Mainstream rental market

Impending mortgage regulation, compounded by changes to stamp duty and income tax relief, is set to mean a fall in buy-to-let activity by private individuals.

Given the extent to which the market is dominated by cash investors, this doesn’t sound the death knell for residential investment. But it is likely to limit supply coming onto the market at a national level, putting continued upward pressure on mainstream rents.

Increased stamp duty

The additional 3% stamp duty that came into effect in April 2016 will deter some buyers and make those who remain committed to investing more price conscious. However, stamp duty statistics show that there were still 59,000 purchases of residential investment properties and second homes in the third quarter of 2016.

Tax relief and mortgage regulation

The restriction of income tax relief on mortgage interest payments will also progressively curb the appetite of mortgaged buy-to-let investors. But with the full effect of this delayed by its phased introduction during a period when interest rates are expected to remain low, a more immediate impact of buy-to-let activity is likely to result from impending mortgage regulation.

This mortgage regulation will stress test affordability at much higher mortgage interest cover ratios, reducing the debt they can take on and increasing the cash they need to put down. Lenders are already beginning to factor this into their loan criteria.

^{Source: Savills Research}

Less capacity for debt

Whereas a year ago lenders would provide a mortgage on the basis of 125% rent to interest cover at a stress tested interest rate of 5%, increasingly loan affordability is being assessed at a higher interest cover ratio of 145% at an assumed interest rate of 5.5%.

A year ago the buyer of a £400,000 property generating a gross yield of 4.0% would have been able to borrow £256,000 – leaving them with a cash requirement of £161,000 including associated costs of purchase.

Under these new criteria the maximum loan available would fall to just over £200,000 at a 50% loan to value ratio. Combined with the additional stamp duty costs, this would increase the cash investment which a buyer would have to find by £64,000 to £225,000.

The drive for yield

This is expected to result in a fall in transactions – we are forecasting that over the next five years mortgaged buy-to-let activity falls by 25%.

Investors with a fixed pot of cash who are committed to buying are likely to be pushed to lower value, higher yielding markets.

For example, someone buying a £300,000 property at a 5.0% yield would be able to buy with a 63% LTV mortgage with cash requirement of under £130,000. In doing so they would be able to enjoy a significantly higher net cash return on the equity they have invested compared to our previous example.

The role of cash

Mortgage regulations and reduced tax relief on mortgage interest will not be a concern for the majority of investors.

Only 19,000 of the 56,000 buyers of ‘additional homes’ in the third quarter of last year did so with the aid of a buy-to-let mortgage.

Likewise, we estimate that only one third of all existing stock in the private rented sector is subject to a buy-to-let mortgage. For those carrying debt the average outstanding loan to value ratio is just below 50%.

Mainstream rents

This suggests the sector remains robust and owners are unlikely to sell existing stock unless heavily indebted.

But their ability to expand will be limited. This is likely to constrain supply and put greater upward pressure on mainstream rents. We have forecast rents will increase by 19% over the next five years at a national level, more than our mainstream house price forecast of 13%.