Buy-to-let: the market’s Achilles heel

House prices in the UK have looked like a classic bubble for some time now. I first warned on this for MoneyWeek three years ago because affordability looked dangerously stretched. Since then prices have risen 18%, according to Nationwide. But as the dot.com bubble showed, once prices are unsustainably high, they can always run further before the final trigger that causes the crash. What we're seeing now in the credit markets could be that trigger. The credit market turmoil may seem esoteric to the man in the street but mortgage rates aren't just down to the Bank of England base rate. Northern Rock for example, sources more than 75% of its funds through the wholesale market, where the spread (or premium) over LIBOR (the London Inter-Bank Offer Rate) has gone from as low as 0.1% in January to more than 0.6% now. That is equal to another half-a-percent rate rise in its cost of funding, that will have to be added on top of the 0.75% rise in base rates since the start of the year.

Gone are the days when borrowers could expect to pay a small, or even zero, premium over base rates for their mortgage. As credit spreads normalise to reflect the true risks lenders are taking, even the best mortgage rates will now need to be 0.5% higher than base rates. If base rates do indeed rise to 6% and spreads do rise to 0.5% over that, a standard 25-year repayment rate would be equivalent to 8.1%. On the average UK first-time buyer's house price of £164,000, and assuming a £25,000 deposit, that'd now be £938 a month.

The median weekly wage last year was £364, or £18,928 before tax. If we assume £2,600 goes on tax, then the median first-time buyer's mortgage of around £130,000 could take up nearly two thirds of the median person's monthly disposable income. Little wonder then, that first time buyers are not only now 10 years older than 15 years ago, but they earn almost £40,000 a year, almost double the national average. Consequently, the housing market is now dominated by buy-to-let investors, who don't face the additional costs of a repayment mortgage. Yet here's the rub. As interest-only mortgage rates have been pushed up from 5% to 5.75% and possibly as high as 6.25% this year by the double whammy of rising central bank rates and rising spreads, the buy-to-let investor's position could become untenable. Apart from this being equivalent to a 25% rise in their cost base in nine months, buy-to-let landlords were already suffering a positive cost-of-carry (when net rental income falls short of debt servicing costs) as far back as the start of the year. Most urban residential rental yields are below 5% on a gross basis but private landlords, after costs, fees, voids and maintenance can't usually expect more than about 3.5%. The way most have been getting around this is by having loan to value (LTV) ratios of as low as 70%. In this way, a cost of debt of 5% at the start of the year, with a 70% mortgage, might still have covered costs, just. Now though, this same investor must be scratching his head as costs have risen by as much as a third of the rent. Negative yield isn't much fun even when prices are rising. But with few new investors likely to be tempted once they've done the maths, rising prices can no longer be relied on. If higher costs do persuade buy-to-letters that property is a bum investment, there's little chance the traditional first-time buyer will be tempted to step in to provide a floor.

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Why not? Well, in 2000, according to the National Housing and Planning Advice Unit, the median loan multiple for a first-time buyer was 2.4 times salary. Now, 2.4 times the median wage implies a mortgage of no more than £45,000, so that's a house price of £55-60,000. First-time buyers' house prices are typically 2/3 of the national mean, so a return to normalcy of this nature implies house prices averaging just £85-90,000. I'm not saying house prices will fall by more than 60% but they could clearly have a severe tumble. It all rests on the different profile of the buy-to-let investor compared to the first-time buyer. The reality is that buy-to-let investors look just like sub-prime borrowers. Good quality owner-occupiers prefer big deposits and low loan-to-value. They prefer repayment mortgages over interest-only, and want to pay their mortgage off as quickly as possible, so prefer shorter loan periods and less frequent remortgaging. They also have a good reason to work hard to hang onto their homes in the event of trouble, and prefer to safeguard against this by having a decent income cushion over and above their mortgage costs. They may even have income insurance or other protection - which is ultimately protection for the lender.

Subprime borrowers, on the other hand, are very sensitive to rising interest rates, because they have little income over and above their mortgage costs. They like to borrow with as little deposit as possible. They are liable to remortgage frequently, and opt for interest-only mortgages when they do. And buy-to-let investors are exactly the same. It's salutary to remember that in the old days, non-owner-occupiers were charged more for a mortgage precisely because it was felt that if they didn't live there, they'd have less incentive to make payments if things got tight. But it's been a long time since mortgage lenders had borrowers streaming in and just leaving the keys to the property at reception. It may be that, as is happening now across the credit markets, lenders to buy-to-let investors are about to re-learn the lessons of prudent lending.

James Ferguson also runs his own share-tipping service, Model Investor.