In June 2021, the U.K. government ended its ban on eviction of residential tenants that it had imposed in March 2020 to protect people affected by the economic effects of the COVID-19 lockdowns. Although data on rental arrears is limited, two separate surveys estimated that by the end of 2020 rental arrears among private sector tenants had risen to approximately 9%. By comparison, arrears on U.K. buy-to-let (BTL) RMBS transactions showed a negligible increase in arrears through the COVID-19 pandemic. What's more, prime U.K. BTL RMBS overall showed lower use of payment holidays and arrears' increases even compared to U.K. prime owner-occupied collateral.

Why did U.K. BTL performance remain resilient through the pandemic? And is it through the worst?

Bright Or Bleak Future For BTL?

Data on rental arrears is limited because the source data is ultimately only the purview of landlords. Nevertheless, a consistent picture emerged in late 2020. Two surveys, one commissioned by the Ministry of Housing, Communities, and Local Government, the other by the Association of Residential Letting Agents (ARLA) each estimated that U.K. private sector rental arrears reached about 9% of total private sector tenants by the end of 2020. This represents an increase from about 2% in arrears before the start of the pandemic, according to ARLA. Over the same period, S&P Global Ratings' RMBS post-2014 originations BTL index estimates that arrears were negligible, having increased by just 0.1% in the 15 months to the end of June 2021.

The increasing trend in rental arrears for the whole market was highlighted and analyzed in the recent "Household Debt and COVID" report published by the Bank of England (quarterly bulletin 2021 Q2). The report comments that people living in rented property have borne the brunt of the COVID-19 pandemic compared to owner-occupiers and highlights possible downstream risks for the U.K. BTL sector. Given that rental tenants hold a disproportionate share of unsecured debt and pressure to pay it, combined with generally lower savings rates, they may find it difficult to service rental payments, leading them to be deprioritized. This, in turn, would reduce rental yields and make BTL unattractive, potentially causing BTL properties to be dumped onto the market. Larger volumes of property being dumped on the market may, at the same time, exacerbate a period of low confidence in the housing market and cause what might be akin to a flash-crash in home prices.

There is, undoubtedly, uncertainty as to tenants' ability to pay when the U.K. government's furlough scheme ends at the end of September 2021, and economic conditions may not support rental prices recovering to pre-pandemic values in all areas in the very near term. However, overall, the ability to replace non-paying tenants with paying ones, albeit at slightly subdued rates, represents a credit-positive factor when compared to the peak stress seen in the COVID-19 era. We have therefore considered the volatility of BTL loan servicing to rental income.

Features Of BTL Loans That Support Strong Performance

Diversification

Diversification in BTL means that if one property is not performing, a landlord would have other loans that are performing, and the excess rent over interest payments on these loans would be sufficient to subsidize non-paying tenants. In such cases, although cash flow, and overall profitability, for landlords is reduced, they can still service their debt. A loan-by-loan analysis of S&P-rated BTL deals shows that, even among newer vintages, originating 2014 and beyond, rent exceeds mortgage payments by approximately 2x (see chart 1). Among older vintages, the coverage is even greater. The debt service coverage ratio (DSCR) is calculated as the estimated rental income, indexed to today's values using the index of private housing rental prices from the Office for National Statistics, divided by the current monthly mortgage instalment. Chart 1 is aggregated at the borrower level.

Analysis of this nature has limitations because it does not show the properties a BTL landlord has with other lenders and therefore is not the complete portfolio of a landlord. Furthermore, over the longer term, excess rent over mortgage payments is required to fund other costs of property ownership that may be deferred in the short term but not in the longer term. However, such analysis does show the approximate position at a transaction level if a receiver of rent were to be appointed.

Older loan collateral, even though often underwritten with lower DSCRs, enjoys significant rental inflation, which pushed DSCRs up, therefore providing even more insulation from shocks such as COVID-19.

Houses in multiple occupation and multi-freehold blocks (HMOs and MUFBs) enjoy an additional layer of diversification. Mortgage lenders to MUFBs and HMOs tend to lend only to professional landlords, already implying diversification. In addition, HMOs and MUFBs are often rented to multiple unrelated tenants. In the event one tenant was unable to pay rent, others would likely be still paying. Absent any other shock, such as a sudden increase in interest rates, based on our calculations, rental arrears would need to reach on average 50% of properties at a portfolio level before there were would be a significant spike in BTL arrears.

Chart 1

Absence of a dual shock

While COVID-19 was undoubtedly a significant shock to tenants, the introduction of worker support schemes insulated many tenants and landlords from the worst effects. Furthermore, COVID-19 did not represent a dual shock, or worse: tenant capacity to pay was not compromised at the same time as interest rates were rising. Indeed, interest rates for those borrowers on Bank of England base rate- and libor-linked loans would have fallen. This is important, as the BTL market has always, generally, looked for rental income to exceed interest costs. Relatively recent changes in regulation mean that these are often stressed at 5.5% (or the fixed rate if the fixed rate is equal to or greater than five years). Market practice and regulation combine to place the typical minimum DSCR at around 125%

Limits on risks for nondiversified/amateur landlords

Amateur landlords, by virtue of holding only one to three properties, may lack diversification and may have found themselves with non-paying tenants without other properties to subsidize the lack of income. However, in such a situation, the typical requirement that borrowers (landlords) need a minimum level of non-rental income, would have allowed them to use earned income to make up any shortfalls. Assuming borrowers with non-paying tenants maintained employment throughout the pandemic, alongside limited alternatives to spend earned income, they would have been able to subsidize underperforming loans.

Is BTL Immune To Wider Events?

Diversification both in terms of properties and borrowers, the increasingly professional nature of BTL, and generally high debt-servicing ratios have helped those landlords affected by rental arrears to continue to service debt.

However, ultimately, COVID-19 represented a shock to only one risk factor that determines BTL performance: tenant affordability. Other factors, such as the prevailing interest rate environment and house prices, were supportive.

Looking forward, although peak stress for landlords may be argued to be over, the recent prominence of 95% owner-occupied lending may facilitate some renters to become buyers and change the supply-and-demand dynamics for certain properties, therefore making some properties harder to let.

Related Research

• European RMBS Index Report Q2 2021, July 27, 2021
• Green Mortgages And Green RMBS: What Are The Challenges? June 28, 2021
• S&P Global Ratings' U.K. Buy-To-Let Market Primer, June 1, 2021
• 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