Published: 12 September 2016 | Author: Richard Donnell, research and insight director, Hometrack
- This analysis uses localised data on rents and capital values to evaluate the potential market impact of a move to enhanced underwriting criteria across the buy to let (BTL) market.
- Affordability testing of BTL mortgages at higher interest cover ratios and stressed rates would result in investors having to commit additional sums of equity to fund new purchases. This would affect demand for new BTL loans.
- Rather than commit more equity, investors could shift their buying behaviour, with a focus on lower value, higher yielding homes. This would increase the collateral risk profile of new BTL purchases.
- Strong rental growth in many markets in recent years means remortgaging should not be adversely affected by the introduction of affordability tests. However, weak rental growth in some local markets will create a remortgaging challenge, especially for loans at higher loan-to-value ratios.
- Overall, we see a moderation in the rate of growth in BTL lending in the near term, and lenders should consider tracking and improving their control of the collateral risk profile of new BTL lending.
Buy-to let (BTL) has been an important driver of mortgage lending growth in the last four years, but this sector of the market faces a mix of policy changes that could affect business volumes. The increase in stamp duty for investment buyers from April this year and the tapering of mortgage interest tax relief for higher rate tax payers both have the effect of increasing the cost of investing and have affected demand.
However, the move by some lenders to tighten underwriting criteria through higher interest cover ratios (ICRs) and stressed mortgage rates has a greater potential impact on the market, especially if applied by all lenders. This is important, given the current Bank of England consultation (CP11/16) on underwriting standards for BTL contracts, with the proposal to introduce affordability testing on new loans.
This paper sets out an analysis and commentary on the impact of increasing ICRs and stressed rates on new lending and remortgaging activity. The analysis uses localised data on rents and capital values to assess the likely effects of the market.
Plain sailing on new borrowing at current underwriting criteria
The majority of lenders have based BTL lending decisions on the requirement that the rental income from a property should be at least 125% of the interest payments on the proposed loan (the ICR). This ratio, together with the stressed mortgage rate and rent level, dictates the maximum loan size up to an industry maximum of 75% of the value of the property. Using data on rents and capital values, Hometrack has calculated the maximum sustainable LTV in all local authorities by property size.
We find that an average two-bedroom property purchased with a 2.45% mortgage rate would, today, meet the 125% interest cover ratio (ICR) across all local authorities in Great Britain. However, once a stressed mortgage rate of 4.5% is applied, 16 of the highest capital value markets are unable to sustain a 75% LTV mortgage (these areas contain fewer than 7% of private rental properties and have an average gross rental yield of less than 4%). This means 93% of private rented stock is in markets where a two-bedroom property could sustain a 75% LTV loan at a 125% ICR and a 4.5% stressed rate.
Impact of higher interest cover ratios on new business
Lenders that have recently moved to higher ICRs for new lending have tended to shift to a 145% ICR, with a stressed mortgage stress rate or around 5.5%. Some lenders have been looking at ICRs of 155% or higher, to understand the likely effect on higher rate taxpayers. Table 1 sets out the impact of higher stressed rates and ICRs on the maximum LTV ratio for an average two-bedroom property across the local authorities of Great Britain. The table shows the percentage of private rented housing within each LTV “bucket” and affordability rate.
Table 1: Impact of higher ICR and stressed mortgage rates on maximum LTV ratios for two-bedroom properties – % private rented stock in each LTV “bucket”
|Maximum LTV sustainable||125% ICR & 4.5% stressed||125% ICR & 5.5% stressed||145% ICR & 5.5% stressed||155% ICR & 5.5% stressed|
|70% - 75%||2%||18%||14%||11%|
|65% - 70%||2%||17%||16%||15%|
|60% - 65%||2%||8%||19%||18%|
|55% - 60%||1%||2%||19%||24%|
|50% - 55%||-||3%||6%||16%|
As ICRs and stressed rates increase, there is a fall in the proportion of rented housing in markets where it is still possible for an investor to buy a property with a maximum 75% LTV ratio. At an ICR of 145% and a 5.5% stressed rate, just 20% of rented homes are in markets where it is still possible to borrow at 75% LTV. The net result is that investors will need to increase the equity needed to take out a BTL loan under a higher ICR and stressed rate.
The bottom row of the table shows the percentage of rented housing where investors will have to put down 10% or more additional equity to take out a new loan. This is before paying the additional 3% stamp duty introduced from April this year. The analysis shows that new BTL loans will more likely be at an LTV ratio of between 55% and 70% with investors putting in an extra £25,000 to £35,000 of equity – and more in the lowest yielding and highest value housing markets.
The maps (below) show the geographic impact under the 145% ICR and 5.5% stressed rate scenario for two-bedroom properties.
Map 1: Maximum LTV sustainable
Map 2: Extra deposit as % of purchase price
Greater impact on larger, higher value homes
While this analysis focuses on two-bedroom properties, the impact of affordability tests is greater for larger, three-bedroom homes, where average values are higher and yields lower. Conversely for one-bedroom properties, the impact is lessened by lower values and higher yields.
Chart 1 plots the proportion of rented housing that is suitable for borrowing at a 75% LTV ratio by size of property under different scenarios. It highlights how higher stressed rates and ICRs reduce the ability to borrow at higher LTVs.
Chart 1: Proportion of rented housing market viable at 75% LTV by property size
Assuming new investors are looking to maximise leverage, the net result of tighter underwriting criteria is to push them into lower value, higher yielding homes, where they can pass higher ICRs and stressed rates. However, this represents a potential risk to lenders. A shift in behaviour that sees investors move to buying smaller, lower value homes would, in our view, increase the risk profile of new lending added to BTL books.
Yields reflect risk, and a move by investors up the ‘collateral risk curve’ would need to be monitored carefully. Lenders originating loans at lower ICRs and stressed rates than others would need to monitor the new flows of collateral on to their books to ensure no additional or unintended increase in the risk profile of new lending.
Impact of higher ICR and stress rates on remortgaging
Remortgaging accounts for a sizable part of the BTL market, and a key driver of remortgaging capacity is how rents have changed since the original loan was arranged. This is even more important should the whole market deploy affordability testing, as some customers may find it harder to remortgage to another lender.
In order to provide an insight into the dynamics of remortgaging, we take a similar approach as that applied to home purchases (above) but instead use capital value data from 2013 to calculate assumed loan amount at origination on a range of LTV ratios from 60% to 75%. Chart 2 shows the proportion of rented properties that could be remortgaged at an ICR of 145% with a 5.5% stressed mortgage rate.
Assuming that all BTL loans originated in 2013 were at 65% LTV, then 83% of rented housing is in local markets where remortgaging would be possible. Strong rental growth in London and the south of England will support remortgaging there. But at 65% LTV, 17% of rented housing is in markets where remortgaging could be more challenging – we have split those into groups where the gap to the ICR hurdle is less than 10% and those where it is more than 10%. These borrowers may struggle to remortgage to a new lender.
Chart 2 – Estimate of the impact of higher ICR and stressed rates on mortgages originated in 2013
In markets where it would be a challenge to remortgage, borrowers would have the following options:
- move to a lender with lower ICR requirements;
- inject more equity;
- try to push the rent higher; or
- stay with the current lender at the reversion rate.
Increasing rents sounds attractive and has had much traction in the media. But the reality is that private landlords are ‘rent takers’ not ‘rent setters.’ They can only obtain the going rent in the market. Landlords can try and push rents but if the income needed to refinance is well ahead of the rest of the market, then the net result is more likely to be a void period.
Markets where remortgaging would be a challenge as a result of proposed affordability tests tend to correlate to areas where there has been low rental growth in recent years, specifically regions such as Wales, Yorkshire & Humberside, the north west and north east. Rents in these regions look very affordable by historic standards and, as the economy and incomes grow, rental growth could alleviate some of the challenges of remortgaging over time.
The BTL market has been a key driver of lending business in recent years. The long-term case for investing in housing as part of a balanced portfolio remains but, with one in five house sales accounted for by investors, there are concerns amongst policymakers that sudden changes in investor demand could result in greater house price volatility.
The changes to mortgage tax relief and stamp duty are intended to moderate demand and make investors consider the costs of investing in a market where there is an equal number of cash and mortgaged investors. The consultation on additional underwriting standards for BTL lending, if implemented, should see more equity injected into the market at the cost of slower growth in lending volumes.
Read our article, Buy-to-let reforms should reflect wider market conditions, lenders say