Oh (land)lord – Even before Brexit, a worrying situation was developing in the buy-to-let market
The EU referendum may have split the country more or less in half but, in one way at least, it has proved paradoxically unifying. A curious phenomenon we might call ‘The Brexit Perspective’ apparently enables people to see whatever they want to see in the current situation so that one side’s black and white becomes the other’s white and black.
Take, for example, the property market. Just the other weekend, it was possible to find the Express scoffing “Project Fear starting to look ridiculous as UK house prices rise” while the Mail fretted “Are we on the brink of a house price crash?” For our part, here on The Value Perspective, we were looking warily at the property market long before campaigning on the referendum began in earnest.
Our pre-Brexit unease had been confirmed earlier in June by data from the Office for National Statistics that showed house price inflation across the UK jumping to 9% in March, as people rushed to beat the imposition of an extra 3% in stamp duty on landlords and buyers of second homes that came in at the start of April.
Also in March, the house price indices for the UK and London had both hit new highs, outstripping their pre-economic downturn peaks of January 2008 by 23% and 56% respectively. The same day, the Council of Mortgage Lenders announced home-owners had borrowed £13.8bn for house purchases in March – up 60% on the same point in 2015 and the highest monthly figure since August 2007.
For their part, landlords had borrowed £7.1bn over March, a rise of 163% on 12 months previously – two startling numbers that rang bells and had us reaching for the Financial Stability Report the Bank of England published in November last year. Sure enough, one of the key risks highlighted there was the state of the buy-to-let sector – particularly in London.
“Strong growth in buy-to-let lending is driven in part by a structural shift in tenure to the private rental sector,” the report observed. “Since 2008, this has been driven largely by the reduced availability of high loan-to-value mortgage lending, which has increased the age at which many potential first-time buyers leave the private rental sector.”
Population dynamics have also played a role, said the report, adding: “These increases in rental demand, alongside low interest rates and low returns on alternative assets in the post-crisis period, have boosted the attractiveness of borrowing for buy-to-let investment”. So far, so logical perhaps but then the report moved on to the subject of affordability metrics and logic started heading for the window.
“New loans to buy-to-let investors are often subject to less stringent affordability tests than loans to owner-occupiers,” it pointed out. “According to industry standards, the affordability of a buy-to-let loan is typically tested by ensuring the rental income exceeds 125% of loan interest payments at a mortgage interest rate of 5% to 6%.”
To recap then, the UK is for various reasons seeing increasing demand for rented accommodation, which is naturally driving up rents, which is precisely the measure on which buy-to-let affordability tests are based, which has to be a cause for concern. For one thing, said the report, buy-to-let borrowers may be more vulnerable than owner-occupiers to an unexpected rise in interest rates or a fall in income.
The example it gave is if mortgage rates were to rise by 300 basis points (bps) – the increase by which the Bank’s Financial Policy Committee (FPC) has recommended the affordability of mortgages to owner-occupiers is tested. At that point, said the report, “nearly 60% of buy-to-let borrowers who took out loans recently would see their rental income no longer covering 125% of their interest payments”.
In historical terms, 300bps is not much slack and the report rammed home the implications by quoting a survey by NMG that suggests some 15% of buy-to-let investors would consider selling their properties if their interest payments were no longer covered by rental income while a further 45% would be inclined to sell if property prices were expected to fall by more than 10%.
“Such pro-cyclical behaviour could exacerbate the scale of a fall in house prices following an unexpected rise in interest rates or a fall in income, which could impact adversely consumer spending and economic stability,” noted the report – although you might reasonably point out the chances of a 300bps rise in mortgage rates has receded somewhat in the wake of the Brexit vote.
Though, as it happens, the July 2016 issue of the Financial Stability Report has just ben published and it confirms: “The FPC remains alert to potential threats to financial stability arising from rapid growth in buy-to-let mortgage lending. The macro-prudential risks centre on the possibility that buy-to-let investors could behave pro-cyclically, amplifying cycles in the housing market as a whole.
“This behaviour could put upward pressure on household indebtedness in an upswing and have an impact on consumption and broader economic activity in a downturn, as well as affecting the resilience of the banking system and its capacity to sustain lending to the wider real economy in a stress.” No matter your Brexit Perspective, this is clearly an area that needs to be watched very closely indeed.
Investment Specialist, Equity Value
I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm.
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