This U.K. buy-to-let (BTL) market primer provides a comprehensive guide to the fundamentals and key features of the market, including current market dynamics, as well as the nuances of different BTL products/securities and how they may evolve in the near term.
The U.K. BTL market, which turns 25 years old this year, has developed significantly since its inception, particularly relating to the products on offer. During these 25 years the market's demise has been predicted many times, most recently in light of taxation changes (first introduced in 2016) and expected severe headwinds caused by the COVID-19 pandemic. However, these predictions have always proved premature. From a property investor's perspective, the BTL market remains attractive given rental yields, low interest rates--meaning alternative investments are low yielding--and individuals' ability to obtain leveraged upside.
The U.K. BTL Market Today
All markets are a function of supply and demand dynamics. Demand for BTL ultimately stems from the need for shelter, but beyond that, improved global mobility, more transient working dynamics, and potential owner-occupiers' difficulty in saving for a deposit despite various schemes such as the government's "Help to Buy" scheme. The supply side has been underpinned by a combination of the U.K.'s relatively landlord friendly tenancy regime, low interest rates, the fact that property investments are one of the few leveraged investments a non-sophisticated investor can make. Additionally, property and rental income is often seen as an inflation hedge by investors, further boosting supply.
In recent years, the performance of BTL collateral has been positive, with total arrears at less than 1% (with the majority of delinquent loans in the early stages of arrears). Our general view when analyzing BTL collateral is based on our view that the wider economic environment has largely benefited BTL collateral in recent years. For example, first-time-buyers struggling to get on the property ladder have been pushed toward the rental market, increasing rental demand and ultimately rents. Additionally, interest rates are low, having fallen further as a result of the 2008 financial crisis and the impact of the COVID-19 pandemic, which means the BTL market has never experienced the simultaneous stresses of high unemployment and high and rising rates. The combination of all these factors results in favorable conditions for BTL collateral, and we would caution that performance may deviate from recent observations without prevailing tail winds. This is why we apply adjustments for BTL loans.
Below is a snapshot of the collateral from transactions we rate.
BTL Market Features
The BTL lending space has become a lot more fragmented in recent years due to the entry of several new, specialist lenders partly spurred on by their nimbler response to regulation (see below) than their larger competitors.
Regulatory environment
In 2016, the Prudential Regulation Authority (PRA) introduced a regulatory framework, for all lenders falling under its remit, out of concern for the stability of the financial system. Before 2016, BTL lending was not regulated. All PRA-regulated entities (mostly banks) must follow PRA regulations. Additionally, we understand that non-PRA regulated entities regulated by the Financial Conduct Authority are required to follow PRA regulations for BTL underwriting. This would apply to lenders who are not banks but that lend to owner-occupiers. Lenders who are not banks and have no authority to lend on an owner-occupied basis are therefore unregulated, which could give them a competitive advantage.
Although nonbank BTL-only lenders are not obliged to adhere to PRA regulations, widespread divergence from the regulatory framework is limited. This is because warehouse providers anticipate that exit strategies could be more challenging if lending differs significantly from that in the market. Additionally, since PRA regulations were introduced to improve financial stability, if an unregulated lender has robust underwriting processes, overall risk may not be high for some lenders.
Regulatory constraints, particularly those surrounding the lack of scope for differentiation in terms of affordability, have pushed lenders to seek alternative competitive advantages within the regulatory framework (see "New U.K. Buy-To-Let Mortgage Rules Will Change The Face Of The Lending And Securitization Markets," published on Nov. 27, 2017). We have seen this achieved, for example, by lenders lending on higher yielding assets (to allow more leverage) which in turn has altered the type of security.
In our analysis we do not apply a specific adjustment for those loans not underwritten in line with PRA regulations, but capture any perceived increase in risk through an originator adjustment, which addresses the overall quality of the origination process, including any risks that place a lender on a clearly divergent path from the market. Any lending outside of PRA regulations may also be captured through loan-to-value (LTV) ratio and debt service coverage ratio (DSCR) adjustments.
Property types and valuations
Although all types of properties backing owner-occupied securitizations may also be eligible for inclusion in a BTL securitization, not all properties in a BTL securitization would be eligible for inclusion in an owner-occupied securitization. BTL transactions are more likely to contain nuanced property types such as houses in multiple occupations (HMOs) or multi-unit freehold blocks (MUFBs). Table 1 highlights the different property types and uses we see in BTL transactions. In terms of analyzing these types of properties, we typically consider a combination of factors such as the overall exposure in the portfolio, the underwriting standards applied, and the lender's valuation process. This may manifest itself through an originator adjustment or a valuation haircut (or both).
Table 1
| Property Types And Risks In BTL Transactions | |
|---|---|
| HMO | MUFB |
| An HMO has two key characteristics: (i) at least three tenants live there, forming more than one household; and (ii) shared use of toilet, bathroom, or kitchen facilities with other tenants. Although some HMOs are evolving such that only the kitchen space is shared. | A MUFB is one of the most common types of flat complexes. Typically, a larger property is divided up into smaller living spaces with no shared facilities. Each property includes a kitchen, bathroom, and living space reserved just for the tenant. |
| HMOs have historically been stigmatized as lower quality housing, which someone would live in if they could not afford a self-contained flat. There is anecdotal evidence this is changing, and they are becoming increasingly popular among younger tenants due to changing social patterns and migration. While HMOs have typically been popular with students, they are now increasingly occupied by professionals. Landlords are typically attracted by higher returns, though HMOs require strong property management skills and greater time investment. | Whereas HMOs are usually converted residential dwellings, many MUFBs are purpose built. Hence, in the event of default, if a sale takes place then the whole block would need to be sold. To account for this, many lenders apply a discount to the "sum of all parts" valuation, because for many properties that they lend against it would not be possible and may be prohibitively costly to create separate leases for each dwelling. Like an HMO, to sell a MUFB sellers need lenders prepared to lend to them and/or cash buyers. If for whatever reason credit was hard to obtain on a MUFB, unlike HMOs, subdivision of the property into separate leases remains an option and would in theory open up the sale to the general market rather than the investor market. |
| HMOs have a different risk profile owing to the following features: (i) higher management costs; (ii) the relatively high level of tenant turnover amongst tenants; and (iii) valuations can often be derived based on a multiple of yields and rental income, so we take comfort when HMO valuations are on a "bricks and mortar" basis for smaller HMOs i.e., are not appraised by discounting rental cash flows. If a forced sale is required, the costs associated with converting the HMO back into a standard residential property can be substantial and limit the potential size of the market. Additionally, purpose-built HMOs may never be convertible to a sole use property and so, in a distressed market a sale to another investor may be the only viable option. These factors are also why we view favorably lenders who are experienced HMO underwriters and specialize in lending to seasoned HMO investors. | |
| Short-term/holiday lets | |
| Although many holiday dwellings could equally be let on a long-term tenancy, we typically consider holiday lets to be riskier than traditional BTL properties. This is because landlords have less visibility over future income due to the short-term nature of stays and given the leisure business nature of the properties. | |
| The success of a holiday let property is also partially determined by the landlord's ability to market the property, the condition of the property relative to nearby properties, the quality and condition of local amenities, and holidaymakers' general preferences. Given all of these factors can fluctuate over time, the risk for investors in holiday lets is typically higher than for other types of commercial and mixed-use properties. | |
| From a lending perspective, we view favorably lenders who have specialist holiday BTL underwriters and procedurally assess in detail income and expenditure projections for the property and apply appropriate downside stresses when assessing loan servicing. For example, a lender may require that all income over 50% must cover all secured debt payments, and income generated by the property can be used in the calculation but must be capped at 50% of projected income. | |
Specific Considerations Of Common BTL Features.
Income
In 2017, the PRA introduced requirements for stressed payments of 5.5% for all BTL mortgages that have an initial fixed rate of less than five years. For those lenders adhering to PRA guidelines, there has been a notable uptick in five-year fixed rate loans given this permits the lender to apply no additional stress (on top of the fixed rate as a test for affordability). Currently, nine out of 10 BTL properties are underwritten on a five-year fixed-rate loan (see our Q1 European RMBS Market Update).
Another method used to partly circumvent this affordability stress when assessing the DSCR is to supplement rental income with additional sources of income, such as the borrower's salary. This is referred to as "top-slicing". We consider "top-slicing" a risk factor if the assessment of the additional income to meet DSCR requirements is not conducted at a borrower's portfolio level, or on a net basis. For example, absent any mitigant, one landlord may use the same source of income to meet affordability requirements for several BTL loans with different lenders. We view this as a risk factor because if there was a future rate increase after the expiry of any initial fixed rate term, the same source of additional income would need to be used to cover interest payment shortfalls on several loans. However, if additional income is considered at the portfolio level or on a net-basis, this risk is mitigated because additional income is transparent. Underwriting would capture if this income is used to supplement interest payments on another BTL loan. Within our analysis, we do not typically consider additional sources of income when calculating our S&P Global Ratings-stressed DSCR and rely solely on rental income.
Repayment type
In the U.K. mortgage market we typically see either repayment or interest-only (IO) as the repayment method used--although due to regulatory tightening in the years after the global financial crisis, IO mortgages for owner-occupied properties are extremely rare and only permitted under particularly low-risk scenarios. In the context of the BTL market however, the IO mortgage remains the repayment method of choice for borrowers and lenders alike. IO mortgages facilitate lower monthly repayments for borrowers, the amount borrowed does not decline over time, and more leverage means more potential upside.
In our analysis of owner-occupied mortgages, we apply an adjustment to IO loans depending on how close to the end of the IO period the loan is. This is in contrast with no adjustment for IO loans in a BTL context because (i) we consider this type of repayment method to be archetypal for BTL mortgage loans in the U.K.; and (ii) since the property is not the borrower's primary residence there is less complexity in repossessing the property, and can often be done without court (or putting in place a receiver of rent) should the loan fail to be repaid in full at the end of the IO period (by the loan maturity date).
Borrower type
General requirements for a BTL investor The underlying borrower in owner-occupied mortgages is the mortgagee and they alone are responsible for personally repaying the debt. In the context of BTL however, the borrower may be either an individual or a company. From an underwriting point of view, lender's typically have common requirements regardless of whether the borrower is an amateur or a portfolio landlord. These requirements are: minimum income thresholds, no first-time buyers, a minimum age limit of 21 years plus, and limited previous adverse credit, for example. These restrictions represent a departure from the looser lending conditions that prevailed before 2008.
Limited company BTL Up until recently most landlords operated as individuals. Changes to regulation, and specifically the requirement that lenders need to incorporate the tax cost when calculating loan servicing, has pushed landlords to use limited companies, where the tax rates are generally lower. In a limited company BTL arrangement, the lender has a first charge over the property, therefore its position is protected from the other creditors of the company. Also, when assessing BTL mortgages we look at whether (in cases where the borrower is a company) there are personal guarantees provided by the directors, thereby ultimately giving the same level of recourse as if it was owner-occupied (and therefore no adjustment is applied). However, in instances where the borrower is a commercial borrower, the level of recourse is, in our view, greatly diminished, so we may apply an increased default estimate to account for this.
Portfolio landlords versus amateurs Another key distinction in BTL lending is whether the borrower is a portfolio landlord (with four or more properties) or an amateur landlord who has a couple of properties that supplement their regular income. Our analysis does not specifically differentiate between the two, but rather will be accounted for through any aggregation. Currently, we do not observe a divergence in performance between amateur and professional landlords.
Lending to portfolio landlords is more complex given the potential risks from unexpected costs arising from multiple tenancies, and potential geographic concentrations, for instance. Typically, lenders have exposure limits when lending to portfolio landlords and generally require a business plan outlining the landlord's business strategy and property management method.
From a credit perspective, lending to portfolio landlords may introduce concentration risks, and specifically the risk that even though the properties are let and generating cash flow, the landlord does not use that to pay their BTL loans. Depending on the size of concentrations this may be a significant liquidity stress on a transaction. For instance, a pool may feature several BTL loans advanced to a single landlord. If we consider the concentration risk to be material, we may perform our credit analysis by aggregating at the borrower level, or perform sensitivity analysis whereby the weighted-average foreclosure frequency (WAFF) is increased by the percentage of the portfolio exposed to the borrower.
That said, this risk is partially mitigated by the widespread use of a receiver of rent (see below), and the relative cost of foreclosing and initiating cross-default proceedings against the landlord as opposed to appointing a receiver of rent. It is also true that concentration risk may also be viewed from the other side, in that a borrower with several properties is protected from any void periods in a small number of properties by all other properties being let and generating cash flow.
In amateur BTL the failure of a single landlord will have less impact on deal performance given that by definition they can have only three properties, however, they are potentially more exposed to a void period on one of their properties. It is for this reason BTL lenders ask for minimum income levels from borrowers.
Servicing
Typically, the servicers of BTL and owner-occupied collateral are the same. However, given the more commercial nature of the relationship between BTL lenders and BTL borrowers than their owner-occupied equivalents, servicers typically apply less forbearance once a loan goes into arrears of 90 days or more.
Receiver of rent
As well as the usual methods of servicing defaulted/delinquent loans (forbearance or repossession, for example), BTL servicers can also utilize the concept of "receiver of rent". The receiver typically has the ability to both collect rent and undertake asset sales on behalf of the lender. A receiver will also assume the regulatory obligation of a landlord, so this option comes with responsibilities and costs. When a receiver is appointed, the tenant will subsequently pay rent to the receiver rather than the landlord, who will then pass the income on to the lender.
By appointing a receiver of rent, the lender can avoid repossession proceedings, which can be costly and time consuming, while continuing to receive payments under the mortgage and allowing the tenant to remain in place. Because the receiver is acting on the borrower's behalf, if it is in their best interest, the lender could leave the receiver to manage the property indefinitely. However, in many cases when the mortgage reaches the end of the initial discount period and the interest rate increases to a higher revert rate, this higher cost of borrowing plus receivership and other fees, may not be covered by rental income. Hence, in this case the arrears status of the account will deteriorate over time and it would not be in the borrower's interest to have a receiver of rent. At this point, the lender may instruct the receiver to sell the property and redeem the mortgage.
Appointing a receiver is not cost free. Based on our research among servicers in the market, the costs associated with appointing a receiver are generally £1,500-£2,000 up front and then up to £200 per month for the receiver. This may make it impractical for low-value properties and properties with low rent, which is partly why lenders have minimum property value requirements when lending. These figures are based on standard properties and would likely be higher should a receiver be put in place for an HMO or a MUFB.
The success rate of receivers in remedying arrears cases is generally high, with our research indicating a success rate of almost 90% during the 2008 global financial crisis (the last time receivers were appointed in significant numbers). Instances where a receiver is in place for a considerable length of time suggests a more fundamental issue with the valuation of the property in question, and that the lender is using the rent received to pay down the debt to avoid crystalizing a loss on the property. Anecdotally, we have heard of several cases of properties with a receiver for well over a decade due to valuation issues, and where the lender is attempting to amortize the balance to a level that would not lead to a loss on sale.
Future Of The BTL Market
The future evolution of the BTL market is hard to predict with certainty given it will be driven by how people choose to live and utilize space. However, possible innovations could come from the blurring of the lines between what is considered a residential property and what is considered a commercial property. This may present itself in RMBS transactions backing larger HMO properties as increasing numbers of rooms have bespoke uses, such as student accommodation. Another potential innovation is shorter lets than the six-to-12-month minimum we normally see. These would blur the distinction between "Airbnb" style lets and a standard residential tenancy. Such an evolution may move housing supply away from the longer-term tenancy market and draw a regulatory response like it has in some European cities. Potential short-term developments will mean more smaller city-center flats to accommodate people who are now able to work remotely and choose to leave larger cities, but opt to own a flat in a city for when they need to be physically present in the workplace.
Related Research
- European RMBS Market Update Q1 2021, May 11, 2021
- Dutch Buy-To-Let: A Promising New Asset Class, March 21, 2018
- Buy-To-Letdown? Recent RMBS Loans Will Struggle With The Perfect Storm Of Regulation And Tax Hikes, Jan. 24, 2018
- New U.K. Buy-To-Let Mortgage Rules Will Change The Face Of The Lending And Securitization Markets, Nov. 27, 2017
This report does not constitute a rating action.
| Primary Credit Analyst: | Rory O'Faherty, Dublin + 44 20 7176 3724; rory.ofaherty@spglobal.com |
| Secondary Contacts: | Alastair Bigley, London + 44 20 7176 3245; Alastair.Bigley@spglobal.com |
| Aarondeep Hothi, London + 44 20 7176 0111; aarondeep.hothi@spglobal.com |
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