Market insight How can the next generation of landlords make buy-to-let work?
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How can the next generation of landlords make buy-to-let work?

Stress testing requires landlordsto put down bigger deposits than before

Higher interest rates mean investors need to focus on yield more than ever before. While existing investors have had the luxury of building up equity, new investors need deeper pockets to get a head start and make reasonable profit from year one.

Stress testing

From a lender’s point of view, the goalposts have been moved when considering if an investment is viable. Affordability for a buy-to-let mortgage is usually assessed by looking at the interest coverage ratio (ICR) – the ratio of gross rental income to mortgage interest payments. While this can vary from lender to lender, the average lower-rate taxpayer’s ICR will usually be around 125%. Higher-rate taxpayers typically see this rise to 145% due to the Section 24 changes.

To mitigate risk, lenders also stress test their customers to ensure their investment would remain profitable should rates rise. Typically, they add an additional 1-2% to the mortgage rate. Applying 2% to the current average mortgage rate on a 2-year fix of 4.84% reduces the number of viable options for new investors given that the average gross yield in England and Wales is 6%.

As a result, buyers are having to put down bigger deposits. With a mortgage rate of 4.84%, the average investor in Great Britain will now have to put down a 46% deposit in order to pass stress testing. Last year, when rates were lower, the average investor would theoretically have passed stress testing at an LTV of 93%.

At current rates, the average buy-to-let landlord in London, where yields are typically lower, would need a 44% LTV product in order to pass a standard stress test. However, in the North East, the average landlord would still be able to take out a 73% LTV mortgage on account of the higher yield.

Because of the heightened ICR and stress tests, a property’s yield in 2023 carries more weight and ultimately determines whether an investment is viable.

For example, at an average gross yield of 6%, an investor with a £200k property would be generating around £12k a year in rental income. With a 25% deposit and a mortgage rate of 4.84%, they would likely be paying £7,330 annually in mortgage interest. To pass the ICR test at 125% the lender would require rental income of £9,170 each year, rising to £10,360 to pass the additional 2% stress test.

A higher-rate taxpayer sees the ICR benchmark move to 145%. This makes the minimum rent required equal to the £10,360 stress test value.

The average higher-rate taxpaying investorwill now need to achieve a yield of at least7% to turn a profit

Generally, the average higher-rate taxpaying investor will now need to earn a gross yield in excess of 7% in order to make even a small profit in year one. Lower-rate taxpayers have more wiggle room and only need a yield greater than 5%, which opens up more locations across the country.

Rising rates have meant that buy-to-let only stacks up in the highest-yielding parts of the country if an investor is relying heavily on mortgage finance. Historically, northern areas have offered higher rental income returns than areas in the South. The average landlord who purchased in the three northernmost regions in 2022 achieved an average gross yield of 7.4%, compared to 5.7% in the South. In financial terms, this can mean £3,750 more post-tax profit for a lower-rate taxpayer based on a home worth £400k.

If an investor purchases a new buy-to-let in a limited company with the minimum 25% deposit, at a mortgage rate of 4.84%, on average they’ll struggle to turn a profit in 92 local authorities, almost a third of all local authorities in England and Wales. Of these, 24 are in London, while only five local authorities in the North are likely to be unprofitable.

Lowering the LTV

Higher rates mean that buy-to-let increasingly only stacks up for investors who can put down a bigger deposit, especially in lower-yielding areas.

With a mortgage rate of 4.84%, the average investor in England & Wales who puts down a 25% deposit on a 6% gross-yielding buy-to-let will turn an annual profit of £1,175 if they’re a lower-rate taxpayer. A higher rate taxpayer would make a loss of £1,392. However, upping the deposit to 40% means these two groups earn profits of £2,990 and £430 respectively in year one.

In London, where the gross average yield is the lowest in the country at 5%, a landlord will now need to put down a deposit of at least 37% in order to turn a £1 profit on the average home in year one. In 2022, the minimum 25% deposit would have been profitable so this costs the average London investor an extra £67,650. By contrast, in the North East, the highest yielding region at 8.6%, an investor could theoretically borrow over 100% of the property’s value and still turn a profit.

Having to put down a bigger deposit naturally begins to cut off geographical areas from some investors’ budgets. Say an investor has £25k: even if they maximised their leverage to 75% LTV, they could only afford to buy the average home in 26 local authorities in England & Wales, once stamp duty has been taken into account. With £50k at this same LTV, the options are expanded to 200 local authorities, all outside London.

Long or short?

While yield is obviously important, many investors have reaped the benefits of capital growth. The average landlord who sold in England and Wales last year having bought five years ago sold their buy-to-let for £81,310, or 31%, more than they originally paid for it.

Over that investment period, they made a total return of £106,090 after mortgage, maintenance and tax on rental returns – 49% of which came from rental growth and 51% from capital growth. Overall, this equates to an annual net yield of 7.8%.

In reality, the average investor tends to own their buy-to-let for much longer. Not only has this served to boost their returns, but it also allows them to ride out any bumps along the road.

Historically, capital growth has comprised a bigger slice of returns for landlords in the southern regions, where yields are lower. For example, in the South West, 64% of gains over the last five years came from capital growth, compared to 40% in the North East. For those further north, capital appreciation has contributed less to overall gains, with higher yields picking up the slack. This has made this strategy beneficial to investors who are focused on monthly cash flows and potentially shorter-term goals.

Returns will nevertheless vary, depending on where we are within the property cycle – and we expect a new cycle to begin in 2025. In terms of capital appreciation, London and the South have tended to lead the charge, seeing the bulk of their price growth at the beginning. The North then catches up later in the cycle. Looking ahead, we’re unlikely to see the same levels of appreciation as during previous property cycles. In cash terms, however, returns may not look too different.

Property type matters:

In general, flats achieve higher gross yields than houses – 7.1% compared to 6.0%. While houses usually have more bedrooms, rents don’t tend to increase proportionately for each extra bedroom. Also, the cost of extra space such as storage and gardens doesn’t necessarily contribute much to the yield.

On the other hand, most lenders take into account service charges and ground rents for flats, which can eat into the profit. The average annual service charge climbed £100 this year to £1,840.

A new way?

With the government potentially set to introduce legislation that requires privately rented homes to be EPC band C by 2025, energy efficiency is moving onto landlords’ radars. A record 58% of EPCs carried out in all privately rented homes in 2022 were rated A-C, up from 32% five years ago.

While new build homes command a premium over older rental stock, 96% of new builds fall into EPC bands A-C, meaning investors would not have to pay for improvement costs. Maintenance and running costs are likely to be lower too. The Home Builders Federation (HBF) estimates it would cost over £70k to upgrade an older three-bed semi-detached home with all the features of a new build.

New builds also achieve higher rents. In 2022, the average new build one-bed flat achieved 13% more in rent than an equivalent older home in the same postcode. For two-bed flats, this figure was 15%.

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