Sunday, 27 April 2008

It is over, baby

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)


JL said...

I never knew any of this. I was always a little wary about BTL, but the data on rental growth (or the lack of it) is really impressive (if that is the right word).

CWS said...

"According to the latest buy-to-let index from lender Paragon, average monthly rents reached a new peak of £990 in February – up from £967 the previous month."

Paragon would say that wouldn't they....

CWS said...

From the FT on Saturday......

Rents squeezed by flood of properties on to market
By Sharlene Goff

Published: April 25 2008 18:16 | Last updated: April 25 2008 18:16

Rents in some areas could fall this year as agents are seeing a flood of available properties, a drop in corporate lettings, and an unwillingness from tenants to lock into new, more expensive, rental agreements.

Falling house prices typically make for a buoyant lettings market as homebuyers delay their purchases in the hope of securing a bargain later. But estate agents say the uncertainty in the housing market and wider economic fears mean clients are refusing to accept rent increases.

Some are also wary about signing long-term contracts in case they miss their chance to buy.

“After a superb start to the year where we grew our business 10 per cent, the last three weeks have been a struggle,” said Judienne Wood, lettings director of Kinleigh Folkard & Hayward.

“We’re in a vicious circle at the moment – because of the credit crunch, landlords want top dollar and because of the credit crunch tenants don’t want to pay it.”

Rents rose fairly rapidly last year as house prices reached unaffordable levels, forcing more people into rented accommodation. But agents have seen a rush of properties coming on to the market as landlords defer sales.

“We are starting to see the lettings market become saturated so tenants have a huge choice,” says Kelly Smith, lettings manager at KFH’s Belsize Park branch. “With more supply than there is demand, rental values will have to come down.”

Savills says the traditional corporate lettings market – properties that let for £1,000-£2,500 per week – has been quiet as fears of job culls in the City discourage employers from bringing overseas workers to London.

“Lettings in the financial sector have been quiet in the last five to six weeks,” says Jane Ingram, director at Savills.

King Sturge’s lettings agency in Canary Wharf is also experiencing lower applicant numbers, while Winkworth’s Clerkenwell and City branch says corporate lets fell in January, but have since recovered.

Savills’ agents in Docklands and Islington saw a drop-off last month. There has been some evidence of a pick-up since, however, which Ingram says could be the result of increased demand from other business areas. “We have noticed that relocation agents have been looking less for financial companies and more for oil companies,” she says.

But further afield, the “country” market – mainly the southern commuter belts – has been holding up well. Demand in the “super-prime” London market has also been strong. Savills has registered multiple applicants for properties costing at least £3,000 per week.

“People are choosing to rent rather than buy at this very high end,” says Ingram. “We have a number of people looking at a house for £12,000 per week.” These clients are commonly from overseas and therefore more immune to the credit crunch.

Ingram says rents at the top end are robust. In prime central London, annual rental growth at the end of the first quarter stood at 6.3 per cent. The biggest annual increase in rental values – 8.6 per cent – was in Kensington, Notting Hill Gate and Holland Park. “It is the top end where we are seeing the strong increases,” she says. “The middle band may take a bit of a hit.”

Recent data from IPD, which analyses property performance, showed an overall return of 17 per cent from the UK residential investment market last year, up from 16.4 per cent in 2006.

A division emerged between different regions, with London and the south-east significantly outperforming the north, south-west, the Midlands and Wales.

aSteve said...

Looking at the "Average earnings relative to rents" graph (BTW - shouldn't that be "Rents relative to average earnings") I see a curious annual pattern...

Does the graph indicate that rents fall during winter, or that earnings increase?

Nationalist said...

Nice post.

Basically BTL was a good idea until the year 2000 and has increasingly been a bad idea since then. Back in 2002 the Bank of England said a houseprice crash was "virtually certain"! That should have been warning enough for wannabe BTL investors.

A lot of fingers are going to get burnt.

powerman said...

"Does the graph indicate that rents fall during winter, or that earnings increase?"

It's probably earnings increasing in Winter as that's when financial sector bonuses are paid.

Alice Cook said...

Powerman is right. The average earnings series has a high degree of seasonality. Average earnings go up in the winter months.

Anonymous said...

Excellent article Alice. I fully agree with this conclusion:

"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."