One of the strongest challenger banks in the marketplace, Shawbrook´s most recent financial data reported £1.5 billion of gross origination levels for the nine months to the end of September, an increase of 23% compared with the same period in 2015. Brexit-related uncertainties in the economy have seemingly had a minimal impact on overall business to date and the lender has firm intentions to continue expansion in the buy to let space. We asked Stephen Johnson, Deputy CEO and Managing Director of the Property Division some questions regarding the impact of the Prudential Regulation Authority (PRA) framework alongside some suggestions as to how buy to let investors can best prepare themselves in the new borrowing landscape.
(1) Would you be able to provide readers with a broad overview of what the new Prudential Regulation Authority (PRA) criteria essentially means for buy to let investors?
The new PRA guidelines, effective 1st January 2017, require lenders to adopt minimum interest rate stresses, and interest cover ratio levels when assessing affordability. This moves the BTL market more towards the residential mortgage market where similar stress rate and affordability limits exists. Lenders have therefore made changes to their approach and ultimately it is likely that investors will see lower levels of funding available to them and the need for higher deposits on purchases. One of the key differences now is that coverage ratios are higher for individuals than limited company borrowers reflecting the additional costs an individual will be incurring as mortgage interest tax relief becomes limited. In addition longer term fixed rate products will not carry the same stress rates and therefore these products may provide different levels of funding variable rate products. Here´s Emma Cox, Head of Sales clarifying some of the implications of the PRA:
From September this year a further distinction between investors and portfolio landlords is drawn, with the cut-off point struck at ownership of 4 properties. Those in the latter group will require a specialist underwrite with greater attention paid to experience and financials of the overall portfolio and underlying business. This likely to limit larger landlords access to some of the keener priced retail BTL products.
(2) Why do you think these regulations were implemented?
The regulations were implemented to tighten underwriting standards and ensure investors were not too highly geared. The regulator is concerned about the impact landlords and BTL can have on overall property price volatility. There was some evidence of more aggressive lending returning to the BTL space, and it has grown rapidly during 2015 and 2016 in contrast to the wider residential housing market.
(3) In terms of the enhanced underwriting criteria, will lenders be required to take into account an individual´s future tax liabilities resulting from Section 24 of the Finance Act 2015 (assuming any existing property holdings are personally owned)?
Lenders are always required to adopt responsible lending practices and need to consider the affordability of their loans to their borrowers. The changes to mortgage interest tax relief reduce the net cash flow of a mortgaged investment property, and therefore needs to be reflected in the underwriting approach. However this is a complex area as tax information can be historic and is highly likely to change in the future, prompting lenders to look at ways to manage this risk and ensure good outcomes for their customers. Most are adopting higher interest coverage ratios to account for this tax change.
(4) With the new rules not affecting buy to let borrowers investing in a limited company capacity, do you envisage the dearth of the personal buy to let mortgage – as a large majority of investors using leverage will increasingly use SPVs to purchase (to avoid the Section 24 tax relief rules)? Furthermore, would it be fair to expect the PRA criteria to apply to SPV buy to let purchases at some point in the future?
This is a topic that has received significant coverage. In truth a limited company structure offers advantages and disadvantages to landlords. Whilst interest is fully allowable, investors need to consider the impact of property disposals in a company (effective tax higher once profits are distributed). For many investors long term estate planning is most important and for them a company structure offers more options for effective planning. My point is that there are many considerations and operating through a limited company will involve more costs (finance costs and associated fees generally higher), together with higher levels of administration. Ultimately it is vital landlords take specialist advice considering all the implications, rather than defaulting to thinking a limited company is an easy or appropriate solution. There is evidence that many landlords are increasingly looking to mitigate the additional costs through rental increases rather than choosing corporate structures. On this issue, readers may be interested in our most recent survey exploring landlord reactions to the new interest relief changes:
(5) Do borrowers looking to refinance on a “like-for-like” basis (i.e. no additional borrowing) need to be concerned about these new regulations moving forward?
Re-mortgages without additional capital being raised (excluding fees) are excluded from the underwriting standards. However the changes to interest tax relief affects many unincorporated landlords and will have historical debt levels that would make the investment ‘loss making’. Lenders will be unwilling to take on such customers and question the responsibility of so doing if that level of debt is not sustainable for the borrower. These customers are also likely to then fall onto higher reversion rates which will amplify the impact on their cash flow. It is hugely important that landlords spend time working out the impact this has, as well as using this time to take action. Many have options which include a review of rental levels, selling property to reduce debt, reducing other costs (self-managing), or setting aside other income they have to cover any shortfall.
(6) I would be interested to hear your thoughts on the Greater London and South East market where yields, particularly on single lets, are relatively low. Although constant demand is usually on the landlord/lady´s side, the lower LTV requirements will more than likely require elevated capital injections not to mention the hefty stamp duty charges at purchase. Combined with the implications of the Section 24 tapering, do you feel that the appetite to lend across London and the South East will diminish?
London and the South-East will always hold strong investment appeal. Yields are somewhat lower and the stamp duty changes announced in April 2016 will have made some properties seem unaffordable, but with an influx of foreign investment, capital growth is likely to remain. This may not be at the same level as historically, but the stability in the market may attract people looking for growth opportunities. If investors are looking for cash flow over longer term capital gains, then the higher yielding properties in more regional areas – particularly further North – may be more of a focus. Southern hotspots remain and regions such as Southend-on-Sea are attracting more investment with strong yields at circa 7%, good capital growth and an improving infrastructure, all within 40 minutes of London.
(7) Taking all these factors into consideration, do you think it´s fair to say that buy to let will, by and large, be exclusively for well-capitalised investors for the foreseeable future?
Highly leveraged investors are most exposed and will feel the impact of the tax relief changes acutely. Those that have grown in a sustainable way, sacrificing pace of growth for less debt, will undoubtedly be better positioned to take advantage of the changing market conditions. We are entering into a phase of lower gearing for investors, however the fundamentals of BTL remain compelling. Yields relative to other assets are attractive, it offers long term capital gain potential, the supply demand imbalance of the UK housing market and its population growth all support tenant demand. Landlords just need to adjust and accept higher deposits and potentially slower growth. Anyone that has heard Shawbrook at industry events will recognise our message that gearing for landlords needs to be sustainable for the long term, unfortunately human nature will always see some driven by greed, risking their whole portfolio by gearing to the max.
(8) What would be your advice to landlords that are highly leveraged on their properties moving into 2017?
Most importantly understand the impact of the tax changes to your net cash flow. It is important to have a good team around you providing the right advice to ensure you reach a positive outcome. Tax advice and a professional mortgage broker would be the first numbers to call in order to build this. Take action – whether that be through deciding to deleverage through some sales, consider rental levels and review your other costs to see if there are savings to be had. Reviewing your existing financing costs can often be a good idea as pricing in the market has improved materially during the last few years.
(9) Reading through the policy itself, it would seem that lenders will be required to assess in detail an investor´s personal financial circumstances. How can an investor best prepare him/herself to ensure that the application process goes through smoothly and successfully?
The first step would be to ensure the investor has a complete and in-depth understanding of their financial position. Having all necessary underwriting documentation available and being able to prove they are responsible borrowers will be of key importance in the current and future lending landscape. This is one area where the value of a mortgage broker can be seen as they understand the PRA guidelines, and will be able to make the borrowing journey as smooth and efficient as possible.
(10) What are the potential (and seemingly innocent) pitfalls during the application process? Would credit card and other forms of unsecured debt, for example, be frowned upon?
There are some pitfalls but much of any BTL underwrite – particularly on the specialist side – just needs to be viewed with common sense. Simply put, one of the main questions a lender will ask is; ‘can the customer afford the loan, and can they prove it?’ Everything else should play a supporting role within a strong risk framework that protects both lender and borrower. Shawbrook has always encouraged a long term, sustainable and sensible approach to lending, and one of the reasons we have managed to achieve this is through our tightly managed panel of professional mortgage brokers whose value cannot be understated. Other helpful tips include the quality of your properties, (remember the valuer will inspect and the lender will make assumptions based upon the quality of the property), as well ensuring you adhere to any and all licensing requirements. Avoiding minor credit oversights also is important as is your digital footprint, which is something most lenders will also review.