It has been a bad week for the buy-to-let industry. Lenders, one-by-one, are cutting investors loose. Banks are unwilling to finance amateur landlords. They want out, and have raised lending rates. The sudden tightening of credit conditions now means that it is almost impossible for any potential buy-to-let investor to obtain financing.
Still, some buy-to-let investors are putting on a brave face. Lynsey Sweales, director of Money Centre, the buy-to-let specialist, claimed that "Our customers are not worried about falling house prices – they are making use of them to buy more property with enhanced negotiating power. They have experience in the field, owning an average of 7.2 properties each, which means they have an adequate financial cushion."
Assuming that one of Money Centre's investors could get financing, which is very doubtful, what exactly would they get for their investment, if they took the plunge today? Not much in terms of potential rental income growth.
Buy-to-let investors have always had to face the reality of rather unremarkable rental growth. The UK's Office of National Statistics produces a monthly index on UK rents. Since 1997, rental growth has varied between 1 and 5 percent. On average, rents grew by about 2.9 percent, fractionally faster than the retail price index.
Although, it would appear that rents have enjoyed slightly faster growth in recent years, this upward trend merely reflects higher levels of overall inflation. Over the last two or so years, rents have actually grown more slowly than other prices.
The relationship between inflation and rents has only limited usefulness for the prospective landlord. The key relationship is between rents and average earnings. Unfortunately, the link offers little comfort for the property investor. Over the last ten years, rents have rarely grown faster than average earnings. Typically, rents grow more slowly than average earnings.
The chart above compares monthly rental inflation, with monthly average earnings growth. In the last ten years, there have been only three occasions when rents have grown faster than average earnings (ie crossed the zero threshold).
Over time, rents have fallen relative to income. Since 1997, rents have fallen by about 14 percent relative to average earnings. (In case anyone is wondering why this series has such a strange shape, bonuses are paid during the winter, and this is reflected in the data).
Unlike house prices, rental incomes are limited by earnings growth and the relative supply of rental properties. While the house prices can enjoy periods of huge speculative growth based upon easy credit, rents must be paid montly, and rarely on the basis of credit. When rents go up, tenants can quickly move and find cheaper properties. Higher incomes will push rents up, but since earnings growth has been slow in recent years, this has put a cap on rental growth.
Rents will also respond to supply. However,these have been good years for renters. This, in part, reflects the wonderful generosity of buy-to-let investors. The increase supply of rental properties has pushed rental growth down. This has done wonders for tenant's purchasing power, who now pay lower rents relative to their income compared to 10 years ago.
So, what kind of potential earnings stream will the new brave buy-to-let investor find in today's market. Compared to ten years ago, one pound of house purchase buys a fraction of rental income. If the ratio of house prices to rents was 100 in 1997, today it is just 41. Or to put it in simpler terms, house prices are much higher, and rents have failed to keep pace.
Reliable data on rental yields is hard to find. There are some dubious claims from the buy-to-let industry, suggesting implausibly high rates. What is clear, however, is that rental income relative to house prices have fallen dramatically, and this implies that rental yields have also fallen.
Therefore buy-to-let investment offers only limited income growth. In fact, from an investment perspective, buy-to-let only makes sense if there is significant capital appreciation. That is exactly what has happened in recent years, and this has encouraged an army of inexperienced investors to plunge into the market.
However, house prices stopped rising around the middle of last year and began to fall rapidly. This turns the entire arithmetic of buy-to-let upside down. A new investor will be hit on three sides; high financing costs, poor rental income growth and negative price appreciation. This is a template for financial ruin.
So, the buy-to-let boom is over. The banks know it and trying to get out. There will be a couple of dimwitted investors who will pile in when everyone else is pulling out. However, as the months pass, the numbers entering will be overwhelmed by the avalanche of investors liquidating their investments and pulling out. This is now a race for the exit. There may be one or two investors who manage to reach the door in time and survive. Everyone else will be burned.
(Data sources: RPI, rental price index (DOGP), average earnings including bonuses, all from the Office of National statistics, house prices are from the Nationwide)