Tipping point

19 October 2009 | By Christine Toner

With the Mortgage Market Review just around the corner thoughts in the industry are again turning to the topic of regulation and which area will be next to feel the force of the Financial Services Authority. And top of the list is buy-to-let.

The buy-to-let market has been in the spotlight since the credit crunch began. In the boom time lending rules were relaxed and once the crunch hit the sector was one of the worst affected.

With finances tight the number of people looking to get onto the housing ladder in general has fallen, let alone the number of those wishing to build a property portfolio. Even for those who do, the fact the specialist sector relied on wholesale funding - which has all but disappeared - means it’s almost impossible. And as those with buyto- let mortgages struggle to meet repayments following a drop in rental yields all eyes are on the future of the sector.

Now even the British Property Federation, which represents property investors, is calling for buy-to-let mortgages to be included in the FSA’s remit to ensure more prudent lending.

It’s clear the message is gently does it with regulation. The specialist market is all but dead, the lenders still around don’t have access to funding and property prices have plummeted. The reg - ulator needs to be sure that if it alters the structure of the sector the whole thing doesn’t collapse.

The BPF argues that the idea that buy-to-let mortgages are similar to business loans and borrowers are more financially adept is unfounded. It says that in the boom time rental calculations went from up to 150% down to below 125%, and in some cases rental payments were the same as mortgage repayments.

But when the proverbial hit the fan lenders went into panic mode and tightened criteria so much that buy-to-let deals became im - possible to get hold of. Indeed, in September the National Ass - ociation of Commercial Finance Brokers revealed the results of a survey that showed buy-to-let business among its members had fallen by almost 88%, from £4bn last June to £476m in the same month this year.

It does not take a genius to work out that flitting between the extremes of easy lending and stringent criteria does not make for a healthy market. It is for this reason that much of the industry believes regulation could be the answer. With more cautious and regulated lending, lenders may feel more comfortable offering de - cent deals and thus reopen the buy-to-let market.

“There is no reason why buy-to-let should have been excluded from regulation,” says Kevin Friend, strategic partnerships director at Mortgages.co.uk. “Too many brokers jumped on the bandwagon. There would not necessarily have been any difference in the fallout the sector has suffered but inevitably a number of bro kers would have been held to account for breaches of regulation.”

Stuart Law, chief executive of Assetz, argues that all property investment should be regulated.

“The sector has become too large to be left unregulated,” he says. “Property in vest - ment represents a significant proportion of many UK investors’ portfolios. It is likely to be the most geared part of these and therefore sub - ject to the biggest potential risks.

“Without reg ulation, many investors are entering into trans actions solely on the advice of a sales person acting for the developer, seller or them selves. And only a small number of salespeople or in vestors have access to sound financial planning training, experience or software.”

But for regulation to be successful it is clear that the FSA must comprehensively understand the mar ket it is regulating.

“There is a persuasive argument that a regulated buy-tolet market would have a positive impact on the industry as a whole and this is more than welcome in these tough trading conditions,” says Guy Garrard, head of business development at Tiuta. “But for it to work properly the rules must be clear and make sense. It is vital that the FSA shows sufficient under - standing of the industry’s needs to en sure it helps rather than hinders it.”

Garrard says at the moment the regulatory scenario is up in the air and so speculation is inevitable.

“There are rumours that if an individual has one or two buy-to-let properties they will be regulated but if they buy a third maybe it won’t be,” he says.

“That makes no sense. If they buy in their own name it might be reg ulated but if they use a tax-efficient limited com pany vehicle it won’t be. If true, this is crazy - and I haven’t even started on the subject of whether the FSA will look at this market retrospectively and the huge can of worms that could open.”

Dean Carter, head of treasury at Nottingham Building Society, says the government and the regulator must be clear about what they aim to do. “Politicians and regulators need to ensure lending institutions have the right staff in place and are supervised adequately,” he says. “There’s no point in having strict rules if supervision isn’t tight enough to spot dangers and take the necessary steps to ensure con - sumers are safeguarded.”

Garrard says while it makes sense to have a single regulatory regime which encompasses a broker’s entire mortgage ad visory portfolio the implementation of a clear and simple yet eff ective set of rules is vital to success.

“If these are in place, understood and valued by all areas of the industry then great,” he says. “If any further costs incurred by additional regulation are justified and worth it then great again. But any intervention from the FSA must boost the market rather than deflate it. I am not holding my breath that this will be possible.”

Indeed, it is the question of who will be regulated and how that has the industry talking. Regulating the whole buy-tolet sector could, it is suggested, have a negative effect on commercial landlords - i.e. those with plenty of experience and large portfolios.

The argument goes that commercial landlords do not need regulation as they are already well aware of the risks involved. But with the property boom came a flood of amateur landlords inspired by numerous television programmes, looking to try their hands in the sector. Few in the industry would argue that this type of lending should not be regulated. But where do you draw the line?

Alan Margolis, chief executive of Cheval, says the FSA should only regulate less experienced landlords with a small number of properties.

“Buy-to-let regulation should only be for so-called amateur landlords, for example, those with three investment properties or less,” he says. “Regulation should not stifle professional landlords.” Concern about amateur landlords is growing but there have been calls to safeguard them since 2007. In November of that year litigation specialist Moore Blatch called for the advertising and promotion of buy-to-let mortgages to carry the same risk warnings as other forms of investment.

Under FSA regulation the promotion of investment products must include the following risk warning - ‘The value of your investments and the income from them may go down as well as up and investors may not get back the amount originally invested’. As buy-to-let is also an investment Moore Blatch claimed investors might seek legal redress if they were not advised that the buytolet transaction was liable to fluctuating returns.

“Some 41% of investors have buytolet portfolios containing only one or two properties and against a background of a 64% rise in house prices in the past five years, many will have seen buy-to-let as a guaranteed investment,” Paul Walshe, head of lender services at Moore Blatch, said at the time.

“But rental yields have fallen and may now not be covering mortgage payments coupled with the danger that in the current market they may see capital erosion.”

Indeed, since then the buy-to-let sector has been even harder hit. But who was to blame for this? Was it just an unavoidable result of the market downturn or did buy-to-let go too far? Andy Young, chief executive officer of The Business Mortgage Company, says it did.

“Many of the problems lenders have encountered with buy-to-let mortgages are a result of them relaxing their criteria and underwriting standards,” he says. “This has nothing to do with regulation as many buy-to-let lenders are authorised for regulated mortgage contracts and applied the same rules to their buy-to-let loans.”

Alan Cleary, managing director of Exact, adds that just like every other lending market the easy availability of cheap credit fuelled dysfunctional behaviour and we are now suffering as a result. The issue once again comes back to inexperienced landlords.

“Many inexperienced individuals got sucked into the concept of becoming easy-money landlords,” says Margolis.

“Often they were highly or even entirely leveraged and the less they were required to put in the more patently unsuitable they became as investors.”

As property prices continued to rise through the 1990s and the first half of the noughties a perception developed that the boom would never end.

Everyone wanted to jump on the bandwagon and it wasn’t only wide-eyed wannabe landlords who got sucked in. While investors were drawn to the industry in an attempt to make a profit, lenders were doing the same.

“The get-rich-quick attitude was partially to blame, almost more among lenders than investors,” says Law. “Investors who got involved perhaps should not have as a result of lax lending and lenders got what they asked for at the end of the cycle - poor quality clients with little net worth.”

There is a general consensus that lending rules became too relaxed - 90% LTV became achievable with little regard for rental income. And it seemed no borrowers were exempt.

“You couldn’t help but raise an eyebrow at sub-prime borrowers being able to access the buy-to-let market,” says David Hollingworth, mortgage specialist at London & Country.

Margolis says in the past, rental yield rather than afforda bility was the key consideration.

“Although this has now changed somewhat, financial promotions of buy-to-let products should mention the risks or downside of being a holder of investment properties - for example, a warning saying something along the lines of ‘make sure you can afford the monthly interest payments if you do not have a tenant’,” he adds. “If they are being advised by brokers amateurs should also be warned of the risks and advice should be properly recorded.”

But regardless of whether the Mortgage Market Review instructs the regulation of buy-to-let few could argue that it is not a viable market. Inexperienced landlords aside, there are many investors who have the know-how to invest cautiously.

And the argument in favour of buy-to-let is not just commercially driven. With first-time buyers continuing to struggle to take that first big step onto the property ladder the rental market is more necessary now than ever.

“Not only is there a commercial demand for buy-to-let, there is a social and political demand as well,” says Cleary. “After all, where would those who currently rent privately live if there was no buy-to-let market? There certainly isn’t enough social housing to accommodate them so it is inevitable that this demand will at some point have to be met by lenders.”

So what would be considered prudent lending in the buy-to-let market and what needs to be done to prevent another crisis?

“I think 80% LTV for clients with good income and capital available is adequate,” says Law. “A reasonable cost covenant would be 125% of interest cover on three-year fixed rates but otherwise 130% cover on five-year swap rates plus 1.5% margin would be acceptable. Up to 100% LTV and interest cover for high quality clients with large income and safe asset bases is fine but there should be no lending to poor quality clients.”

Young agrees that there is a right way and a wrong way to underwrite buy-to-let mortgages and hopes that lessons have been learnt.

“Some lenders relaxed their underwriting rules too far to grow their market share and accepting applications with no check or assessment of rental income is asking for trou ble,” he says. But many specialist lenders, such as Paragon Mortgages, con tinued to underwrite cases properly and as a result their arrears levels are now considerably lower than other lenders’ residential mortgages.

“Clearly, the key to successful underwriting remains knowing the customer. Only after being satisfied with their ability and willingness to pay the mortgage should consideration be given to the property being used as security. In my view LTVs should not exceed 80% and rental stress should be at least 125%.”

Cleary says one of the biggest problems has been fraud. “New-build property created the perfect environment for fraud - sters to flourish,” he says. “The biggest fraud was the overvaluation of properties and this will eventually flow through into losses for lenders. In future, lenders will have to control the supply chain much more closely. We should expect to see them publicly stating that their new-build policies are tighter, that their valuation and conveyancer panels are severely restricted and that brokers are being chosen on quality rather than volume.”

With new rules and regulation a possibility in the buy-to-let market there is a chance that some brokers dealing in the field may leave, although Hollingworth says it is unlikely there will be a mass exodus because most brokers offering buy-to-let advice will more than likely also be offering regulated advice on owner-occupier mortgages.

What is clear is that for the sector to rise again and survive, caution must be the order of the day. Repairing the market will involve a tricky balancing act. Restructuring needs to take place by both the regulator and the industry, but not to the extent that the sector comes crashing down around us.

 

Complex modelling will be necessary in the buy-to-let sector in 2010

Unemployment spikes will be mirrored by spikes in demand for buy-to-let properties in future

Proposals to reform mortgage regulation are expected to be published by the regulator this week and these could include caps on LTVs in an attempt to lessen the risk from future property bubbles. What would this mean for the buy-to-let sector?

Obviously, reform of this kind would affect firms’ ability to provide buy-to-let lending given the market’s classification under the non-conforming banner, with its insidious association with increased risk. But several distinct markets are often lumped under the buy-to-let umbrella. When carefully managed, some of these have the potential to provide lower default rates than traditional lending.

The spectrum of buy-to-let is much wider than that of owner-occupation. It is full of oddities and sub-markets which differ from one another. For example, at one end there are large numbers of city centre flats in the North, bought by private individuals in the boom time and often for inflated prices. There is now little occupier demand for these, which has led to reduced revenues for investors and inevitably to an increased default rate on loan payments.

But at the other end of the market the default rates on property bought in residential areas in the South-East continue to be low. In this niche demand is steady and mostly unaffected by recessionary pressures. Our data shows that 35% of all buy-to-let properties are less risky than the average owner-occupied property, and where these are.

It is the countercyclical potential of the buy-to-let market which is most interesting for the future. We are likely to see future unemployment spikes mirrored by spikes in demand for buy-to-let properties. People may lose their jobs but they still need somewhere to live and there is insufficient social housing to cope.

It’s clear that with increased regulatory interest and such diversity in the market, reliable intelligence and detailed forecasting will be essential for lenders and investors in the sector. Complex modelling will become more necessary as we move through 2010 to justify new lending and seize the opportunities buy-to-let presents.

 

 

Lenders have caused problems

Huge errors were made which led to the losses taxpayers are now paying for

The market for buy-to-let property has been hit heavily by the credit crunch and the liquidity crisis. It is also a victim of the lending practices many participants indulged in during the boom time, but problems were certainly not the fault of intermediaries.

In effect, buy-to-let lending crossed a barrier and ended up being populated by inexperienced lenders that were more used to dealing with vanilla home loans and didn’t understand the drivers of successful buy-to-let lending. Because of this, huge errors were made which ultimately led to the losses taxpayers are now paying for.

Many have blamed a get-rich-quick attitude among those who got involved in buy-to-let investment. While there’s nothing wrong with looking for investment opportunities, the problem was that property clubs sold heavily to the notion of greed. The first rule - carrying out due diligence - was never undertaken by those investing through clubs. The rest, as they say, is history.

Add to this the lax buy-to-let lending rules effectively pouring petrol on the fire of greed and you have a major issue. For example, a fundamental of buy-to-let lending is the need for a sustainable rental valuation - regardless of the rent currently being paid, could that money be easily obtained in the market if the property was vacant? Given that lenders were accepting random rental valuations from letting agents it is hardly surprising that abuses took place.

Today’s market is rather different but it has taken considerable pain to reach this point. There are a lot of nuances in buy-to-let and it’s certainly more complex than normal home loans. The Financial Services Authority needs to consider the investment advice given, particularly by clubs, to ensure potential borrowers understand the risks and are protected from the small number of unscrupulous brokers who are only interested in a quick buck.

So the mistakes of the past could be the catalyst for the regulation of buy-to-let, which I am not against. But I do worry that we could suffer from the law of unintended consequences if the wrong type of legislation is enacted.

This could drive potential borrowers out of the market. A positive of regulation is that it would get rid of the cowboy brokers who still operate in the sector. A lot of excellent brokers had their businesses undermined by the ones who didn’t know what they were doing.

For example, I was at a dinner last year when a broker berated me for a couple of hours, telling me that if only we went to 90% LTV and 100% rental cover on a self-cert basis he could clean up. No thought was given to the fact that property values were dropping or the rental cover rate was never going to cover the loan payments. That broker had no thought for his clients, just his profits.

 

Regulation could restrict lending just as demand from tenants booms

Lenders with a specialist buy-to-let focus have outperformed those in the prime sector

The death knell of buy-to-let has already been sounded by many commentators looking for an easy target and some cheap media coverage, but let’s look at the facts. The buy-to-let arrears rate has outperformed the wider mortgage market in 30 of the past 34 quarters and is improving while general mortgage arrears deteriorate.

Also, the arrears performance of lenders in the sector varies significantly. Those with a specialist focus have outperformed prime residential lenders.

These lenders have not relied on credit scoring models but instead properly assessed the ability of individuals to make payments and their credibility as landlords on a commercial basis. They have taken care over the valuation process, assessing not only the condition and value of properties but also how sustainable tenant demand might be.

Buy-to-let failed when lenders took a consumer approach to what is a commercial product and didn’t adequately assess borrowers or underlying assets.

In a bid for market share some lenders assessed credit on an automated basis that was better suited to consumer borrowing. They didn’t adopt a specialist approach to valuation, ignored the importance of rental cover and affordability and got too close to developers and - perhaps more dangerously - property investment clubs.

Investment clubs were one of the driving factors behind the wave of speculative investment in property. Too many consumers piled into new-build because they thought they could make a fast buck, usually by flipping properties. This was not buy-to-let, it was speculation and some lenders were slow to spot the problem.

Traditional buy-to-let, properly underwritten and based on sustainable levels of tenant demand, has performed well in the past 18 months and played a vital role in helping to meet housing needs. The gap between home ownership and the social housing sector is widening and the private rental sector has had to fill the breach.

The private rental sector will play a more prominent role in the housing market in future but it needs finance. Credit for landlords continues to be choked because of the closure of the wholesale markets and lack of government support for specialist lenders.

So the Financial Services Authority’s expected proposal to regulate the sector will restrict lending just as tenant demand is expected to grow. Buy-to-let has a strong future but this must be fostered by the right regulatory environment. The market needs to focus on promoting high quality credit and valuation processes that ensure buy-to-let risk is assessed as the commercial activity it is while cutting out speculation.

 

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