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Safety in numbers

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  • 11/08/2003
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The buy-to-let market is seen as an increasingly important investment option, but what simple steps can be taken to reduce the investment risks?

The rise of the buy-to-let market has been attributed to a number of separate factors, but in essence it is likely that it has developed so quickly because of a combination of all of them. It follows that the key to reducing the risks of investing in this sector is to understand all of these factors and how they interact.

The first and obvious growth factor is that buy to let is a product the market badly needed. Before a few far-sighted lenders introduced buy to let, investing in property via a mortgage was virtually impossible because commercial rates were applied and rental income was not taken into account for the servicing of the loan.

It is often overlooked that mortgage brokers are more than partly responsible for its growth because it is they who have taken these products to the masses, and they are now responsible for 80% of all buy-to-let loans.

There is also the fundamental underlying fact that we are all living longer. In his book The English, Christopher Hibbert records that around the time of the first Queen Elizabeth no more than 5% of the population was over 60. By 2014, National Statistics is predicting that there will be more people aged 65 and over than there are people under 16. Not only that, but on average a man aged 65 today can expect to live to the age of 81, or 84 for a woman. One important consequence of this rapidly ageing population is that pension funds of all kinds ‘ state, company and private ‘ are going to be squeezed, a situation currently aggravated by the limping stock market.

So, unless people are prepared to work until they are 75-years-old they will need to build larger retirement funds, and faster. This demands that people take retirement planning seriously and consider committing more to their pension payments and that they look at broadening at least part of their investment into other vehicles.

Unfounded fears

This brings us to the current state of the housing market. In the UK the supply and demand of housing stock has generated significant price rises in recent years. As a result, investing in bricks and mortar brings the possibility of capital growth that is more attractive than traditional investment returns.

However, these price rises have brought about fears of a price collapse and subsequent problems for the buy-to-let sector. This is unlikely to happen according to figures from the Council of Mortgage Lenders, which found there were 275,500 buy-to-let mortgages in the UK at the end of 2002 and of these only 0.42% were three months or more in arrears, less than half the equivalent figure for the mortgage market in general ‘ suggesting strong rental demand. Also, Association of Residential Letting Agents (ARLA) figures show that 11% of all UK housing is now rented, against just 7% in 1989.

A typical UK rental property bought on a mortgage with a 25% deposit and sold in five years’ time will, ARLA projects, deliver a net annual compound rate of return of 19.06% before tax. In this example the property is sold and so will attract Capital Gains Tax, but even then it compares favourably with traditional investment returns, and to the average annuity rate for a 65 year-old of 6%-7% (the lowest in 40 years). It is hardly surprising therefore that buy to let is the investment flavour of the decade, never mind the month.

In its infancy, buy-to-let activity was very much centred inside the M25 motorway, but as awareness of the concept spread further afield, so have the borrowers. As the latest figures from lenders on ARLA’s panel show, the buy-to-let boom is spreading nationally. Predictably, London and the South East remain the greatest areas of activity, accounting for 35.1% of all new buy-to-let mortgages from January to March 2003. But in fact this represents a drop of 3% over the previous quarter as the buy-to-let influence moves north of Watford. The Midlands, for example, now accounts for 13.7% of new buy to let, the North West takes 16% and the North East ‘ which has shown the biggest rise of all over the last quarter ‘ now has 19.7% of the buy-to-let share. The rising popularity of buy to let in that region may partly be explained by its relatively modest house prices, making property investment affordable for more people. In the first quarter of this year the average buy-to-let loan size in the North East was £54,100, compared to £92,400 in the South East.

However, all this does not mean that rushing out and buying any old property and putting a ‘to rent’ sign outside is automatically the road to double-figure returns. Renting out a property has its risks and investors should think about it carefully and do their homework.

When calculating its average return of 19.06%, ARLA made a number of assumptions ‘ the most telling of which is that the property should be let and earning rent for 47.7 weeks in any year. In other words, if a property lies empty for two or three months the owner’s investment plans could fall short of their target.

It all comes down to basic marketing and the rules are the same whether you are offering a can of beans or a home to rent. Who exactly are you pitching at? What is the nature and quality of product your market expects and how much will they be prepared to pay for it? If someone wants to invest in an area where there is a university or large college, their potential market could be student accommodation. Cheap, cheerful and close to the place of the learning is the order of the day ‘ as long as the property can accommodate enough student tenants to achieve a rental income equal to 130% of the mortgage cost, as required by most lenders. One possible difficulty, incidentally, is that most insurers consider students on the ‘high risk’ list and may not grant buildings cover.

Potentially less problematic are people in regular employment: singles, younger couples and families. If investors are targeting these groups they must consider their needs.

Singles and couples who have a reasonable income tend to rent for one of two main reasons. Either they are saving for the deposit on a home of their own or else they are career-driven individuals who put the convenience of being able to relocate quickly above the need to put down roots.

Typically, most of these people will look for flats or terraced houses. To attract and retain these tenants at a good rental level means the property must ideally be located in a lively area where other singles and couples are living, giving them a sense of ‘community’. This also extends to amenities: decent local bars, restaurants, health and fitness clubs and good transport links will all add to the appeal, reducing the risk of long and costly void periods.

Family business

Generally speaking, families will rent because one or other partner has moved to another part of the country through work. These families tend to be looking for homes in residential areas around big cities, along motorway corridors and in places of high inward investment where major businesses are setting up new operations or expanding existing ones.

Families will normally be looking for a quality semi or detached house and they will not just want a certain number of bedrooms, reception rooms and some kind of garden ‘ they will also be looking for good schools, good health care and leisure facilities and good local shopping. If anyone trying to market a family home gets their ‘postcode’ homework wrong then even if the property offers the right accommodation on paper, they still risk the potential disaster of the house lying empty month after month.

Buy-to-let investors who really want to minimise risk should consider talking to a reputable letting agent. These are the people who know the pattern of demand in their area and the letting potential of any property. They will also sort out things like references and tenancy agreements to protect landlords from nasty surprises later on. In addition, some letting agents operate a ‘rent guarantee scheme’ that pays a fixed monthly income to landlords whether or not the property is let.

A further level of risk control comes from finding a lender who offers flexible buy-to-let mortgages. Investors can make overpayments when a property is let which then allows them to underpay or take repayment holidays if a property is empty. Some mortgages also allow drawdowns to cover expenses like repairs and refurbishment.

Given steady housing growth, sensible planning by borrowers and prudent lending by mortgage providers, buy to let looks set to move from its niche position into a mainstream long-term investment option, opening up a whole new area of opportunity for mortgage brokers. The typical average age of buy-to-let borrowers is 40-years-old ‘ usually the time when people start to take their future financial provision seriously. And the older the population gets, the more rewarding it should become.

key points

The typical rental property is bought and sold in five years, giving favourable returns when compared to more traditional investments.

Investors need to take their time to investigate locations and properties.

Investors with a flexible mortgage can build in protection against rental voids.

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