Buy-to-let – some thoughts

Going in today is not for the faint hearted. You have higher up-front costs, a squeeze on margins, no idea of future legislation and potentially falling house prices and rental income.

There is no doubt that over the last 20 years, buy-to-let property has been a good investment. Landlords have not only benefited from an increase in house prices but rising rents; the average house price in the 1990s was around £45,000, today that figure is close to £250,000. At the same time however, rental yields have moved from 12% of the property value to about 4.5%. It is clear to see how people investing 20 years ago did well.

But investing 20 years ago was not as easy; the rental market wasn’t well established and for many it was more affordable to buy than rent. The old saying with investing is true; the time to invest is when people are nervous, and not when there is euphoria. It is not only property, but investing in the stock market is the same – investing in a FTSE 100 tracker at the peak of the tech boom would have seen an investor tread water for the last 16 years. Only now are they starting to see profit, and this could be true of those investing in property today, and 20 years hence.

This blog is not about whether it is right to invest in property, but more as a marker for those who think now is a good time to invest. For some time, I have been concerned that we are close to a 1988/89 peak/crash in property; my view hasn’t changed although the timescales for this are less certain. But there are early warning signals coming out. We are seeing the supply of rental properties rise, at the same time as the number of people looking to rent fall. Where demand is high then rent can increase, but the reverse is true and we are now seeing rents come down. For example, in London, rents are down on average just over 4%, and this is filtering out across the country. There is also some uncertainty on property values; with the market starting to slow, leading some to be concerned that we are hitting the peak (or perhaps just over the brow of the hill).

It is very easy to pick on London but BREXIT could have an impact on the entire market. We are already seeing this with higher value houses being harder to sell. In London, this becomes a bigger issue if investment jobs move to continental Europe or Ireland. It is also not just the value of houses, but if these people no longer rent then it reduces demand for properties. This filters countrywide as people sell to move out of London; less money to spend means that they will naturally drive down prices in the regions. On the flipside, it is not all gloom, with the North West of England seeing rent increase by over 4%, and even in London there are areas which are more buoyant than others.

There still might be a case for investing in buy-to-let, but considerable research needs to be done around where you are looking to buy. If you invested in the FTSE 100 at the peak in 1999 then you wouldn’t have done well. But there were pockets of opportunities where investors would have had high returns. The key like any investment is research, it is about identifying areas where there is potential for house values to increase as well as rental income. A good example would be properties close to the HS2 rail link; once built what will this do to the value of properties and rental income? There is also the potential influx of workers during the build. Equally a property in Bridgwater or closer to Hinkley could be a good investment. But all of this still carries a risk, and perhaps already some of these areas carry a premium.

The simple fact is that buy-to-let is a popular investment, and for many it is an alternative means of retirement planning. The reasons for doing it seem sensible; you put down a deposit, and have a capital repayment mortgage. Assuming the rent covers the mortgage and other expenses, at the end of the term you have a house which you have effectively paid nothing for except the deposit. To some extent yield and gains don’t matter, providing that when you come to sell the property its value is more than the deposit you paid, plus the stamp duty (and other costs at purchase), and capital gains tax, and the rent after expenses (including tax), covers the mortgage then you will have won. But even writing this down shows that there are many factors which impact on whether this is a good or bad investment. And of course, many investors opt for an interest only mortgage to keep cost down which means the debt must be repaid at some point.

The big challenge is that if any of the dynamics change negatively then it can quickly become a bad investment; in this blog, I want to consider three factors – firstly interest rates are more likely to go up rather than down, secondly government interference, and thirdly peak house prices and declining rents.

Interest Rates

Interest rates are at an all-time low, they could go lower but the reality is that they are more likely to go up at some point. My view was that they would have gone up by now, I now feel this will not happen before 2019 but it will happen, we just don’t know when.

The government knows that when rates go up it will be difficult for some to make the mortgage payments. To counter this there are now tougher rules on lending, with borrowers having to demonstrate that rental income would cover the mortgage payments by a ratio of 145% if rates went up by 5.5%. There are ways around this, through peer to peer lending but as people buying their own houses have discovered, the affordability checks on mortgages are making it harder not only to buy a property but also re-mortgage. If you are turning to alternative sources of borrowing, then it may well be that you can’t afford to do what you want to do!

If you can’t re-mortgage then you either have to pay the higher payments (variable rate) until the end of the term, or are placed into a position where you have to sell the property which might not be at the best time.

In summary, one of the big attractions of buy-to-let is the ability to borrow money; if that is harder to do and more expensive then it becomes a less attractive investment.

Government interference

As people are finding it harder to get on the property ladder blame has been focused on buy-to-let landlords; rightly or wrongly they have been able to build up property empires pushing the value of property up. This sucks supply out of the market which artificially increases prices. In turn it means fewer people can afford the houses that come to market, and they then must turn to the rental market. As demand for rental property increases so does the rent that can be charged.

The government have stepped in to address this imbalance. We have mentioned mortgage affordability but two other changes are stamp duty and tax.

Stamp duty

With stamp duty the old regime meant that there was no stamp duty on properties up to £125,000, and then it was tiered:

  • 2% on the portion of the sales price between £125,001 and £250,000;
  • 5% between £250,001 and £925,000;
  • 10% between £925,001 and £1.5m;
  • and 12% on anything above £1.5m

For second properties, this is now:

  • 3% on the portion of the sales price up to £125,000
  • 5% between £125,001 and £250,000;
  • 8% between £250,001 and £925,000;
  • 13% between £925,001 and £1.5m;
  • and 15% on anything above £1.5m

On a second property of £300,000 this has seen the cost increase from £5,000 to £14,000.

Assuming the additional costs of buying a property are £2,000 then this means to breakeven on capital growth, you need a return of 5.3%. The reality is that this figure will be higher, as there is likely to be capital gains tax plus selling costs at the point of sale. So perhaps this could be as much as 10%. Under the old system, it was about half of this. We haven’t even considered any potential capital expenditure in getting the property ready to rent, or any work whilst the property is held as an investment. The big difference a few years ago was that there was potential for house prices to rise whereas now there are question marks around this.

Tax

By 2020 the current rules on mortgage interest tax relief will be phased out and replaced by a 20% tax credit. If someone earning £30,000 receives rental income (after allowable expenses) of £15,000, and pays interest on the loan of £10,000, the table below shows the difference in how tax is calculated:

Current Rules New Rules
Rental Income £15,000 £15,000
Less Mortgage Interest Relief £10,000
Net Rental Income £5,000 £15,000
Tax @ 20% £1,000 £3,000
Less Mortgage Interest Tax Credit @ 20% £2,000
Total Tax Payable £1,000 £1,000

 

It is worth adding, for a basic rate tax payer under the new rules, it could force someone into the 40% bracket as rental income will be added to income before the tax credit is considered. For example, if our basic rate tax payer earns £35,000 their income would become £50,000. This also has potential implications with child tax credit and child benefit payments.

Just touching on the changes for someone who is already a higher rate tax payer; the additional tax could be significant, using the same example as above but with 40% tax:

Current Rules New Rules
Rental Income £15,000 £15,000
Less Mortgage Interest Relief £10,000
Net Rental Income £5,000 £15,000
Tax @ 40% £2,000 £6,000
Less Mortgage Interest Tax Credit @ 20% £2,000
Total Tax Payable £2,000 £4,000

 

For higher rate tax payers, they can pass a proportion of rental income to a spouse but care needs to be taken particularly if they own part of the property (for example, if any lending is taken out by the higher rate tax payer, and / or there is a shared ownership of a property). Form 17 (declaration of beneficial interest in joint property and income) can change the split of income to the actual share but it cannot pass all the income to the lower rate tax payer; and CGT would be due following a change in beneficial ownership.

A potential way around this is to set up a company for new property which is not subject to changes in tax relief on interest payments. The tax is also different, profit will be taxed at corporation tax rates. Income then can be taken via dividends; but the tax-free allowance on dividends has been cut from £5,000 to £2,000, so tax will be due on any income above that at 7.5% for basic rate tax payers, 32.5% on higher rate and additional rate taxpayers 38.1%. For those with property already to move them into a limited company will be a deemed sale and repurchase so there will costs and potential tax in doing this which might not make it attractive.

Other

This interference is not the first, and won’t be the last. Landlords can no longer deduct 10% of their rental profits for wear and tear and can only claim relief on costs they have actually incurred (letting agent fees, accountants’ fees, insurance, maintenance and repairs).

Recently the Chancellor has announced that he would ban agents from charging tenants’ fees for administration services; the cost of these would then fall to the landlord. In theory, they will try to pass this back to the tenant via higher rents, but if rents are falling then it will be hard to do this.

Liquidity

Property is not a liquid asset. Like any investment, the price can move up and down. The easiest time to sell is when the market is buoyant, the time not to sell is at a depressed stage of the market. Selling at the wrong time can mean difficulties liquidating the investment.

Just to add to the mix capital gains tax is higher on buy-to-let or second properties at 18% or 28%; and from April 2019 tax must be paid within 30 days of the sale of the property.

There is evidence that house values are starting to slow. If as we suspect the market has been artificially spiked because supply has been reduced, then only small factors would see prices come down and income squeezed; for example, interest rates rising, and increased government legislation. Some or all of this will happen at some point and this will push down prices. This has a double whammy because as prices come down, properties become affordable and those renting can buy. As people buy, fewer people rent and therefore there is greater potential for void periods and as well as rents being driven lower. With void periods, and lower rents, income gets further squeezed, forcing more properties into the market and so it spirals until it reaches a natural bottom. In the peak to crash and back up, it was nearly 10 years for properties to breakeven after 1989.

A fall in house values will have a serious impact on liquidity, and our view is that this will happen at some point. In terms of timing that is harder to guess but there are signs this is happening.

Is buy to let a bad investment?

There is little doubt that it is not as good an investment as it once was. Increasing costs and unknown future legislation makes it a very difficult investment, but it can work for some investors. Using borrowing to purchase the property can be attractive if the figures work; researching areas to identify potential opportunities is crucial, because where values are depressed they will offer the greatest potential for property value growth and improvement in rental income.

Going in today is not for the faint hearted. You have higher up-front costs, a squeeze on margins, no idea of future legislation and potentially falling house prices and rental income. For those already in the market it is much harder, they may well have made considerable gains so to sell would create considerable cost in terms of tax. Margins might be squeezed at this point but they may still be better to hold on depending on individual circumstances.

It is worth adding that some investors will buy properties for cash; but the same applies in terms of identifying good opportunities for growth through property value and rental income. But using all cash to buy a property does mean that you are sacrificing liquidity, which can be a worry especially if we are at the peak of the market. Equally, if the reason for doing buying a property for cash is the income and the margins are squeezed then that income becomes less attractive.

Conclusion

Evidence shows clearly that buy-to-let has been the place to be over the last 20 years. There are however considerable headwinds facing the market, and therefore new investors must have realistic expectations of any potential future returns. At some point the capital growth on property will revert to the mean; to assume it will keep going is unrealistic. The market has been distorted by supply being taken out of the market; as investors find margins squeezed they can easily become forced sellers and often only the cheapest properties will sell (it becomes a buyers’ market). You also have many investors with interest only mortgages, if they can’t re-mortgage or want to take capital they must sell. All of this means at some point the supply side will free up, and this will push down prices.

Government interference is a big problem because although some changes have been made, there is a feeling there will be more to come. This makes it very difficult to see how this might impact any investment, both in the short and long term. Added to this you have the normal concerns of any landlord which includes void periods, tenants not paying rent and liquidity.

Of course, it should be said that there are opportunities and in some cases, it can work. This needs considerable research to identify these, and there is likely to be greater risk. I still believe it is not for the faint hearted and perhaps as part of a diversified mix of investments it can work, but investors have to be realistic that this is now a much more risky investment.

Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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