What would really happen to buy-to-let lending if house prices fall?

By John Goodall on 23rd June 2016

Last week Berkley Group reported that premium London property is feeling the pressure from global macro uncertainty, spurred on by an impending potential Brexit.

What would really happen to buy-to-let lending if house prices fall?

What’s causing these prices to fall?

Stamp duty has been the greatest cause of a fall in prime property, with costs being absorbed into market prices and therefore affecting sellers not buyers. For example, the marginal stamp duty rate on a £5m house has moved from 7% in 2014 to over 10% today.

This change has indeed trickled down to the more affordable property, but the stamp duty tiers have skewed this affect. Additionally, rules for overseas buyers to purchase property stamp-duty free via offshore SPVs have tightened up and deterred some foreign investment in London. Low interest rates have undoubtedly had an effect on the housing market too, but as these remain low it is unlikely to be having a material effect on the current price changes.

What does this mean for buy-to-let?

On the face of it buy-to-let lenders like Landbay facilitate property lending and so when property prices fall, the security on our loans is reduced. However, that is only part of the equation. Property price levels in buy-to-let lending only matter if and when there is cause to repossess and sell a property.

In buy-to-let mortgage credit risk, there are three key points to consider:

  1.   Default risk: will the borrower keep up their loan repayments?
  2.    Cure rate: if the loan defaults, will the borrower catch up on the payments and return the mortgage to a performant state?
  3.    Loss given default: if the loan is in default, what is the potential loss?

In simple terms when a borrower defaults, the property is repossessed and the sale proceeds either cover the outstanding mortgage presenting no loss, or they don’t and lenders suffer some loss.

Regular, owner-occupied mortgages are mostly dependent on borrowers’ personal incomes, sometimes supported by a cushion of savings. However, in buy-to-let it’s different. The mortgage is supported by the rent that a tenant pays. If the tenant doesn’t pay the rent, then the lender is reliant on the landlord having additional income sources either from employment or additional properties that they let out. At Landbay the rental coverage is typically 160% (minimum 125%; currently 172%), so if a landlord has six properties then the rent from four will cover their mortgage repayments. At Landbay we actively lend to professional landlords with multiple properties.

What happens in a recession?

If, following the EU referendum or for any other reason, we enter a recession, lenders will most likely, and rightly, tighten up on lending criteria. This would affect consumer landlords first, individuals who might have been considering taking on their first buy-to-let property, or refinancing the one or two they already have. This is unlikely to have a noticeable effect on professional landlords with a large portfolio, as these landlords would just hold on to their properties and delay refinancing their mortgages.

In terms of defaults on existing mortgages there are various things to consider. In the case of a recession, rents are unlikely to fall nearly as fast as property prices. As mentioned above, rents service buy-to-let mortgage repayments. The knock on effect on mortgage defaults is organically delayed and this holdup allows for portfolio landlords to sell off properties to mitigate their defaults where necessary. However, experienced portfolio landlords who have benefitted from low interest rates and good positive cashflows will see an opportunity to increase their portfolios as amateur investors withdraw.

The demand for rental housing has been consistent and it hasn’t just been driven by immigration. There is a social change happening as we move towards a continental tenure, with people actively choosing to rent for flexibility and mobility. Aside from in 2008, average rents in the UK have typically and consistently risen by about 2-4% a year for the last 30 years, but there are regional differences of course and buy-to-let lenders should understand the local market to judge the sustainability of demand.

Buy-to-let cure rates are also extremely high. In the UK, mortgage lending is full recourse lending which means that the borrower is on the hook for the full amount of the loan and if there is a shortfall they can be taken to court.

In addition, lenders like Landbay have the ability to become receiver of rent if a borrower is in arrears and rent is being paid. In this scenario the rent is paid directly into servicing the loan and potentially paying back any arrears. This is unique to buy-to-let mortgages and if you look at industry data you will see that between 80 and 90% of buy-to-let mortgages that are in arrears are in a ’receiver of rent’ state. This is why specialist buy-to-let lenders lost very little money during the Global Financial Crisis.

So, prime property prices may be falling, but this has little to no effect on the performance of buy-to-let lending. Rent is the key driver of cashflow in the buy-to-let lending market and while security is important in all credit environments, access to a cash-generating asset is superior.

Comments

Bland Unsight

01 Jul 2016 12:47pm

Isn't your treatment of Loss Given Default perhaps too rosy? Sure, if a BTL loan falls into such serious arrears that the lender has to repossess, then the rental income to the lender via the receiver of rent may ensure that the loan is serviced, but the recourse to the borrower may be worth nothing if they themselves have limited net assets. Work by the Strategic Society Centre ("Understanding landlords") suggests that landlords are disproportionately indebted in their role as owner-occupiers; the likelihood is that the net assets of the BTL borrowers are strongly correlated with the performance of house prices. Hence in the case of a serious correction in house prices, the loan security (i.e. the house) will have to cover the loan. There are lots of geographical markets where prices have not really recovered from the last crash and the distribution of LTVs in the big lenders' loan books reflect that (see Rugg & Wallace, "Buy-to-let mortgage arrears"). Examination of the financials of the lenders' boom securitisation master trusts confirms the same thing. The willingness and ability of buy-to-let lenders to nurse failed BTL loans on their balance sheets until the UK property market recovers from a post-Brexit shock is not a dead cert, in any way. We must admit the possibility that a firesale is possible and that early entrants (1996-2003) eventually respond to falling prices by seeking to exit whilst there are still capital gains on the table to collect. Nothing is certain, but that is kind of the point! The vast amount of straight no chaser BTL at the table (probably now knocking on £200bn by latest CML public domain figures) added to the amount of consent-to-let (£100+ according to Neal Hudson at Savills) and the amount of 'disguised' BTL employed by investors from overseas means that London, for example, could be precarious in ways that were unimaginable in 1989. The fact of Brexit may now expose how BTL lending is the UK property diamonds fatal flaw.

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