Most investors will still turn a profitwith mortgage rates of around 5%
Here, we explore what higher mortgage rates mean for investors coming towards the end of what would now be considered a cheap fixed-rate deal. We’ll also analyse how the length of ownership – which often dictates capital growth returns as well as yield – has an impact on a landlord’s profitability. This will help us paint a picture of the number of landlords who may fall into the red and face having to sell up.
How have higher mortgage rates hit investor profits?
Higher mortgage rates have fundamentally changed the sums for investors. Given that most landlords are on interest-only deals, even the smallest rate rises have a significant bearing on profitability.
Here, we’ve taken an example of an investor coming towards the end of a 2-year fixed rate mortgage on a privately rented home worth £200k. Assuming they have a 60% loan-to-value (LTV) mortgage at a rate of 2.2%, they would likely have been paying £2,666 each year in interest. With mortgage rates now closer to 5%, their annual payments would more than double to £6,060.
Based on the average 6% gross yield in England and Wales which generates £12k a year in rental income, the average basic rate taxpaying landlord will see their posttax profit shrink from £4,490 to £1,780.
The changes to Section 24 mean investors can now be taxed on a loss
For a higher-rate taxpayer re-mortgaging at a 60% LTV, 5% rates will shrink their post-tax profit t to just £120 each year after mortgage payments, maintenance costs and tax. Rates of 6%+ will push them into loss-making territory.
The changes to Section 24, which removed landlords’ right to deduct finance costs before tax and replaced it with a 20% tax credit, mean investors can now be taxed on a loss. If these changes were reversed, the average higher-rate taxpaying landlord would still turn an annual profit of around £605 with a 6% mortgage, instead of making an £850 annual loss. This illustrates the significant impact of these tax changes, which were introduced at a time when interest rates were expected to stay low for the foreseeable future.
How does yield impact profitability?
Most existing investors will have seen their yield (based on their original purchase price) increase over their investment period due to rising rents. And this will help cushion the blow of higher mortgage costs. Rents would, however, have to rise by 28% across England and Wales to make up for the increase in mortgage rates to 5% over the last year.
Investors who bought in 2015, for example, initially achieved an average gross yield of 6.1% in the first year; however, thanks to rental growth, the same property would now achieve an average yield of 7.3% relative to the initial purchase price. Even a landlord who bought in 2021 will already have seen their yield rise by 0.6%, which will partially insulate them from the impact of rising interest rates.
On paper, the average landlord now needs to be earning a gross yield in excess of 4% to turn a profit. This is based on a lower-rate taxpayer or limited company landlord who owns a £200k buy-to-let with a 60% LTV mortgage. By contrast, in 2020, when rates were lower, investors could still make money with yields of 2%. Higher-rate taxpayers now need a yield of at least 5% to stay out of the red once mortgage payments, maintenance costs and tax have been accounted for.
The average lower-rate taxpaying landlord with a 60% LTVmortgage needs to achieve a 4% gross yield to turn a profit,versus 2% last year
Can capital growth ease the pain?
With yield becoming more important than ever, capital growth is taking more of a backseat. However, it’s important to note that existing investors have made significant gains – typically, the longer an investor has owned a buy-to-let, the more time they’ve had to benefit from rising house prices. Assuming they haven’t withdrawn any equity, their loan will be proportionately smaller compared to the property’s value today than when they bought, meaning their LTV will be lower. The average lower-rate taxpaying landlord who bought five years ago will have paid around £155k for a property that’s now worth £200k. House price growth has meant their 75% LTV mortgage of £116k taken out in 2017 now equates to 58% of the property’s current value. On paper, this means they’ll likely turn a profit of £2,070 when re-mortgaging at a rate of 4.84%, the average rate in February 2023.
Investors who have owned the longest will be most sheltered from rising rates
A landlord who bought last year with the minimum 25% deposit will likely make a profit of only £760 this year as a limited company or lower-rate taxpayer. Meanwhile, the average investor who bought with a 75% LTV mortgage 20 years ago will likely be re-mortgaging at a 32% LTV in 2023, generating an annual posttax profit of £4,120.
Based on the example above, a 75% LTV landlord paying basic-rate tax would only be able to tolerate mortgage rates of up to 5%. However, the average 60% LTV landlord would be able to turn a profit with a mortgage rate up to 7%.
This illustrates that it’s younger investors who maximised their borrowing to purchase a buy-to-let more recently who are at considerably higher risk of falling into losses due to rising mortgage rates. Older landlords, especially those who haven’t released equity, will be less affected.
