There haven’t been many times in the 26 years since the buy-to-let mortgage was launched that the rental market has been as buoyant as it is today. And our forecasts suggest that the heat of the market is set to stay for the foreseeable future.
Nationally over the next four years, we’re expecting rental growth to come in well above pre-Covid levels, rising around two and a half times faster than house prices. This is likely to mean that average gross yields (before any costs are accounted for) will rise from 6.1% today to 6.7% by the end of 2025.
The lowest yielding areas, London and the South East in particular, will record the fastest rental growth anywhere in the country. This will begin to close the gap with traditionally higher-yielding parts of Northern England where returns can hit double-digits, from 2.2% to 1.8% by 2025. Prime Central London will be alone in seeing yields rise more slowly as price growth begins to outpace rental growth towards 2025.
Rising rents (and therefore yields) reflect investors being able to pass on most, if not all, of their rising mortgage costs to tenants. Areas with lower yields are particularly at risk, as are landlords who bought over the last couple of years who are yet to see rents rise relative to their mortgage debt. A mortgage rate of around 4.0% would likely mean interest payments will eat up a little over half the rental income of an investor putting down a 25% deposit in areas with an average gross yield of 6.1%.
In particular higher mortgage rates will hurt higher rate taxpaying landlords with low yielding properties in their personal name hard. Here rising interest rates will eat away at their cashflow while they are taxed on their rental income before mortgage costs are accounted for. Depending on where the base rate settles, it is likely a not insignificant number of investors in this position will find themselves facing a tax bill despite paying more in mortgage interest than they receive in rent.
In areas with average yields, any increases in the base rate above 2.5% will likely wipe out these investor’s profits. While in lower yielding areas, it’s likely a 2.0% base rate will wipe out profits, suggesting we’re already fairly close to the point where higher rate taxpaying investors aren’t making any money. This is likely to stem investment into buy to let, pushing the majority of new and eventually existing investments into a company structure.
All of these price pressures facing landlords will feed through into rising rents. While the ability of landlords to raise rents is always dictated by the market, the lack of homes available to rent strongly curtails renters’ ability to negotiate, increasingly investor’s ability to pass on costs. At the same time rising interest rates will further inflate tenant demand with some would-be buyers priced out and others choosing to carry on renting and wating for prices to fall.
From the middle of next year however, we expect interest rates to fall back slightly, albeit not back to the levels where they bottomed out in 2021. In the medium term this will alleviate the upward pressure on landlords costs, eventually serving to slow the pace of rental growth. At the same time, any future falls in mortgage rates gives rise to the prospect of capital growth picking up from 2024 onwards. Although it’s likely price growth will remain at lower levels than during house price cycles.
In summary we think over the next year or so buy-to-let is steadily moving towards a higher cost environment. Landlords (the 50% with a mortgage in particular) will face higher costs which for the most part will progressively be passed on to tenants over the next couple of years. This will however mean that in the short-term investors looking to buy today will find it harder to make purchases stack up, and lenders’ stress testing will larger deposits are required in lower yielding neighbourhoods.
This is likely to focus purchases into higher yielding areas where costs eat up a smaller part of their rental income. These additional costs are likely to persist for the short rather than the medium term. At the same time investors who either own homes outright, or have relatively low levels of mortgage debt relative to the value of the home today, will see both gross and net yields rise. These equity rich landlords will enjoy rises in rents which won’t be matched by higher costs.
