Buy-to-let is a British phrase referring to the purchase of a property for the specific purpose of renting it out. The U.K. banking industry has a specific type of mortgage designed for this purpose. However, the credit crunch in recent years has caused most UK lenders to cease offering these kinds of mortgages. In the U.S. although we may not have a seperate type of mortgage lenders do typically differentiate between owner occupied mortgages and mortgages designed for landlords. To compensate for the additional risk of a non-owner occupied house, lenders typically require a larger downpayment and charge higher rateson a buy-to-let property than for an owner-occupied property. In addition, they take into consideration estimated rental income rather than relying strictly on the landlord’s personal income.
The Benefits and Risks of Buy to Let
Just as with all property rental, the benefits for a buy-to-let landlord is an accumulation of wealth as your tenants pay off your mortgage or if house prices increase. Rising house prices in the UK have made buy-to-let a popular way to invest. Although leverage is what allows you to accumulate value in the property it also involves some risk if the house isn’t generating a positive cash flow and the landlord is relying on the expectation that the house can be sold later for a higher price. If other factors cause housing prices to decline the landlord can lose money.
Inflation benefits the landlord, because he will have borrowed to purchase an appreciating asset (hopefully equal or greater than the rate of inflation) but he gets to pay back a fixed amount in currency that is worth less than the value that he borrowed. In addition, he is able to raise rents to keep up with inflation, so income increases while the major factor in expenses (the mortgage) stays fixed.
Recent research by BDRC for Alliance & Leicester showed that 71% of landlords made a profit, but 22% were only breaking even or losing money.
Gross rental yields (the difference between the rent the landlord receives and the costs of ownership in percentage terms) in the world’s premier cities range between 1.6% (in Taipei) and 11.7% (in Moldova’s Chisinau). Gross rental yields on residential property have trended down globally for several years, and have generally continued to fall since the housing crisis. On average, English buy-to-let yields were just under 5.5% in 2007 down from over 7% in 2002.
Buy to let has some tax advantages that are available to UK BTL investors. Rental income is considered in the same as salary, therefore tax is generally assessed at 20% or 40%. However, landlords can deduct the interest portion of their BTL mortgage repayments as well as maintenance costs on the property from their rental income. Also, no National Insurance contributions are levied. If the landlord has used the BTL property as a main residence for a period then capital gains tax relief may also apply (so called “flipping”). These income tax incentives have made BTL investments more popular over the last few years.
The new landlord friendly legislation afforded by the 1988 Housing Act, coupled with the introduction of competitive mortgage products, brought new investors into the property market. As landlords gained the power to evict problem tenants more easily the prospect of becoming a landlord became more attractive. The housing crash between 1989 and 1994 saw an increase in the number of tenants, as people lost their homes thus creating a significant growth in demand for the new Buy-to-Let landlord. Buy-to-let as a term was coined in 1995 as a marketing badge for a finance initiative launched by the Association of Residential Letting Agents (ARLA), although this type of lending had existed for many years.
They have been attracted by rental incomes, rising capital values and a perception that the risk in housing is lower than for equity based investment. More recently, investors have seen buy-to-let as an alternative to their pensions, especially in light of the negative publicity pensions have received. However, the sector is still dominated by professionals. Analysis undertaken by Capital Economics found that although 53% of landlords own less than five properties, this represents less than 3% of the dwelling stock. Further, at the other end of the scale, 13% of landlords own 74% of the stock.
In 1997, the Council of Mortgage Lenders (CML) started collecting statistics on buy-to-let and some observers have interpreted the growth in buy-to-let lending, as reported by the CML, as evidence of a boom. However the CML only measures the growth of the new specialist lenders in the market – such as Paragon Mortgages, Mortgage Express and BM Solutions, whilst omitting the core back book of loans to residential property investors by mainstream lenders.
The apparent growth in buy-to-let lending is attributable to the success of specialist lenders in taking market share by offering bespoke products and services and attractive pricing. In fact, as much as 40% of activity is remortgaging as established landlords switch from more expensive commercial mortgages.
Despite the growth of the buy-to-let market since its inception, the private rented sector remains predominantly undergeared, with only 19% of the 2.7m properties mortgaged. Not only does this put buy-to-let growth into context, it also shows the growth potential remaining in the sector.
The Association of Residential Letting Agents conducts a quarterly survey of residential landlords to gauge their views on the market. In the 2005 3rd Quarter survey (September 2005), respondents showed resounding commitment to their buy-to-let investments. Of the landlords surveyed, 90% said that they would hold on to their investments even if house prices fell, 62% said that the average life expectancy of their property investments is ten years or more and 58% said that they intend to acquire further buy-to-let investments in the near term. The overall average life of their property investments was 16 years.
Buy to let mortgage products grew in popularity in the years following the millennium, and by 2007 the market was filled with wholesale lenders. Some of the largest banks in the world began wholesale lending, including the Royal Bank of Scotland and HBOS. Capital was raised through the practice of repackaging mortgage securities and selling them to another lender at a higher price. These securities were ultimately worthless, and this contributed heavily to the downfall of a number of buy to let lenders in 2008 and 2009. Due to the low prices of buy to let loans being lent by these wholesale lenders, it became even cheaper to buy to let than to have a residential mortgage. The standard package tended to be allowing a mortgage of 85% of value, with rental cover at 125% (i.e. Mortgage payments £5,000 pa would require rental receipts of £6,250).
The market peaked in 2008, before collapsing not long after. The market dropped dramatically, moving from $27.2 billion worth of lending in 2008, to just £8.5 billion in 2009 as lenders removed available products by the week, and with new products having a maximum loan to value of 70%. To add even more to the problem of gaining finance, valuers were becoming extremely cautious, with mortgage valuations often significantly less than the purchase price agreed. By the end of this period, the market had halved in value. The dramatic rises that the market saw in the first decade of the 21st century were wiped out within a matter of weeks. New government regulation has been announced in order to improve protection to consumers. This regulation will ensure that lending does not reach the low prices and unsustainable levels of 2007.