The combination of rising interest rates and falling rental yields is racheting up pressure on buy-to-let investors, particularly those who are entering the market now as house prices touch new peaks.
The view among analysts is that these factors combined might begin to deter newcomers looking to make a property investment. It could also drive some lenders to introduce restrictions on deals offered to buy-to-let investors.
“It could restrict the level of gearing lenders are willing to provide, and while I don’t think it will have too much of an impact on buy-to-let investors who are in the market and have already done well from it, entrants might think twice before deciding to go into it,” warns Mark Harris, managing director at Savills Private Finance. “They might decide too much gearing is involved to make an investment.”
Data out this week from broker Landlord Mortgages indicates that annual rental yields on buy-to-let properties in the UK slumped to new lows in the fourth quarter of last year. In England, they hover at about 5.74 per cent, down from 7.1 per cent in 2002. In Scotland, which historically boasts some of the best returns in the UK’s buy-to-let market, they fell from 8 per cent to 6.46 per cent over the same period and in London from 6.37 per cent to 5.81 per cent.
Mortgage brokers say the decline in rental yields stems in part from the robust rise in the price of properties as a surge in demand from eager buyers across London, Liverpool, Edinburgh and Manchester has pushed up the cost of housing in the UK.
To make matters worse, interest rates hit their highest level in more than five and a half years on Thursday when the Bank of England surprised the City by raising the cost of borrowing to 5.25 per cent. The move means that most lenders are set to raise their rates on existing variable mortgages and on new fixed-rate deals by roughly a quarter of a percentage point from next week.
The combination of lower rental yields and higher borrowing costs could prove a tipping point for those borrowers who opted for a variable rate deal. Ray Boulger, senior manager at the broker John Charcol, says borrowers have now been hit with three quarter-point rises in less than a year and that this will “definitely have an impact on the housing market”.
In London, using a rental yield of 6 per cent, assuming maintenance costs and voids give you a net yield of 5 per cent, and using a typical buy-to-let interest rate of 5-5.5 per cent, you now need a deposit of 15 per cent of the property’s value for the rent to cover interest repayments on a £300,000 flat, according to the broker Mortgage Express. However, if interest rates rise further or maintenance costs prove greater than expected, such a buy-to-let investor could be out of pocket
This explains why demand from buy-to-let investors could be damped. But the interest rate rise could also be ominous news for existing tenants as landlords may seek to pass on the cost of higher mortgage payments in the form of higher rents.
While rents have risen, they have failed to keep pace with spiralling property prices. The contrast is stark. Rents have risen roughly in line with inflation while the cost of the average property in the UK jumped by 54 per cent from December 2002 to December 2006, with the average home now costing £186,035, according to the Halifax House Price Index. Yields could fall further this year if residential property prices continue to climb.
Many mortgage brokers indicate that while rental income is important for all property investors, many are driven primarily by the prospects for capital growth.
“The typical investor is not that sensitive to the yield. We know from survey after survey that what most investors want to do is just cover their cost,” says Malcolm Harrison, spokesman for the Association of Residential Letting Agents, an industry group. “And what we do know of the typical investor is that they do give themselves a fairly good cushion and understand the calculations they have to make before they invest.”
In the past, mortgage lenders viewed buy-to-let investors as risky and were less inclined to lend to them. In recent years, they have become more comfortable with the market and have loosened their restrictions. But they could demand more from borrowers in coming months given the changes in the economic environment, analysts predict.
As it stands, lenders decide how much to lend to buy-to-let investors based on two factors, according to Boulger. First, they analyse rental income and second, current and projected interest rates.
Typically, a broker will expect a prospective buyer’s rental income to cover 100 to 125 per cent of his yearly mortgage interest repayments. So on a 100 per cent rental cover deal, an investor would have to receive say, £500 per month in rent to cover monthly mortgage interest costs of £500.
Buy-to-let investors are also entitled to borrow up 90 per cent of the value of their property. But more investors may find it hard to borrow on such generous loan-to-values as this week’s interest rate rise will make it more difficult to cover rental income.
