While the debate about whether house prices will fall in 2023 on the back of higher interest rates rumbles on, for most investors it is academic. For landlords whose investment horizon is nearly always as long as the average owner-occupier (around a decade), the more important question is: what will higher interest rates mean for both house prices and rents over the medium to long term?
If the end of 2022 turns out to be somewhere close to the top of the market, trough to peak price growth during this house price cycle will be much lower than in previous cycles. And relatively slow price growth by historic standards (averaging around 6% annually during the last cycle) has come at a time when interest rates have, for the most part, been steadily falling. That said, for investors who sold in 2022, capital growth still made up 61% of their total return.
While the impact of higher interest rates on house prices is still open to debate, it seems increasingly likely that, rather than a short sharp correction, higher rates are more likely to weigh down on price growth towards the end of this house price cycle and into the start of the next. While house prices may not fall in cash terms over the next year or two, in real terms (after adjusting for inflation), it seems much more likely that they will.
Higher interest rates will likely make rentinglook like relatively good value compared to buying
It’s our view that the low interest rate environment of most of the last 15 years encouraged relatively large numbers of new landlords into the market and meant rents grew considerably more slowly than they might otherwise have done. It’s possible that rents stood 10% lower at the start of 2022 than they would have been if mortgage rates were at today’s levels.
The relatively rapid shift to higher interest rates between 2022 and 2023 will undoubtedly stem the number of new entrants to the market. So, even if the sector doesn’t shrink significantly, any growth will lag increases in the wider population.
At the same time, higher interest rates than we’ve been accustomed to will continue to make renting look like relatively good value compared to buying with a 10% or even 20% deposit. This is likely to mean rental growth remains strong, well above the 2013-2019 annual average of just 2.6%.
While tax and regulatory changes have not been favourable to landlords, these adjustments have been relatively minor financially in comparison to the impact of interest rate changes. This means that where rates settle longer-term is likely to shape the forward trajectory of rents.
Most economists believe interest rates are to peak this year, before falling back towards the end of 2023 and into 2024. However, the new normal for mortgage rates is more likely to be 3-4% than 1-2%. This will probably keep a tighter lid on house price growth, but rental growth will continue simmering away.
So, how should landlords position themselves in the future, when a growing proportion of returns are likely to come from rents rather than capital growth? The average landlord in the North of the country is used to this, but it will be a relatively new phenomenon for landlords in the South, who have traditionally seen 60-80% of their returns come from house price growth only realised when they sell or re-mortgage.
In the medium term it’s likely that rents, particularly those in the south, will adjust to reflect this new reality. It is our expectation that faster than expected rental growth will partially offset slower capital growth. This means the yield gap between the North and the South of the country will close.
For newer landlords, these higher rents will help to maintain their margins. While in the past some landlords may have been willing to accept small monthly returns in exchange for the promise of stronger capital growth, tomorrow’s landlord will increasingly need to make sure their new purchase washes its face with some wriggle room each month, rather than relying on price growth to boost returns when they eventually come to sell.
Higher rates in the medium term are also likely to make growing a portfolio without a large cash injection a much slower proposition, reducing a potential source of new rental stock. When prices are rising rapidly, extracting the proceeds of price growth via re-mortgaging to put towards the next deposit is a relatively straightforward process. However, slower price growth is likely to mean that portfolio growth in the future will be funded by rental income and personal savings.
Meanwhile, landlords who are relatively heavily leveraged and achieving gross yields much below 5% may find themselves better off reducing their mortgage balance than purchasing another property, a reversal of the arithmetic at the same time last year.
Taken together, higher interest rates and government reform of the sector is likely to make buy-to-let a longer-term game. Slower price growth will make it less tempting to sell up and cash in, while the additional time it takes to build equity means it will be slower to scale up. Therefore, we expect landlords who are buying today to own the property for considerably longer than an investor who bought in a decade ago.
Fundamentally, though, longer investment horizons will quietly push landlords towards quality over quantity. Slower price growth also means the market will become less forgiving when it comes to bailing landlords out of poorer purchases. But, with rent increasingly accounting for the vast bulk of an investor’s return, the incentive to find a low-risk tenant and provide a home which keeps them content will never be higher.
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