Not a time to be a buy-to-let landlord

Cover of MoneyWeek magazine issue no772

Back when MoneyWeek started, buy-to-let seemed a really good idea. It was. Now, though, it really isn’t, says Merryn Somerset Webb.

In one of the early editor’s letters for this magazine – back in May 2001 – I wrote about investing in property. The Daily Mail had just published a huge front-page headline saying, “House prices ‘sure to plunge’.” I didn’t think they would. At the time, UK house prices were knocking around fair value on an average price-to-income ratio of around 3.2 times. The long-term average (1974-2000) was 3.1 times.

Not exactly crash territory, particularly given that interest rates were low and going lower. So I advised readers to ignore the Daily Mail and to buy property as an investment. Houses, I said, are a “genuinely scarce resource which usually offer a reasonable yield and are almost guaranteed to give you good capital growth over the long term”.

We changed our tune at MoneyWeek a few years later. House prices had soared – 3.2 times had become 6 times and we were sure we saw a nasty credit bubble building. House prices, we thought, were actually sure to plunge. It took a little longer than we thought. But they did eventually. Today we aren’t predicting another huge crash. We are worried about London but not really much worried about the rest of the UK. However, that doesn’t mean that we would suggest you invest in buy-to-let property. We would not. Why? In a nutshell, it is because George Osborne doesn’t want you to.

Osborne’s buy-to-let bashing

In his last Budget, the chancellor announced that one of the main drivers of buy-to-let – the tax relief available on mortgage interest payments – is to be abolished over the next few years. At the moment, the tax system for buy-to-let mortgage interest is pretty simple. You add up the interest on your debt and take it away from the rental income you receive.

You then declare only the remainder as income on your tax return. That means that you effectively get tax relief at your marginal rate of income tax, be that 20%, 40% or 45%. The new system will be less kind. All the rent will be counted as income and a tax credit of only 20% of the cost of the mortgage interest will then be applied (see the box below for how this works).

We had suspected this might be on the cards (the chancellor needs first-time buyer votes more than he needs the buy-to-let vote), although it came as something of a bombshell to the sector. But Osborne wasn’t done there. He also announced that investors would no longer be able to write off 10% of their rent automatically as wear and tear: instead they would only be allowed to write off actual expenses.

Then, just to cap the whole thing off, he used his Autumn Statement to tell us that capital gains on property sales would now be due in 30 days (rather than once a year) and that all second properties would now come with an extra three percentage points of stamp duty attached to them from April next year. See what I mean when I say that Osborne really doesn’t want you to be in the buy-to-let business? This all makes an enormous difference to the way in which the finances of buy-to-let work. You don’t need to listen to me on this. Listen instead to former Bank of England economist Rob Thomas.

Just before the general election in May this year, he published a report called “Buy-to-let comes of age”, in which he predicted a happy time ahead for investors – think returns of 11% a year for a decade, says the Daily Mail. At the time he reckoned that only a Labour government could spoil the party (with its rent controls, etc). He reckoned wrong. Circumstances have changed and so has his mind. Now he says: “The taxation changes… will plunge buy-to-let profits into losses and will leave many landlords with tax bills they can’t afford.”

To make the point he has done a case study of a buyer, putting all the new taxes into the equation. He takes a buy-to-let purchase of £205,000, funded by a 25% mortgage and a 75% loan. The buyer is a higher-rate taxpayer and he buys the place next April (after the new stamp duty is put in place). The starting rent gives a gross yield of 4.8% (fairly typical) and rises at 2% a year. Occupancy is 94%, operating costs are 25%, and the interest rate is 3% (rising to 4% after a year).

In the tax year from April, the post-tax profit will be £996. That’s not much of a return on an awful lot of work. But it’s all downhill from there: as the new taxation method kicks in, the profits fall to £312 and then £91, before the whole caboodle collapses into losses of £129 and then £347. Thomas thinks that house prices will keep rising at about 4% a year. If he is right, there is a consolation prize here: £32,500 of theoretical capital gains (which would then be taxed at 28%, of course). If he is wrong, there is nothing ahead but annual losses – and if interest rates rise further than he has put in his sums, really nasty annual losses.

Clear out the amateurs

It’s worth noting too that if you are looking to get into the buy-to-let market after next April you will need to think very carefully about how much you can afford to pay for a house. It may be rather more than “3% less than it is now”. Let’s say you have £81,500 to invest today. You buy a house for £200,000 (a lot of buy-to-let lenders insist on a 40% deposit) and use £1,500 to pay the stamp duty.

Taxing times

You have a buy-to-let investment today that earns you £20,000 a year. The interest costs come to £15,000 a year. You deduct the interest from the rent, then pay tax on the remaining £5,000. If you are a 40% taxpayer, that means £2,000 for HMRC and £3,000 for you. Come 2020 this changes.

Tax is now due on the full £20,000 (something, by the way, that might also push a lot of lower-rate taxpayers into the higher-rate band – something they certainly aren’t expecting). That’s £8,000. You then get a credit worth 20% of the interest. That comes to £3,000. Your tax bill is now £5,000 (up 66%). Add that to your interest costs and your total profit for the year is zero.

Now let’s move forward a year. You still have £81,500 to spend. But you can’t buy a £200,000 house. Subtract the inflated £7,500 stamp duty bill from your cash pile, and you have only £74,000 left. That’s only enough of a deposit to secure a loan to buy a £185,000 house. That’s not a 3% drop in the price you can afford. It’s a 7.5% drop. An equilibrium will be found here, but you get the point: it isn’t just making a profit once you are in the market that just got harder – getting into the market just got harder too.

You can have a go at mitigating some of this. The obvious way is to run your mortgage applications via a limited company – Kent Reliance says that applications of this type were three times higher in September this year than last year, and that a quarter of all buy-to-let finance demand now comes through limited companies. Doing it like this would mean you wouldn’t be hit by the income tax changes (you can still offset all debt and expenses against profits inside a company), although you will still have to pay stamp duty when you buy.

But this only really works for new purchases. Switch an old property into a company and you will be hit up for both capital gains tax and a second round of stamp duty (you have to sell the property and buy it back inside the company).

Otherwise, you could cut your stamp duty billby buying 15 properties (the chancellor has suggested that companies with this many won’t pay the new stamp duty), or finding someone to join you in buying them. We wouldn’t advise the latter: if you haven’t a professional set up it will lead to rows – and, says The Times, might even attract the attention of the financial watchdog, the FCA (which could consider it a fund). Fifteen years ago buy-to-let seemed like a really good idea. I wish I had done it.

Today – taking into account all the changes over the last year – it seems like a really bad idea. I’m not going to do it. All this legislation is designed to knock small (and accidental) landlords out of the market, leaving the way clear for professional property investors. Given that the new numbers make buy-to-let investing look a very tough way to earn an uncertain return, we figure we had best leave them to it.

What you can expect to make from buy-to-let – for now

According to the Kent Reliance building society’s latest “Buy-to-Let Britain” report, gross (ie, pre-tax and all other costs) yields across the UK are now 4.9%, with the average rent hitting £897 per month. Adding in house-price inflation, the average landlord has made a “total annual return of 11.3% per property” as of the end of September. The table shows the average yield across all regions of the UK, except Northern Ireland.

Region Gross yield Total annual return
London 4.4% 13.7%
East of England 4.4% 12.6%
South West 4.7% 9.0%
Yorkshire & The Humber 6.4% 10.1%
North West 7.1% 9.7%
Wales 4.6% 5.5%
South East 4.5% 13.1%
North East 5.0% 4.6%
West Midlands 5.7% 10.4%
East Midlands 5.9% 9.6%
Scotland 5.6% 0.3%
Great Britain 4.9% 11.3%