Record low interest rates have been a boon for a generation of private landlords. But the party's coming to an end, says James Ferguson.
Buy-to-let has been an investment phenomenon. At the turn of the millennium, few people had even heard of it and even fewer had ever contemplated becoming private landlords themselves. Yet by 2007 a full one in five mortgages were being given to buy-to-let investors. That dropped off after the crisis. And that might have been the end of it. But sustained record low interest rates since the crash have helped buy-to-let lending recover. In 2009, it comprised 8% of new loans by 2014, it was back up to 13%. And now, according to the Bank of England, 15% of all mortgage debt outstanding is to buy-to-let landlords.
This, however, may well prove the high-water mark in what has become a boon to some older private investors, but a scourge to aspirational young families across the UK and it's not just because of the chancellor's new rules on tax relief, though that certainly won't help. I'll explain more on all this in a moment but first, let's sum up where we are now.
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A profoundly distorted market
Ultra-low interest rates have had a profoundly distorting impact on the UK housing landscape. Today, almost a third (31%) of households a record level own their property outright, helped by record low interest rates that have allowed them to repay their mortgage balances early. The bad news is that these same low rates have also sustained very high median average house prices, which are now well over seven times gross median salaries in England, according to government data. That compares to the pre-crisis trend of around 4.5 times.
As a result, despite ultra-low mortgage rates keeping monthly payments low, extremely high house prices represent a massive barrier to first-time buyers. Almost a fifth of all households (19%) are now in private rented accommodation the highest proportion since the 1960s.
What's going on? There is ample evidence that buy-to-let landlords have been able to take great advantage of rising immigration, the decline in social housing provision, and the obligations on local governments both to house the needy and pay a market rent to the landlords who own that housing. The average monthly rent for a two-bedroom house in England is now just under £600 (£7,140 a year).
Compare that to the situation for owner-occupiers. The average debt of the UK's 11.1 million outstanding mortgages is £114,535 and the average mortgage rate is 3.1%. This means that on average annual mortgage interest payments are only £3,540. So homeowners are paying roughly half the average rent. So why don't more people buy?
It's reasonable to compare first-time buyers with buy-to-let investors directly, because they are both largely chasing the same properties: buy-to-let landlords will be letting out houses to private renters who might otherwise have bought. And on the face of it, low rates should make it just as easy for first-time buyers to afford a mortgage as it is for buy-to-let investors. On top of that, banks prefer to lend to owner-occupiers, because they are less likely to default if it means losing their homes: the average mortgage rate charged to owners is around 3%, whereas for buy-to-letters it is 4%, a third higher. Another strike against buy-to-let is that tenants tend not to look after rental properties as carefully as they would their own home, so maintenance costs are higher. Other costs for landlords include rental voids between tenants, agent's
fees and legal costs. In all, property investors can only expect to net about 70% of the gross rent, bringing the average buy-to-let gross rental yield down from 4.2% to about 2.9% net.
At this stage, first-time buyers seem to hold all the cards, leaving the success of buy-to-let a mystery. However, buy-to-let certainly up until now has enjoyed a few crucial, and massively significant advantages.
A mystery solved
First, there's the deposit. This is the first stage at which buy-to-let investors (who tend to be older) can outflank first-time buyers (who are generally younger). According to the Office for National Statistics (ONS), the median UK house price is £210,000. As a result of this, a 15% deposit would equate to the average annual pre-tax salary. And this might be underestimating the challenge. Santander claims that the average deposit from their own first-time buyers is typically £53,000, which is almost two and a half times the national average salary for 22 to 29-year-olds of £21,609. Small wonder that more than half of first-time buyers now buy with help from their parents.
For those without access to the generous terms offered by the Bank of Mum & Dad, it's increasingly difficult to buy. The average renter now spends 41% of their income on housing, according to the Money Charity. That's before all other living and working costs, and it's a good deal higher than the 34% that Nationwide building society reckons the average homeowner spends on their mortgage costs.
As a result, it's taking young people up to a decade of work to save enough on their own. During the 1990s, the average age of a first-time buyer was 27-28. But now, most first-time buyers are well into their 30s specifically, 37 before they can go it alone, according to the Mortgage Advice Bureau. It doesn't help that low interest rates on savings accounts have driven national household savings below 5% of post-tax income, the lowest since 2008.The second great advantage that buy-to-let investors enjoy over their first-time-buyer rivals is that owner-occupiers have to pay their mortgages off if they want to have a house to live in when they retire. This is where low rates bestow a vast affordability advantage on buy-to-letters. At high rates of interest such as the 15% interest rate the UK faced for a year in 1989-1990 the monthly difference between a repayment mortgage (where you pay off some of the capital every month) and an interest-only one (where you just pay the interest) is negligible. Mortgage rates are typically 2% above base rates, so back then, whereas the interest-only buyer paid 17% a year, the annual outgoings for a homeowner with a 25-year repayment mortgage would only be very marginally higher at 17.25%; a 1.5% premium. However, the wonders of compounding mean that at 3% mortgage rates, it's an entirely different story.
The returns from compounding interest rates are geometric not arithmetic. If I invested my money at 2% a year for 25 years, I'd make a 65% profit. If I invested at a rate of 10% I wouldn't make five times as much, I'd make 17 times more a 1,100% profit. The same process works in reverse with mortgage debt. The higher the rate, the faster the repayment element works. A zero-interest, 25-year mortgage would need to be repaid at a rate of 4% of the debt a year. By the time interest rates reach 15%, the repayment part takes care of itself. At today's record low 3% mortgage rate, a 25-year repayment plan would require annual payments of 5.7%, or 84% per month more than a buy-to-let investor, who's only paying interest.
A 5,000-year low
This means that buy-to-letters enjoy great competitive advantages over first-time buyers in a low-rate environment and right now, rates are the lowest they have ever been. MoneyWeek's own Merryn Somerset Webb is always keen to prove the point by showing anyone who'll listen a chart that shows UK interest rates going back 320 years to the formation of the Bank of England. But in June, Andy Haldane, chief economist at the Bank itself, presented a chart to the Open University. This one went all the way back to 3000BC and it still suggested that rates had never been lower in all that time than they are today.
So whether it happens early next year, as many are predicting, or somewhat later than that, we can be fairly sure that thereis only one way that rates can move from here, when they do and that's up. That will be painful for buy-to-letters when it happens. The economics of buy-to-let are very sensitive to low rates. In 2005 there was a visible slowdown in buy-to-let activity it fell about 25% below trend following a one-year, 1% rise in base rates that took place the year before. So in the long run, the solution to the UK's distorted housing market will be the renormalisation of rates.
The third advantage vanishes
Up until now, however, buy-to-let investors have enjoyed a third and overwhelming advantage over first-time buyers preferential tax treatment. Firms (including buy-to-lets) are taxed on profits revenues less costs. One such cost is debt interest payments. Homeowners with mortgages have to pay interest out of their post-tax income (once upon a time they didn't, but that was scrapped a long time ago), but not buy-to-let investors. They can offset their interest costs against rental income, and thus easily end up paying no tax at all. The quid pro quo for homeowners is that they aren't subject to capital gains tax (CGT) on any profits when they sell (except on the final sale, when inheritance tax is likely to take a chunk). But this CGT break is no use to a first-time buyer who is obstructed from getting on to the housing ladder in the first place.Chancellor George Osborne's decision to phase out buy-to-let tax relief at the higher income-tax rate on interest payments by 2020, as well as restricting the "wear and tear" allowance to costs that are actually incurred (as opposed to the current blanket 10% write-off), should go some way to re-levelling the playing field. That's a good thing. There's no doubt that many buy-to-let investors help others while helping themselves, but some, at their worst, can be little better than slum landlords (see the column on the right). And it's not just first-time buyers who have been sacrificed on the altar of buy-to-let. Taxpayers paid £24bn last year in housing benefit (rent) and there is little doubt that buy-to-let has helped push this cost through the roof.
But once the tax relief changes take place, things will look a bit different. Let's assume that our first-time buyer has got around the initial deposit problem. Currently, in a head-to-head battle between a prospective first-time buyer and a buy-to-let investor who both want the same property, the latter always wins. Despite a higher interest rate of 4% for buy-to-let, compared to 3% for the first-time buyer, the first-time buyer has effectively to pay 5.7% on their repayment mortgage. Not only that, but the buy-to-let investor can claim tax relief on the interest of up to 45%, lowering the effective interest rate paid from 4% to 2.2%. That makes a property with the average gross yield of 4.2% (2.9% net) profitable enough that the buy-to-let landlord can afford to gazump the first-time buyer.
But once tax relief is restricted to the 20% basic rate, the buy-to-let investor's effective borrowing cost will rise from 2.2% to 3.2%. This is now on the wrong side of many investors' comfort zone, because although gross yields average 4.2%, net they only come in at 2.9%, which is less than the new effective cost of debt will be. If rates start to rise in the meantime, even if it's by a relatively small amount, then the buy-to-let advantage will be further eroded. It may not be the death knell for buy-to-let, but the chancellor's tax changes will make it an increasingly level playing field for first-time buyers, who haven't really had a look in over the last 15 years.
James Ferguson is a founding partner of the MacroStrategy Partnership LLP (macrostrategy.co.uk).
Making money out of misery
Landlords don't always have the best reputation and, in some cases at least, that's justified. Let's take a look at an actual example that was reported in The Daily Telegraph last year.
A run-down, one-up, one-down, two- to three-bedroom, end-of-terrace house in the West Midlands is bought for £80,000 in 2012. After £32,000 of refurbishment costs, it becomes a five-bedroom HMO. HMO stands for "house of multiple occupancy" which is where the "slum landlord" moniker starts to become appropriate. The buy-to-let owner lets his property out for £18,000 a year, which works out at about the same as the national average rent per room paid for a two-bedroom house with two to three occupants. The trouble is, this is not an average house.
Your standard two-bedroom house has about 70 square metres of gross internal space. That shrinks to 50 metres of net internal area after you consider the corridors, bathrooms and stairs, and translates to 37 metres of "habitable space" excluding the kitchen, utility rooms and storage. Typically this would work out at around 15 square metres per person.
But to create the extra bedrooms, our HMO King is depriving his tenants of any habitable space at all. Even after accounting for refurbishment costs, this house is worth only half the national average. Yet the buy-to-let landlord has found a way to extract what is effectively more than two and a half times the national average rent out of what is now barely habitable accommodation.
He can only do this because, with net immigration now running at over 300,000 people a year, councils have been swamped with demand, which they are obliged to satisfy at whatever the local "market" rent is. Our buy-to-let landlord and others like him get to make hundreds, even thousands of lives a misery and we are forced to subsidise it through our taxes because of the rules governing local council housing obligations. There's only one winner here.
Where to look for property bargains
New tax rules will make residential property in the UK less attractive to buy-to-let investors. But certain areas of the country have more potential than others, says John Stepek. Read more here.
James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.
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