Generation rent – Investors Chronicle

One of the great social changes of the last few decades has been the decline of owner occupation and rise of private renting. According to the Resolution Foundation, 18.4 per cent of all households now live in private rented accommodation, twice the proportion we had in the mid-1980s.

This disguises an even bigger shift away from ownership among younger people. Only just over a quarter of 25-34 year-olds now own their own homes whereas over half did so in 1989 – although the proportion has risen recently thanks to a slowdown in house price inflation, greater availability of mortgages and changes to stamp duty.

Although the private rented sector has expanded, it is still smaller than in many other wealthy European countries. In Germany, for example, 40 per cent of households rent, twice as many as in the UK.

There is, however, another big difference between the UK and Germany: rents are higher here. The European Commission estimates that almost two-fifths of UK tenants spend more than 40 per cent of their disposable income on housing. In Germany, only just over 20 per cent do, and in France less than 15 per cent. According to Homelet, average annual rent is now over £11,000 a year. But the ONS says that the typical household has after-tax income of just £29,400. 

Yes, there are European countries where tenants spend more on rent, but these tend to be poorer ones such as Greece and Romania. So, why are UK rents so high? 

It’s not because they’ve risen a lot recently. According to the ONS they have grown only 23 per cent in the last 10 years, only a percentage point more than wages. Thanks to this the average rental yield is now only 5.2 per cent, slightly less than it was in the early 2010s.

These facts tell us that rents are high largely because house prices are high, and have been for many years.

It’s tempting to blame this upon a lack of new building. But things aren’t so simple. Countries that saw massive construction booms in the early 2000s also saw soaring house prices, such as Spain and Ireland. There’s a reason for this. The price of any asset – housing, shares gilts and so on – depends upon the supply and demand for the stock of the asset. And flows of supply – such as new builds – are only a tiny fraction of this stock and so have little effect upon prices. Just as prices of gilts or equities depend on things other than new supply, so too do the prices of houses.

Instead, the biggest reason for high house prices is the combination of easy mortgage availability before the financial crisis, and falling real interest rates since. The latter bid up house prices not just by making big mortgages more affordable but also in the same way a lower discount rate raises the prices of any asset – by raising the present value of future benefits. And in raising house prices and so making owner occupation unaffordable, low real interest rates have increased demand for rented accommodation thus raising rents. For landlords, these threads have tied together neatly.

Generation rent - Investors Chronicle

The effect on the wider economy might be benign. Andrew Oswald at the University of Warwick and Danny Blanchflower at Dartmouth College have shown that lower levels of owner occupation are associated with lower rates of unemployment. One reason for this is that renters can more easily move to where there are jobs. Also, nimby owner occupiers object to economic development in their neighbourhoods thereby slowing the formation of new businesses. And high mortgage lending can crowd out lending to businesses. For these reasons, it might be no accident that unemployment has fallen as the rental market has expanded. 

On the other hand, though, if people are spending so much of their incomes on rent they have less to spend on things produced by more dynamic businesses. This deters entrepreneurship and innovation by restricting the market. It might also be no accident that the rise of renting has led to a fall in productivity growth.

Perhaps the biggest effect of the rise of renting, however, is political. According to the latest poll by Ipsos Mori, Labour leads the Tories by 34-28 per cent among 25-34 year-olds. In the 1980s, by contrast, the Tories had a lead among this group. There’s a reason why Lady Thatcher was so keen on expanding home ownership. She thought this would encourage people to vote Conservative; She was right.

This political shift threatens a backlash against landlords. One manifestation of this is the demand for greater tenants’ rights. Scotland has already introduced indeterminate tenancies, under which a landlord is no longer able to ask a tenant to leave simply because the fixed term has ended. England could follow. And mayor of London Sadiq Khan plans to run for re-election on a promise to introduce rent controls.

There’s another policy change for landlords to worry about. New prime minister Boris Johnson has promised increased public spending on prisons, the NHS, police and schools as well as tax cuts. All this means a looser fiscal policy. Because the Bank of England believes there is little spare capacity in the economy, such an increase in incipient aggregate demand would – other things being equal – lead to higher mortgage rates. That would not just mean greater outgoings for landlords but also lower house prices.

Yes, a no-deal Brexit would prevent this if it plunges the economy into recession. But recessions are bad for house prices and landlords, too. CD

Who'd be a landlord?

Recession or no recession, the tide may have already turned for buy-to-let investors.

Six years ago when Kate Simmonds divorced her husband and received the proceeds of her share of the sale of the family home, she knew exactly what she wanted to do with it. Invest in buy to let. The money wasn’t enough to buy the sort of home she wanted for herself and her teenage children, but it stretched to a decent sized deposit for a flat in trendy east London. It was an action that joined her to the ranks of the UK’s 1.5m private landlords, but it’s one she now regrets.

A combination of rental voids, higher-than-expected costs and overheads, changes to how landlords are taxed and nightmare tenants meant there has been far less profit and far more stress than Kate bargained for.

Generation rent - Investors Chronicle

Kate’s not alone in feeling squeezed. Up until just a couple of years ago, landlords enjoyed more than £7bn of annual tax relief on the cost of their buy-to-let mortgages. But the tables have turned somewhat and now an additional £1.4bn of tax every year is flowing back the other way – from landlords to the Treasury – in higher rate stamp duty and watered-down tax relief on mortgage costs. Another £150m is expected to pour in annually from the withdrawal of two further reliefs (see below), and, last year, a capital gains tax windfall of £1.4bn arrived as landlords sold up and got out. Hounding landlords is turning into a nice little earner.

But the tax office hasn’t been the only agency ganging up on landlords. The Prudential Regulation Authority, alarmed by the damage that buy to let, which provides a fifth of all homes in the UK, could cause to the wider economy should loans go bad, has cracked its own whip and put the kibosh on easy borrowing. Landlords have also been brought to heel by laws and rules aimed at keeping unscrupulous ones in check. Tenant fees have been banned and deposits (which have been capped) must be protected in special schemes. Landlords have to tell tenants about their rights and ensure properties are safe and fit to live in. Ignore an enforcement notice from the local council, and you can be stopped from using the property. Gas and electrical items and supply must be properly inspected, and smoke alarms, carbon monoxide detectors and proper fire escapes must be provided. Although fines for breaches can be laughably small, dozens of rogue landlords have been jailed for putting tenants’ lives at risk.

Nevertheless despite all the blows, buy to let (BTL) can still make for an attractive and highly profitable investment. After all, demand for rental properties remains strong – waiting lists for council housing are long and many renters are unable to afford to buy. Low interest rates mean cheap mortgages and there is plenty of competition in that market.

Generation rent - Investors Chronicle

Managingthe tax bills

Still, BTL investing is undoubtedly getting trickier.

Anyone in the UK buying a property to rent out now has to pay an additional rate of stamp duty on top of normal stamp duty. The rules, says Robert Pullen, partner at Blick Rothenberg, are carefully written so there are few loopholes. For example, you and your spouse or civil partner are classed as one unit, and if you were to put the property in the name of a minor, you, the parent, would still be liable. However, rates on some transactions, such as ones involving mixed-use dwellings (this could be a shop with a flat above it) or a single purchase of multiple dwellings, are lower.

On a BTL property costing £325,000, stamp duty adds £16,000 to the purchase cost in England and Northern Ireland (compared with £6,250 pre April 2016); £18,850 in Scotland and £15,950 in Wales, which explains why BTL purchases went through the roof ahead of the change and then fell off a cliff, with a muted recovery since then. In Q1 2016, just ahead of the stamp duty change, there were 49,100 BTL property purchases. In Q1 2019, there were 15,200.

Another measure that’s hit profits has been the withdrawal of the right to deduct the full cost of mortgage interest from rental income. Up to April 2017 landlords were entitled to deduct all mortgage interest costs before paying tax. This relief is being tapered away and from April 2020 landlords won’t be allowed to deduct any mortgage interest. Instead they will receive relief at a rate of 20 per cent on the whole of the interest, or their property profits if this is lower. In our worked example, Landlord B is paying an extra £5,000 tax on his rental income as a result of the change.

But the tax changes won’t affect everyone. Where there is no mortgage, or where total earnings fall within the lower rate tax band (up to £50,000 in England/NI) or the rental income is paid to a spouse or partner with no or low earnings, tax bills will be unchanged. In fact, in 82 per cent of cases there should be no additional tax to pay.

However, where property profits are now higher, landlords might lose their entitlement to child benefit, might not qualify for a mortgage, or could find that their total income has been pushed over the dreaded £100,000 threshold, at which point they risk losing some or all of their tax-free personal allowance, adding thousands to their tax bill (pension contributions can help to solve this problem). 

Other reliefs lost include the wear and tear allowance, which was worth up to 10 per cent of gross rental income, regardless of whether old beds and cookers had been replaced. But it is still possible to claim the cost of actual like-for-like replacements.

Two further valuable reliefs, Lettings Relief (worth up to £80,000) and Principal Residence Relief (PRR), are due to disappear or shrink from next April. “As a result of these proposals, landlords will now have capital gains that are not covered by the reliefs,” says Mr Pullen.

PRR gives relief from capital gains tax when a property is sold. Landlords who have lived in a rental property previously as their main home could add the last 18 months – now being cut to nine months – to the time they had lived there, and this portion of ownership would not attract a capital gains tax bill. The 'last months rule' used to cover 36 months, so you can see where this might go next. However the rules were being exploited. Around a third of all landlords are believed to have lived in their rental properties as their main home at some point.

The big squeeze on amateur landlords has encouraged many to exit the market – between 2010 and 2018 the proportion of landlords with just one property has declined from 78 per cent to 45 per cent, according to the Ministry of Housing. But others have responded by choosing to grow their business using a corporate structure.

The benefits of a limited company

For many new landlords and for those adding to their portfolio, incorporation has become a popular option, thanks to the advantages it brings. These include being able to deduct the entire amount of mortgage interest from the rental income, and, if a landlord can afford to allow the rent to build up as cash within the company, only paying 19 per cent corporation tax, compared with up to 45 per cent on rent received as an individual. But depending on the level of income received now or expected in the future, this might prove pointless, as it means missing the chance to use the annual personal tax-free allowance currently worth £12,500.

If landlords can let the cash to build up in the company, another benefit is the ability to pay off the mortgage much earlier, says Lauren Peters, chartered financial planner and senior financial adviser at Fiducia Wealth Management.

For anyone with a large pension pot, the company route makes even more sense. “Landlords who are planning to extract tax-free cash from a pension, say because their pot is nearing the lifetime limit and they want to crystallise it, could inject the money into a buy-to-let company as a director’s loan,” says Ms Peters. “Not only does this mean their money is put to work earning a rental income, but the company can also add interest to the director’s loan when it is repaid later on.” 

Interest paid on the loan would be taxable, although the return of the capital itself would not be.

She adds: “You can employ family members, for example your children over the summer holidays say, or a partner, in admin roles and pay them up to £12,500 tax free. You can also make them directors of the company too with their own shareholdings. Dividends can be paid out and will be tax free if you have not used your £2,000 annual dividend allowance.”

Finally, a director’s loan can help make retirement income extremely tax efficient. “Take a landlord who is working now and expects to retire in seven years’ time. He makes a loan to the company and allows the rental income to roll up. At retirement, he takes his state pension which might be worth £9,000 a year, plus a further £10,000 a year from a Sipp. Of this £6,500 would be taxed at 20 per cent, giving him a net income of £17,700. He could then top this up with chunks of tax-free capital in the form of returned director’s loan repayments, and tax-free dividend payments of up to £2,000 a year,” says Ms Peters.

However, there are downsides. Higher rate stamp duty still has to be paid on residential property purchases bought by companies, and a property which costs more than £500,000 will incur a 15 per cent stamp duty. There are fewer BTL mortgages for limited companies and landlords face additional responsibilities and costs running the company, such as those for employing the services of an accountant.

Investors who require income to be paid out might be better off holding the property personally. That’s because in paying oneself a salary, a landlord may then have to pay tax on money that has already been taxed.

It’s not practical to move properties into a limited company as this would necessitate selling and repurchasing the properties creating capital gains and stamp duty liabilities.

Securing a mortgage

Since the PRA intervention, the loan-to-value ratio now generally stop at 75 per cent. “A handful of lenders offer LTVs of more than 75 per cent but the rates and fees are prohibitive so they tend to be avoided,” says Nicholas Morrey at John Charcol.

Rental income from the property will need to cover between 125 and 145 per cent of the mortgage repayments and must also be enough to pass a stress test based on interest rates of 5.5 per cent.

“A higher-rate taxpayer with a two bedroom flat in London worth £500k with a £300k mortgage, could expect to pay around £500 in interest on a 2 per cent fixed rate. But because the lenders’ stress tests are built around 145 per cent at 5.5 per cent, the rent on this flat needs to be £2,000 per month otherwise it will fail the stress test,” says Mr Morrey.

Some lenders allow excess disposable income from non BTL earnings to be included in the stress test but they will take spending, retirement age and tax status into account.

Mr Morrey says opting for a five-year fixed rate deal can help, even if undesirable, because lenders can use the five-year rate rather than the nominal stress test rate making it more likely the numbers will work.

For investors adding to a portfolio of buy-to-let properties, special underwriting measures will be applied by lenders to account for higher levels of debt, and other risks such as geographical concentration. Experience levels may also be considered, too. 

Prospective landlords can at least benefit from a wide choice of deals. But Mr Morrey cautions that new risks are emerging here, in particular relating to the capital solvency of some specialist peer-to-peer lenders versus lenders whose loan book is 100 per cent collateralised. “They may have the loosest criteria but not necessarily the best rates and some have gone bust,” he says.

So while the rules of the game have changed, it still makes sense to invest in buy to let, as long as the sums add up. Direct property holding allows investors to diversify their overall portfolio, and for some landlords, owning BTL is less about the income stream and more about the longer-term goal of getting the mortgage paid off.

That’s not to say things won’t get trickier. Labour politicians have talked of introducing rent controls and further strengthening tenants’ rights. And further costly tweaks to tax could be made. All of which underlines the importance of spending time factoring in all costs and likely yields, along with worst-case scenarios, to ensure you have a fat enough profit buffer. RC

  

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