How the Government murdered the buy-to-let market in London and the rest of the UK

I don’t own a home yet in London. Like many millennials, I am saving enough cash to build a substantial down payment. My target is 25% of the house price, plus 5-7% for unforeseen expenses. Long story short, it takes time and discipline is key.

As an EU national, I’m quite sensitive to Brexit-related developments. I don’t plan to leave the UK (I love it here) but I’m still keeping an eye on the negotiations (or lack of) to assess any potential impact on my investments. For instance, we now know that the decision to leave the EU is a significant factor in the slowdown in London real estate prices. London house prices are a lot more sensitive to Brexit due to the number of EU citizens working and living in the capital. Even a slowdown in the number of EU citizens arriving in London is likely to weaken the demand for London homes. This is not simply due to a quantitative factor such as the number of people arriving and leaving. There also is a qualitative dimension: many EU citizens occupy high-paying jobs in the City requiring specific skill sets in finance but also the ability to speak multiple languages to cater to clients’ needs across the continent.

For those reasons, I am in no rush to splash a large amount of cash on an overpriced 2 bedroom + apartment in London. I first want to see if this slowdown will materialize itself in something bigger.

Having said that, it still hurts to lose money every day in a low-yielding saving account with inflation surging due to the continued weakness of the pound. I, therefore, thought about buying a studio or small one bedroom and rent it, whether in London or further north. I had two reasons: 1) I hoped the returns would be better than what I’m getting from my savings account and 2) the investment would have acted as a hedge, meaning that if house prices were to suddenly surge after an agreement was found with the EU, then I would have effectively bought the dip. I, therefore, looked into various metrics (such as regional house prices, downpayment requirements, taxes or expense deductibility to name a few) to see if this could be a worthwhile investment.

My conclusion is that a buy-to-let real estate investment is one of the less yielding and tax effective investments, especially for a millennial landlord who does not own his main residence in the United Kingdom. Here are my reasons supporting this conclusion.

• Reason #1: Banks will refuse to lend you if you don’t already own your main home

This is self-explanatory: most banks will refuse to extend to you a buy-to-let mortgage if you don’t already own your main home. For instance, HSBC, which is the bank I use the most, was quite explicit on this: I had to show that I either owned a home in the UK or that I owned a piece of property abroad, with supporting documentation at hand and relevant certified translations, if required. I discussed this with a few of my friends and they ran into similar issues with their respective banks (Barclays, Natwest etc). I did not hire a broker to source a better deal. I suspect he would have found a deal, although at a significant premium in terms of interest rates.

I’m not sure I really follow the banks’ rationale here. I guess the assumption is that if you already own a piece of property, your net worth is higher and the risk of default on the buy-to-let mortgage is lower. This reasoning only holds if your main home is fully paid off (or close to being fully paid off). This may not, however, be true and you could already be significantly leveraged and have a huge portion of your mortgage to pay off. This leads to odd results: the potential investor with no debt is not allowed to have a buy-to-let investment but the already over-leveraged homeowner is eligible.

Besides, the bank will secure the mortgage with a lien on the buy-to-let property and will carry other due diligence checks. It is a bit of an odd standard to me, and I’m not sure I find it entirely fair either.

• Reason #2: Buy-to-let investors are losing tax relief on their buy-to-let mortgage costs

Buy-to-let investors borrow to benefit from leverage. In practice, this means taking a mortgage and paying back interest to the bank. Once the property is purchased, the tenant moves in and pays rent, which is taxable income.

Historically, buy-to-let investors had a significant advantage over people who would purchase a property as their main home: they could offset their mortgage interest payments against the income earned from their rental property. First, you collected the rent. Second, you deducted the interest payments and other expenses incurred throughout the year. Third, you would pay tax on your net rental income (and not on your gross rental income). By doing so, the amount of taxable income would be significantly reduced, which meant less taxes due to HMRC.

Since April 2017, the tax relief available to landlords of residential properties is greatly reduced and will eventually be restricted to the basic rate of income tax, which is 20%. Essentially, you can no longer reduce your rental income (and tax bill) by deducting all mortgage interest payments. Instead, landlords are given a tax credit of 20% on their gross rental income. And as you can imagine, to landlords, especially those on interest-only mortgages, a 20% tax credit does not even come close to the ability to offset all financing costs against the rental income.

The changes are so bad that the government decided to phase in the application of the new regime so that the pain to landlords would be spread over 4 years. The phase-in regime is:

• In the 2017-18 tax year, 75% of your pre-2017 mortgage tax relief can be claimed;
• In the 2018-19 tax year, 50% of your pre-2017 mortgage tax relief can be claimed;
• In the 2019-20 tax year, 25% of your pre-2017 mortgage tax relief can be claimed.

The changes hit higher rate and additional rate taxpayers the most because they don’t get all the tax back on their mortgage repayments. The tax credit only refunds tax at the basic 20% tax rate instead of the 40% or 45% tax rate to which they are subject.

Below is a table showing what to expect:

In my opinion, this is one of the biggest killers in the buy-to-let market. Newspapers consistently report that buy-to-let investors are now nowhere to be found and I suspect the changes to tax relief on financing costs is the primary reason. As the effect is phased in, I would expect landlords to slowly realize what is going on when they fill out their self-assessment. I believe that we will see an avalanche of studios and 1 bedroom apartments on the market in a few months’ time when landlords notice the higher tax payments and realize that they are no longer making any money (or not in sufficient amounts to be bothered to deal with tenants and real estate agencies).

• Reason #3: Buy-to-let investors must pay an extra 3% of stamp duty

Since April 2016, individuals and companies need to pay an extra 3% of stamp duty if they buy an additional residential property in England or Northern Ireland. The surcharge applies even if the property you own is outside the UK. Buy-to-let investors often already own their homes and/or have multiple buy-to-let properties. They are therefore hit by the 3% surcharge. Below is a comparison of the existing stamp duty rates against the higher rate:

 

As an example, buying a second property worth £300,000 means that you are paying an additional £9,000 just with the extra 3% stamp duty surcharge. This is an addition to £5,000 for the regular stamp duty, bringing the total amount to a pricey £11,000.

One option to mitigate this surcharge is to incorporate a company and purchase the property through the company. This is one solution. However, there are costs also to running a proper company. From book-keeping requirements to company house filings, be ready to do a lot more work. In my view, this solution is only worth considering if you have a significant property portfolio. If you are buying a studio, I don’t think it’s worth the hassle.

• Reason #4: Buy-to-let investors are subject to tougher lending criteria

The Bank of England recently rolled out strict new affordability tests. Buy-to-let investors must now pass new affordability assessments based on hypothetical “stress rates” of 5.5% for five years, regardless of the actual interest rate locked in by the borrower. Lenders have also moved to require rental income to cover 125% to 145% of mortgage costs (the rate may vary based on your tax band and lenders’ practices). Those stricter lending criteria also take into account the reduced tax relief now available to buy to let investors.

When I ran a few simulations with my HSBC counselor, this meant that my down payment had to be between 40% and 50% of the house price. Without a significant upfront down payment to reduce future mortgage payments, rental income is unlikely to be sufficient to cover the required 125% or 145% of mortgage costs. Sure, this reduces the risk of the investment because interest payments are lower as you are borrowing less. But I did not find those arguments to be very compelling and I thought the opportunity cost was too high.

Once again, first-time buy-to-let investors are the ones likely to be the most penalized. Other investors with larger real estate portfolios should be able to juggle the changes, especially if some of their properties are already fully paid off.

• Reason #5: New energy efficiency measures are being introduced

Landlords must also now comply with new energy regulations. New tenancies or renewed tenancy contracts must now carry at least an E rating on the Energy Performance Certificate. Non-compliance can lead to a fine of up to £4,000.

This means that landlords may have to upgrade their properties to make them more energy efficient. I suspect some of those expenses may, however, be deducted and therefore reduce taxable income. Still, this is an outgoing expense that will impair cash flow, in addition to the hassle of dealing with contractors and tenant while the upgrade is carried out.

 

Key takeaways:

• Focus on buying your main home first. Owning property through buy-to-let investments should come after as tax and regulatory changes make it too expensive.
• Buy-to-let investments are still interesting for long-term investors whose portfolio have reached a critical mass to navigate the changes.
• Incorporating a company will help mitigate some of those issues but the solution is not very practical.