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Playing the yield

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  • 29/05/2007
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Jonathan Moore scrutinises the buy-to-let market against a climate of rising interest rates and tightening market conditions

The buy-to-let market has been growing against toughening economic conditions, with interest rates rising to 5.5% in May. Many economists predict a further quarter percentage rise, likely to be in August when quarterly inflation figures are revealed.

Innovative buy-to-let mortgages are the result of the impact of increasing interest rates, as rents in the short term have failed to keep pace with rate rises. This therefore means that the rent-to-interest cover – the basis of buy-to-let mortgage lending decisions – is more difficult to achieve as mortgage payments rise against stable rents.

However, investors should not be deterred – lenders began reacting to this situation over a year ago by relaxing the percentage rent required over the mortgage payment. Some lenders are offering pioneering products at 100% rent-to-interest cover, meaning rental income only needs to match the mortgage payment, but investors should be aware that such products will attract a greater arrangement fee. Rent-to-interest cover mortgages at 110% and 115% are also now common.

According to Paragon, buy-to-let activity has remained consistently strong throughout 2007, allaying concerns expressed in some quarters that rising borrowing costs might dissuade investors from growing their portfolios and retaining their commitment to the market. The buy-to-let specialist lender suggests that on the back of higher interest rates, landlords are able to increase rents paid by the growing number of people who live in rented accommodation. At the same time, landlords are responding to this strong demand for rented homes by purchasing new properties for their portfolios.

Significant returns

Average rents charged on a typical buy-to-let property have risen by 6.5% over the past quarter, from £9,942 in January to £10,591 in April, according to the May edition of Paragon Mortgages’ buy-to-let index. Total returns – taking account of both capital appreciation and rental yield – are also following an upward trend, increasing from 8% in January to 11.6% in April. Several regions, including East Anglia, South West, Wales and the West Midlands, achieved total returns that were significantly above the national average.

John Heron, managing director of Paragon Mortgages, says: “The market remains buoyant for both intermediaries and lenders, with good volumes of business for both property purchase and for refinancing of existing portfolios. Investors are encouraged by the strength of tenant demand, which enables them to increase rents on existing tenancies when they are renewed and apply a higher rent to new tenants than they would have charged three or six months ago. As a result, total returns are higher now than they were in January and yields remain firm at 6.1% for the third successive month.”

In a recent survey conducted on behalf of Paragon Mortgages, almost a third of landlords said they were reacting to rising borrowing costs by increasing rents, while another 43% reported they are taking no specific action as a result of the interest rate rises. As further evidence of their confidence in the future, in the survey 12% of landlords said they were increasing their involvement in buy-to-let as a reaction to the rises in borrowing costs.

Furthermore, there are an increasing number of buy-to-let mortgages that work on income multiples rather than rent-to-interest cover. This year groundbreaking new products have been introduced that do not require a property’s rental income to be verified or income multiples to be met. The lender simply stipulates that the investor must have had a residential mortgage and a buy-to-let ­mortgage for the last 12 months. These products are designed for experienced investors and would be ideal for properties requiring renovation, subsequently heightening future rental income. These new products challenge the traditional lending criteria in the buy-to let-market. They are also suitable for investors who are focused on long-term investment and gains through capital appreciation.

Rising capital

The tightening of rental yields is unlikely to dissuade investors from continuing to build portfolios because landlords have traditionally viewed capital appreciation as their main source of profit. Many see rental income as a means of covering mortgage payments and property upkeep.

Recent research from the Association of Residential Landlords shows only 5% of buy-to-let investors are solely seeking rental income, and more then half of all investors are looking to hold on to their properties for a minimum of 15 years to gain capital appreciation.

Despite rising interest rates, capital appreciation remains strong particularly in areas such as the South East and London, where a lack of supply coupled with city bonuses continues to drive up property prices. To beat tougher rental yields, landlords could look at traditionally higher-yielding rental property types such as houses in multiple occupancy and flats over commercial premises. To avoid further interest rate exposure, many landlords have made the decision to remortgage to fixed rates both for new purchases and to consolidate their existing property finance.

Fixed rate buy-to-let mortgages are also being priced upwards, because they are based on SWAP rates. Three-year SWAP (15/05/07) stood at 5.91% and five-year at 5.81%, so investors who believe the market is awash with cheaper fixed rate mortgages may have a nasty shock.

Mortgages for Business has seen a rush of investors seeking fixed rate mortgages, and it would urge investors to act quickly to secure fixed funding because lenders are increasingly pricing upwards. n

Jonathan Moore is head of marketing at Mortgages for Business
www.mortgagesforbusiness.co.uk

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