues to benefit from demand for buy-to-let mortgages from professional landlords. New buy-to-let advances were £671m during the first-half, up a fifth on the same time the prior year and the highest level of new lending in 10 years. The group has benefited from regulation introduced last year by the Prudential Regulatory Authority, requiring lenders to differentiate between portfolio and non-portfolio landlords, based on the number of properties owned with buy-to-let finance. Those changes have increased costs associated with writing new buy-to-let loans, causing some non-specialist mortgage lenders to pull-back from new business. Given Paragon specialises in underwriting complex and corporate cases, that’s given it a competitive edge. Over 70 per cent of buy-to-let loans written during the first half were for complex customers – those with large portfolios or specialist properties – or landlords operating through limited companies. That was up on 60 per cent the prior year. What’s more, these types of customers make up around 86 per cent of its buy-to-let pipeline.

Paragon has been transitioning from a largely wholesale-funded lender to a banking institution during the past three years. That culminated in the bulk of the group’s activities being moved under subsidiary Paragon Bank last year, to reflect the shift in funding to being retail deposit-led. At £4.3bn, retail deposits account for 64 per cent of all post-2010 funding, which reduces Paragon's reliance on costlier wholesale markets. Admittedly, this low cost of retail funding will rise when interest rates are eventually lifted, but so too should the amount that can be charged for loans, and forecasts for rate rises remain very modest. 

Restructuring unlocked additional capital, prompting management to lower target dividend coverage from 3 times to 2.75 times earnings at the end of 2017. That’s expected to reduce to 2.5 times by the end of this year. Those dividend payments are in addition to the £165m in share buybacks that have been undertaken since 2015. A further £50m was planned for the current year. However, this has been halted halfway through following the announcement this month of the acquisition of Titlestone Property Finance and a book of associated residential development loans for £274m in total. Had the purchase taken place at the end of March, it would have reduced the CET1 ratio from 15.5 per cent to a still healthy 13.8 per cent.

Acquiring the residential development finance company is part of management’s plan to diversify its lending streams, substantially adding to its existing £76m of development finance loans. The average yield on the Titlestone portfolio is 11 per cent – higher than the wider loan book – which should help expand the net interest margin which is good news given the increased competition Idem faces in the debt purchasing market.