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Towards a buy-to-let alliance

In this open letter to lenders, professional landlord Nick Gillingham argues that a closer business relationship between lenders and landlords would benefit both parties, especially in the present climate

At the moment, many of you len-ders must be licking the deep wounds your organisations have suffered in the buy-to-let sector of the mortgage market. You should be reflecting on your past errors and looking for a different way ahead.

There is a massive private rental sector in this country without which millions of people would be homeless, unless one were to contemplate millions of properties being taken into public ownership which neither national nor local government has the money to do.

Yet for many mortgage lenders, the buy-to-let experience has not been good so the purpose of this article is to highlight the fact that there are two distinct groups in the sector, and that clear distinctions need to be made between them when determining the mortgage terms you are prepared to offer.

In recent years, the underwriting of buy-to-let mortgages has been seriously flawed. Buy-to-let mortgages as we know them today did not exist at the time of the last recession but even so, lack of experience is no excuse for some of the fundamental mistakes that were made by lenders.

These errors were simply a consequence of poor underwriting and bad lending practice. In a nutshell, in the race to achieve market share many lenders ignored banking basics.

I have a background in both commercial and consumer finance and one of the things I was taught many years ago was that the three Cs of credit are character, capacity and collateral, in that order. And by the way, I still use these principles today in assessing the suitability of prospective tenants.

So the most important of the three Cs is character – the profile of the borrowers involved – and the least important is collateral – the value of the assets supporting the borrowing.

The underlying principle here is that lenders should never agree to make loans unless they think the chance of them having to enforce their security is minimal.

Most lenders can only blame themselves for the recent poor underwriting of buy-to-let mortgages. They threw away the rule book, their biggest mistake being the failure to differentiate between armchair investors who, wanting to hitch a ride on the back of rising property values, were suckered into overpriced and unwise speculative investments and professional landlords who continued to act responsibly and manage their portfolios based on commercial principles.

The problem is that, along with the above-mentioned armchair investors, lenders were also suckered in by the hype surrounding supposedly ever increasing property values. Also, we should not ignore the fact that there are numerous mortgage fraud investigations underway at the moment in which a number of so-called property professionals appear to have conspired to mislead lenders, although I am tempted to comment that the lenders concerned should accept a large proportion of the blame for not asking enough questions.

In any other area of banking, if a business was to approach a lender and ask for a loan of £200,000 the lender would ask to see its past three years’ accounts, trading outlook, projected cash flow, full financial details of all the principals involved and how much cash these in-dividuals would be putting up.

Then the lender would probably make an offer conditional on a requirement for further security, the motive behind taking added security not be being to enforce it but to ensure the commitment of the borrower.

So why, when approached by prospective borrowers who had never previously had anything to do with renting out property and who had no experience of being landlords, were lenders prepared to throw money at them like it was going out of fashion?

Also, why did lenders manipulate their underwriting criteria and ignore gifted deposits and other incentives to enable loans to be made to these inexperienced investors when it was obvious that a stress test involving a relatively small shift in interest rates would clearly show that in many cases, their capacity to service their mortgages could be undermined?

The consequence of these mistakes was to create the easy money that helped fuel property prices and inflate a bubble that served to further undermine lenders’ collateral – the final C.

Now the chickens are coming home to roost in a big way and will continue to do so for some time.

In the recession of the 1990s we did not see lenders going all out to penalise professional landlords. In fact, professional landlords had nothing to do with that recession – and neither do they have anything to do with the present one. Yet lenders that have been burned by amateurs in the past still do not seem willing to differentiate between amateurs and professionals.

In fact the opposite seems to be the case, with many lenders citing exposure as the reason, preferring amateurs with just one or two properties to seasoned professionals with years of experience and multiple properties.

But as many lenders will find to their cost, large numbers of amateurs are poised to leave the market, many repossessed and bankrupt.

This is the time for lenders to revert to a proper banking approach when it comes to buy-to-let lending.

At the moment, the cost of a buy-to-let mortgage – by the time you add in set-up fees – is over 2% a year more than the cost of a residential mortgage.

In everyday banking, the interest rates charged to decent, well run businesses are lower than those charged to individual borrowers. Why should the opposite be the case when it comes to mortgages?

Professional landlords are not get-rich-quick merchants trying to jump on the bandwagon of rising property prices. They consider themselves to be in business for the long term.

In recent times, unwilling to buy properties at prices that could offer no commercial returns, professionals have been sitting on the sidelines or seeking out the occasional bargain.

They invest carefully in the most app-ropriate properties, are not exposed to short-term price fluctuations, are more likely in the current climate to negotiate sharper deals than residential buyers and are rarely likely to be involved in forced sales.

So here are a few pertinent questions for underwriters:

  • How do you differentiate risk between residential mortgage borrowers and professional landlords?
  • In each case, how many income streams support the servicing of the mortgage?
  • With unemployment set to rise to three million this year and many small employers closing down, which category of buyer offers the greatest security bearing in mind that if a tenant loses their job, housing benefit can be claimed to pay their rent?
  • Who has gained most from recent interest rate cuts – landlords with well structured portfolios and borrowings tied to the Bank of England base rate or residential borrowers?
  • Who is most likely to benefit from increasing income in the next year, bearing in mind that many employers expect to cut the wages and salaries of the employees they don’t fire while well funded landlords will continue to receive income?
  • Who is likely to be more conservatively funded – experienced landlords or first-time buyers?
  • Who has the market knowledge and is likely to manage lenders’ security most effectively?

    The housing shortage in the UK continues, rental demand in desirable locations remains strong and many first-time buyers and other groups are shut out of the market. This is unlikely to change in the foreseeable future.

    In the face of an increasing population and a rising demand for housing, home building has almost come to a standstill and developers are likely to take years to gear up again so the housing shortage is likely to become more pronounced.

    Any talk of softening rental demand is merely temporary. Owners struggling to sell their properties who revert to renting them out will go looking for somewhere to rent themselves, adding to rental demand.

    So the answers to the questions above are self-evident and if you lenders reach the same conclusions I do, it’s about time that the mortgage terms you offer professional landlords were eased.

    Aside from the fact that professional landlords will only invest where returns meet their criteria for making profits, many lenders currently face another important problem – how do they achieve the best prices for their repossessed properties and where will they find buyers?

    By making mortgage terms so tight for professional landlords, you lenders have frozen many out, limiting competition and leaving yourselves with just a few potential cash buyers who are squeezing you for every penny.

    While it’s widely accepted that the frozen interbank lending market is making it difficult to fund all the mortgage business available, squeezing professional landlords who think in terms of profit in favour of residential buyers who think in terms of cost does not seem to be making the most judicious use of your funding.

    For the reasons identified above, professional landlords clearly represent better covenants and, given sensible financing options, often have the ability to pay better prices than residential purchasers for the repossessed properties lenders will increasingly need to offload.

    So how can lenders best serve their own interests? The obvious answer is to improve funding for professional landlords who can demonstrate a successful track record of running residential letting businesses.

    Going back to the three Cs of credit, the collateral element becomes less important if it is clear that prospective borrowers have good business histories and solid income projections that can withstand stress testing.

    Whether the value of a property falls to the point at which it goes into negative equity hardly matters if a professional landlord’s business model is sound and their mortgage can be serviced, making repossession and forced sale a remote possibility.

    In summary, what I’m talking about is lenders correctly evaluating their risk and reward scenarios and taking a more sensible view of working with professional landlords.

    In effect, lenders should be entering into business partnerships with landlords. And by the way, if anything knocks residential borrowers off their financial perch such as unexpected babies, divorce or unemployment, you must know where they are headed. It’s time to get professional landlords on board, don’t you think?

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