Lenders are ramping up their affordability calculations in anticipation of changes to landlord tax relief. Where will this leave cash-poor landlords in low yield areas?
This week, Newcastle Building Society became the latest lender to impose stricter affordability criteria for buy-to-let borrowers.
The lender follows in the footsteps of Nationwide’s specialist subsidiary The Mortgage Works (TMW), which on 11 May increased its rental cover threshold to 145%. It also cut its maximum loan-to-value (LTV) ratio from 80% to 75%. In the days since, Barclays, Foundation Home Loans and Keystone have all announced similar policy shifts.
A response to market conditions
These decisions are not out of the blue. In April 2017, the government will begin phasing out tax relief on buy-to-let mortgage interest. By the 2020–21 tax year, mortgaged landlords in higher tax bands will pay more income tax than they do now. The measures will also affect some basic rate taxpayers.
The changes taking place now will help lenders ensure that clients have adequate income to meet growing overheads. They also limit the amount that a client can borrow, particularly in more expensive areas. As costlier properties tend to generate lower rental yields, landlords will need to put up more equity to qualify for a mortgage.
This has led to worries that cash-poor landlords in areas like London and the South East will struggle. Some have commented that buy to let will become a “rich person’s game”.
Criteria improving elsewhere
The idea that TMW’s criteria would create a ‘domino effect’ has proven to have some mileage. But in other areas, lenders have become more flexible.
One big change we’re seeing is pay rate stress tests. Lenders often calculate rental cover at a notional interest rate. 5.0% is common, and the typical figure is rising as part of broader criteria changes.
But for longer-term fixed rates or loans under a certain loan-to-value (LTV) threshold, many lenders apply lower stress rates. Some even permit calculations at the product pay rate. Popular ‘lifetime’ tracker loans are often calculated at the pay rate, as there is no reverting rate.
Reducing a 5.5% stress rate by 50 basis points to 5.0% allows as much as 10% more borrowing. Depending on the area, this can mean thousands or even tens of thousands of pounds.
Treatment of limited companies
Landlords who invest through limited company structures pay corporation tax rather than income tax. Thus, the new tax relief laws will not affect them. Lenders recognise this, and what used to be a niche product has become more prominent.
In the last three months alone, the number of limited company products on Commercial Trust’s sourcing system has grown by one fifth. The average rate has fallen from 4.64% to 4.39%. And despite the wider climate of falling interest rates, the rate differential between limited company products and ordinary products has shrunk by 15 basis points.
Some lenders have exempted limited companies from their tougher criteria. Notably, Foundation Home Loans is keeping its rental cover ratio at 125% for limited company applicants.
We have also seen a few lenders eliminate the price differential altogether, pricing their limited company deals the same as their standard ranges.
Options for smaller landlords
According to the Residential Landlords Association (RLA), 84% of landlords have considered raising rents to offset rising costs.
But in areas where rents already account for two thirds of average income, this is not practical. Tenants’ finances are as large a factor in determining rent levels as supply and demand. Pushing rents too high could lead to arrears, expensive evictions or void periods. (Many landlords prefer to keep rents level to retain good tenants and avoid the costs of filling an empty property.)
Many landlords are considering setting up limited companies to limit their tax costs. Whilst potentially a beneficial arrangement, this approach is complex, and requires professional tax advice.
A less drastic measure, and one all landlords should consider, is a portfolio review. It may be possible to increase equity in more highly-geared areas through property improvements, overpayments or switching to a part or full repayment mortgage. (Though be aware of early repayment charges (ERCs) if considering either of the latter two options.)
The investment climate of the property sector has never been immutable. There are always changes, and though there may be setbacks in the short term, forward-thinking investors have always adapted and found new ways to prosper.
Just be sure to consider all your options and speak to the appropriate professionals to help determine the best route forward.