The changing shape of buy to let
An investment favourite of recent years may be less attractive, due to new legislation and uncertainty over interest rates.
Buy to let has become one of the hottest investment areas: mortgages to landlords accounted for about 17% of all new lending in 2015, according to the Council of Mortgage Lenders, up from 12% in the first half of 2008. Buy-to-let lending is also growing faster than other areas, with the value of loans agreed in the first three quarters of 2015 up almost 50% on the same period in 2014, compared with an increase of just 5.3% for loans to owner-occupiers over the same period.
But two changes in tax legislation announced last year will have a significant impact on the buy-to-let market. Existing or potential investors in the sector should therefore take the opportunity to review their exposure and consider whether it is still an appropriate asset.
The popularity of buy to let is partly a result of government policies across the developed market to engineer recovery from the financial crisis. Interest rates have been at a record low of 0.5% since March 2009 as policymakers have struggled to boost lending and economic growth, making cash a very poor investment but borrowing very cheap. Investors have sought safety by buying gilts and blue chip bonds, so their prices have risen sharply, while yields, which move inversely to prices, have fallen. Quantitative easing has increased liquidity and pushed the prices of many assets higher, including residential property. Add to the mix the housing shortage that has dogged the UK market for years and it is no surprise that house prices have been so buoyant, with the price for an average house up 38% over the past 10 years, according to the Halifax House Price Index.1
Buy-to-let investors have been further encouraged by rising rents, as the housing shortage and market recovery have priced younger buyers out of the market, forcing them into rented homes. The Buy-to-Let Index compiled by LSL Property Services shows that rents have risen by almost a quarter over the past five years2, making the returns available elsewhere look lacklustre.
But in buy to let, as in any other areas of investment, there is no such thing as a risk-free return. Tax changes made in last year’s Budget and again in the 2015 Autumn Statement have significantly altered the economics of the industry; an interest rate rise is on the horizon, which will also push up mortgage rates and make financing buy-to-let properties more expensive. Buy to let is also a demanding area of investment, with challenges ranging from the difficulty of finding reliable tenants to the amount of time it takes to buy and sell; prospective investors should carefully consider the risks before entering, or increasing investment in, the market.
Indeed, the Bank of England’s (BoE) Financial Policy Committee has highlighted the sector as a potential risk to the economy as a whole: ‘As the market continues to grow, particularly if driven by loosening underwriting standards, the sector could pose risks to broader financial stability, both through credit risk to banks and the amplification of movements in the housing market.’
The tax changes could have a significant impact. Currently, tax relief on the interest on mortgages used to buy rental property is available at the highest marginal rate, but from April 2017, that will gradually be reduced until, by 2020, relief will be restricted to 20%. For anyone who is paying tax at the highest rate of 55% and funding a buy-to-let property with an interest-only mortgage, the effective financing cost will rise from 45% of the interest charge to 80% within four years.
Estate agent Knight Frank warns: ‘Removing higher rate tax relief on buy-to-let mortgage interest payments will affect the returns for many property investors. Given that interest rates are also predicted to gradually move upwards from this year, some buy-to-let property owners, especially those relying on rental yields rather than capital growth, could start to question the rationale behind their investments.’
That was not the only tax change affecting the buy-to-let market: the wear-and-tear allowance, which permitted landlords of furnished properties to claim tax relief of 10% of the rent received every year, will now end; from this April, landlords will only be able to deduct actual expenditure on refurbishment against their rental income. In the autumn, the Chancellor added a further two tax disincentives. First, those purchasing buy-to-let properties – and second homes – will have to pay an additional 3% of Stamp Duty, starting this April. Second, the government is planning to apply Capital Gains Tax (CGT) to buy-to-let investments within 30 days of sale. The government is consulting on implementation but it is due to take effect in 2019.
Unlike your main residence, rental property is subject to CGT levied at either 18% or 28% on any gains above the tax-free allowance, currently £11,100, depending on your overall level of income. Tax changes aside, investing in rental property is not as straightforward as investing in equities or fixed interest, and the returns can be far more unpredictable. Market values can, and do, fall and there can be big regional variations in performance. House prices fell sharply in the two years from July 2007, as the financial crash rocked confidence and slashed the availability of mortgage finance. While the Halifax House Price Index shows that, by the end of 2014, London prices recovered from these falls (they were 10% above their 2007 peak), average prices outside the capital were still below their previous high.
Successful buy-to-let investing requires finding tenants who pay on time and look after the property. Unfortunately, however, none of that is guaranteed: landlords have to be prepared for periods when the property will not be producing income, whether because it is between tenants or because of defaults on payment; refurbishments and repairs can be expensive; and agents’ fees for finding and managing tenants can be high. Evicting a non-paying or delinquent tenant can be both costly and time-consuming.
Property is also an illiquid asset: investors who decide to exit could find it difficult to sell, particularly if the decision coincides with a general rush to the exit among buy-to-let landlords. Even in a buoyant market, it can take months of uncertainty before the deal is completed; in a falling market, properties can remain unsold for months or even years.
The cut in mortgage tax relief could coincide with a rise in financing costs as interest rates gradually rise from their current low level – and even a relatively modest increase will add dramatically to monthly servicing costs. Buy-to-let investors who are relying on rents to cover the cost of loans could find themselves with a far lower margin of comfort between the income and costs of investing. The BoE points to surveys suggesting that 40% of buy-to-let lenders would sell if interest rates rose above their rental income – a level of selling which could have a big impact on the housing market generally, and not just buy to let.
Buy to let has been an attractive market for many investors, particularly given the distortions that post-crisis measures have had on a range of asset classes. But returns are not guaranteed. It is important that anyone contemplating starting, or adding to, a rental portfolio is fully aware of the risks and future challenges to the market; and they should seek expert financial advice.
1 http://www.lloydsbankinggroup.com/, October 2015
2 http://www.lslps.co.uk/, October 2015
Buy to let mortgages are not regulated by the Financial Conduct Authority.
Your home or other property may be repossessed if you do not keep up repayments to your mortgage.
The levels and bases of taxation and reliefs from taxation can change at any time and are dependent on individual circumstances.