In 2016, landlords in the UK Buy-to-Let (BTL) market have incurred the following setbacks to their finances:
- Stamp Duty Land Tax (SDLT): From 1 April 2016, BTL and second home purchases began incurring a 3% surcharge, on top of usual rates applicable to purchases of residential properties.
- Income tax: Individual (as opposed to corporate) landlords can currently offset mortgage interest payments against rental income, meaning higher rate tax payers can claim higher levels of relief. Between 2017 and 2020, this will be phased out and replaced with a tax credit capped at a maximum of 20%.
- Wear and tear: Prior to April 2016, landlords were allowed to subtract one-tenth of their rental income when calculating taxable profit, to cover “wear and tear.” However, now landlords can only deduct the actual expenditure they incur on replacing furnishings.
Bank of England Consultation on Lending Affordability Checks
As a fourth and further setback for BTL landlords, the Bank of England’s Prudential Regulation Authority (PRA) is currently consulting on new affordability checks to regulate the BTL market. For landlord’s requiring debt to proceed with purchases of BTL properties, we provide an explanation below of the potential impact of the proposed affordability tests and provide options for BTL landlords.
Banks usually loan no more than 75% of the value of a property. When deciding the affordability of a loan, lenders usually assess the Interest Coverage Ratio (ICR) – the relationship between monthly rental income and the cost of a mortgage, which is usually 125%. ICR is calculated at an increased (stressed) interest rate, to provide a safeguard to withstand periods where the property is vacant or to protect against interest rate volatility. Accordingly, a widespread market practice in the BTL lending market, is to use the mortgage’s ICR in assessing affordability. Rental income is also an important factor when determining the ability of BTL landlords to service their debt. In addition to rental income, some borrowers use personal income to support their ability to service their debt.
Such affordability tools constrain the amount of loans advanced, so as to reduce the probability of default, particularly in an environment of rising interest rates. At higher levels of indebtedness, borrowers are more likely to encounter payment difficulties in the face of shocks to income and interest rates. The PRA is therefore proposing that all lenders use an affordability test when assessing a BTL mortgage contract in the form of either:
- an ICR test; and/or;
- an income affordability test, where lenders take account of the borrower’s personal income to support the mortgage payment.
The PRA is seeking to establish a standard set of variables that should be reflected within the ICR test and the income affordability test. To ensure that lenders are being prudent in their affordability assessment, the PRA is proposing that lenders, among other things, give consideration to:
- all costs associated with renting out the property where the landlord is responsible for payment;
- any tax liability associated with the property; and
- where personal income is being used to support the rent, the borrower’s income tax, national insurance payments, credit commitments, committed expenditure, essential expenditure and living costs.
The PRA closes its consultation at the end of June 2016 and is proposing a minimum stress rate of 5.5% on ICR of at least 125%. However, as a pre-emptive strike, some mortgage providers have voluntarily required borrowers to show that monthly rent will cover 145% of the interest payments.
What does this mean for BTL purchasers who are purchasing with debt finance?
BTL buyers will require bigger deposits on purchases, to reduce the loan to value ratio of the property, especially on high value properties. Alternatively, borrowers preferring a loan to value ratio of 75% will find fewer available properties.
If the industry moves to an ICR of 145% at stressed interest rates of 5.5%, the BTL properties suffering the most are those in high value, lower yielding markets such as South East of England and London.
Options for investors:
Potential options for investors exposed to the proposed new lending restrictions include:
1) increase rent;
2) invest in lower value and higher yield areas;
3) obtain higher yields, by investing in houses of multiple occupation, to increase levels of income; and
4) purchase without debt finance or with lower debt finance.
Landlords without a BTL loan will be protected from the above mentioned rental coverage lending requirements/limits on mortgage interest tax relief changes.
BTL purchasers using corporate vehicles to purchase BTL properties
A trend in 2016 has been for BTL investors to opt for corporate (as opposed to individual ownership) of their BTL properties, by purchasing via a limited company. Those who borrow through companies can offset costs against rental income. Furthermore, profits at Companies House are taxed at lower corporation tax rates.
Future UK BTL market prediction
The expected reduction in mortgage tax relief for individual BTL landlords means that experts in the market have predicted that there will be an increase in rent of 5-6%, (higher than inflation), based on the tax changes that landlords have been encumbered with.
Recent surveys have found that despite the financial restrictions imposed on BTL landlords this year, BTL investment is still considered to be a lucrative long term investment option.
With the new SDLT surcharge, loss of higher rate tax relief on mortgage interest for individuals and tightening of loan conditions, there is likely to be a shift to larger investors as opposed to individual landlords of properties.
As house price increases may fall, there is likely to be slowed capital appreciation on assets and less likelihood for any high gearing on investments to be reduced as quickly.
Investors will look for cash flow on their investments and lenders will (voluntarily or if required by the PRA), assess the income of the borrower, to assess whether a loan is affordable, as an alternative, or in addition to the ICR/stress test.
In addition to the above, the issue of Brexit has recently unsettled foreign investors in the UK BTL market, meaning they have held back from investing in the UK property market, owing to uncertainty over the future of the UK’s membership of the European Union (EU) – the “wait and see” approach.
If Britain leaves the EU following the referendum this month, some experts predict there will be a further sharp fall in sterling/price correction in UK property, making assets cheaper for foreign funds and private buyers to purchase. Therefore opportunistic, capital strong, international property investors could flood into London/the UK, purchasing office blocks, land and luxury homes, after a period of holding back investment flows, therefore prompting a boost in the commercial and residential property sector. However, other experts predict that investors may reduce their exposure to sterling, if Britain votes to leave the EU and will thereby sell up London properties, amid uncertainty in the markets and prior to the pound reducing in value further.
If Britain invokes Article 50 of the Treaty on the EU – the formal mechanism for leaving the European Union, there is an anticipated two year period of deep uncertainty, as the Government attempts to renegotiate trade agreements.
The future of the BTL market is currently uncertain and the vote this week will be important for the future of the London/UK property and particularly the BTL market, with the referendum on Britain’s membership of the EU occurring on 23 June 2016 and the closure of the PRA’s consultation on underwriting standards for BTL mortgage contracts closing on 29 June 2016.
For further information regarding this topic or any other property and construction matter, please contact Stephen Brower – Head of Property, Hayley Cloherty – Associate, or any member of Edwin Coe Property team.
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Please note that this blog is provided for general information only. It is not intended to amount to advice on which you should rely. You must obtain professional or specialist advice before taking, or refraining from, any action on the basis of the content of this blog.
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