Buy-to-let borrowers have been taking Britain by storm. Once an investment mainly reserved for the wealthy, residential property investment is now easily accessible to all kinds of people. The result has been a buy-to-let boom, which has left the Financial Services Authority (FSA) wary of the potential pitfalls lenders and borrowers could experience in the face of such rapid growth.
The private rented sector has been recovering for the last decade, but the concept of buy to let was only introduced five years ago by the Association of Residential Letting Agents (ARLA). Since then ‘ particularly over the last two years ‘ buy-to-let business has grown significantly in the UK. According to the Council of Mortgage Lenders (CML), in 2001 there were more than 130,000 buy-to-let mortgages outstanding, worth £10bn ‘ up more than 60% over the past year.
A staggering 50,000 people had invested in the buy-to-let market for the first time and three-quarters of all buy-to-let borrowers were based in London and the South of England, when the research was conducted.
Lending figures from ARLA show that the average value of a buy-to-let property in 2001 was £143,000 across the UK, but more specifically £166,200 in the South East, compared to £96,700 in the rest of the country. Little wonder that warning bells were ringing in the regulator’s office.
Speaking at the CML’s Annual Conference at the end of 2001, John Tiner, managing director of the FSA, voiced concerns that lenders need to manage their exposure carefully and borrowers should be wary of overstretching themselves. His key focus was on the South of England, where not only is there a concentration of buy-to-let lending, but the purchase price of properties is significantly higher.
While Tiner accepts that growth in this sector offers new business opportunities, he believes investors may face potential affordability problems in borrowing to fund this type of investment. He said: ‘investors should be clear-sighted about the long-term nature of this investment and the possible difficulties they may face in cashing in their property investment in the event of a weak market.’
But on the plus side, CML research indicates that when house prices weaken there is a greater demand for rental properties. Yet with so many novice investors rushing into the buy-to-let trade it is easy to see why the FSA feels now is the time to warn borrowers and lenders of the dangers.
A risky business
So what risks are lenders up against? The director general of the CML, Michael Coogan, confirms that the buy-to-let sector of the mortgage market is growing in importance, but represents less than 2% of all mortgage lending. He is not surprised that people are attracted to buy to let ‘at a time when stock market investments look uncertain.’
Against this backdrop, Tiner suggests lenders should prepare for increasing levels of default, take into account the potential impact of changes in interest rates on borrowing and monitor cases where there is a high loan to value and high income multiple.
Many lenders would argue these are precautions they already take and most do have appropriate safeguards in place. They ensure borrowers have a high enough income to be able to make payments if the tenant defaults.
Products are designed and priced accordingly ‘ generally with a slightly higher rate of interest charged to the borrower than on a residential mortgage to reflect the risk. The loan to value ratio is also usually limited to a maximum of 80%. If a borrower can afford a 20% deposit on a property, it is likely they can afford to meet repayments.
Unfortunately, some borrowers, however, will put their own home at risk to finance a deposit, such is their enthusiasm to get into the buy-to-let market.
Furthermore, lenders usually insist that borrowers have a guaranteed rental income of up to around 130%-150% of their monthly mortgage payments and a valuer will carry out an assessment of the property to determine if rental income expectancies are realistic.
So is this enough? In principal, yes. But the point the FSA appears to be flagging up is that the sensible practices put in place by lenders must not be relaxed. Buy to let may still only represent a small sector of the mortgage market, but it is still significant and increasing in importance.
In their eagerness to have their own market share, lenders must be aware it carries greater risks with it and some are already implementing less stringent policies.
John Tiner points out: ‘House prices in London and the South East are highest relative to income and loans have been at the highest income multiples in these areas. This exposes investors to growing risk of market under-performance in these regions. All lenders should be monitoring this part of their portfolio carefully.’
There are, for example, some lenders that only ask for 100%-110% guaranteed rental income. In the same vein, some have increased loan to values up to 85% and even the income multiple level.
However, where one criteria is relaxed, it is usually offset against another ‘ such as lowering the percentage of rental income requested while reducing the percentage on the loan to value.
Most importantly, though ‘ and the best lenders will being doing this already ‘ borrowers interested in entering the buy-to-let market must get the right advice up front. They need to understand not only the benefits, but also the potential pitfalls of buy to let.
At a time when interest rates are at their lowest for a generation, showing little favour to investors seeking returns on the stock market and deposit-based accounts, you can hardly blame them for seeking an alternative source of income.
However, with the rapid explosion in buy to let ‘ especially in London and the South East ‘ some lenders and brokers have been conducting business with too many people who do not understand the market.
The CML has tried to combat this to some extent by providing lenders with a leaflet to pass to all enquirers. But good advice constitutes more than passing a borrower a leaflet and lenders and mortgage intermediaries must be responsible for understanding what they are selling and for providing sound advice.
The recommendations John Tiner has put forward are sensible and will not be a cause for concern for professional lenders which treat the buy-to-let market with the seriousness it deserves.
There is no doubt that investing in buy to let carries more risks than other forms of investment. Investors must take heed of the CML and seek expert advice. When a borrower becomes a landlord they are in effect running a small business and must be aware they are taking on a medium to longer-term investment that carries many complications.
In areas such as the South, which are saturated with properties for rent, the risk of rental voids is increasing. ARLA reports that the average empty period between tenancies is 27 days, so a landlord must budget for at least one month without rent each year.
As we hear more talk of job losses, landlords must prepare for a drop in rental demand or even worse, an increase in defaults on rent. It could be that we are heading into a period that sees buy to let as a tenant’s, rather than a landlord’s, market. However, while these issues may be a cause for concern in some areas, it is unlikely there will be any significant decrease in demand for rented properties.
House prices are strong overall and it is unlikely we will see interest rates spiral in the way they did in the early 1990s. While property prices remain high, demand for rented property will also remain high as many are forced to rent, unable to raise the deposit.
The average first-time buyer is now in their late 20s, the number of students is rising, work and lifestyle patterns are changing. There is also an increase in homes breaking up, leaving part of the family seeking alternative accommodation. All these factors point to a continuing demand for private rented property.
So where does this leave the landlord? It is probably a good time to invest in property, while rates are low and demand is high, but it must be done wisely.
Understanding the pitfalls
Property is a long-term investment, not to be taken on lightly. Brokers and lenders must ensure the landlord is aware of all the potential pitfalls. These range from the basic old clichÃ© of ‘location, location, location’, to legal responsibilities for carrying out repairs, ensuring safety and dealing with problem tenants. Not to mention the possibility of rental voids, defaults and a potentially weakening market.
Having said that, the picture is by no means gloomy. With the plethora of competitive buy-to-let mortgages now available, through a range of lenders and brokers, and the gap between residential and buy-to-let rates decreasing, borrowers are spoilt for choice.
Plus, lenders’ experience of buy to let has been extremely positive so far, according to the CML, with very low levels of default and few repossessions.
Provided would-be landlords enter the market with their eyes open, they could make very good returns in the long term. In fact, ARLA has predicted the private rented sector will grow to 15% of the total housing market over the next decade. The CML, a little more cautious, suggests investor interest in buy to let will remain strong, but perhaps not to the same extent as it has been over the last couple of years.
Lenders and borrowers should take heed of warnings, but as long as they adhere to good practice there is no reason why buy to let should not prove to be a profitable investment for all concerned.
Sarah Hodgson is press office manager of Skipton Building Society
John Tiner of the FSA has voiced concern over the rapid growth in the buy-to-let market.
While problems in the economy can increase demand for rental property, investors must be prepared for a possible increase in defaults.
In Southern England, landlords can face an average of 27 days a year when the property remains un-let.