Readers will have no doubt been met with weekend press coverage on record residential rent increases by UK landlords, but in fact this trend is certainly not exclusively British. The FT reported on Monday that rents jumped by 12% on average across the UK and that London led the way with a 17% year-on-year rise to an average of £2,332 a month. The popular thing to do, especially with general elections less than 18 months away, is for politicians to point the finger to the other side of the bench and ask for rent controls to “protect” tenants from aggressive landlords. We don’t disagree that consumers need protecting (while at the same time seeing record wage growth), we do have to consider the fact that landlords are facing an increasingly difficult time refinancing in the coming years as their mortgages reach the end of fixed rate terms. We’ve also seen in countries like the Netherlands that government-imposed rent controls have the opposite effect, as the availability of rental homes has dried up following property sales by landlords.
Like every borrowing homeowner, landlords have enjoyed cheap mortgages since the start of QE, and this has likely also had the effect of increasing property valuations more than they would have done otherwise. As a result, capital gains had been the primary motivation for landlords, with rental income only marginally profitable in many cases. The typical Buy-to-Let (BTL) mortgage term is 5 years with a Loan-to-Value ratio (“LTV”) of 60-70%, and an interest coverage in the 1.4 to 1.6x range (and generally higher than the minimum required 1.25x for professionals or Limited Liability Companies (“LLCs”), as they benefit from tax advantages). We are less concerned about valuations here due to the significant equity that borrowers have in their properties, but without rental increases some of the borrowers just won’t be able to pay the higher rates after their 5 year term. Here it is important to make the distinction between amateur and professional landlords; we prefer professionals. This group of landlords will have different fixed rate mortgage maturities, bigger cash reserves and different rent profiles. They are therefore better capable of freeing up liquidity, increasing rents on properties on part of their book to build up a buffer, or selling part of their portfolio to service their mortgages.
Let’s have a look at where we stand and what the risks are.
Moody’s wrote a very good report last week titled “Buy-to-Let RMBS – UK: Rent hikes and equity injections are helping reduce refinancing risk” where they look at all collateral of the deals that they rate and what trends they’re seeing and what needs to happen to allow landlords to comfortably refinance their mortgages. They specifically focus on 2018 and 2019 mortgages, which will come to the end of their initial fixed rate periods in the coming 2 years and, safe to say, that they see these as most at risk (as, in their view, we’re approaching peak rates).
In their report Moody’s note a few things, firstly LTVs are low; house price appreciation has helped to bring the average LTV down to 58.1% for the 2018 and 59.6% for the 2019 mortgage vintages. This means that there’s over 40% of equity in the properties and that’s giving landlords a very large incentive to either pay the higher variable rate or refinance. Secondly they report that performance has remained very stable thus far, they’ve seen a small uptick in early stage arrears, but loss rates and mid and late stage arrears are still close to all-time lows. Compare this to loans extended in 2006 and 2007, LTVs were typically 80-85% and were faced with a sharp 20% correction in house prices in 2009 (and don’t forget that this wasn’t severe enough to cause losses for RMBS bonds).
But more interesting is that they stress test borrowers based on interest coverage (“ICR”) for those that do not refinance but move on to the higher Standard Variable Rates (“SVR”) - this is an analysis they last updated almost a year ago. In Oct 2022 they found that almost 12% would have an ICR below 1.1x if rates increased by 3.5% from their original fixed rate (~3.4% for the 2018 and 2019 originated mortgages). This original analyses was out of date almost immediately after publication, as current SVRs are on average about 7.8%. Based on their updated analyses they see that up to 8% of the total pool of mortgages with fixed rate periods ending in 2023, 2024 and 2025 will struggle to pay the newer and higher rates if they do nothing. Firstly that’s already a big improvement from a year ago, so increasing rents are helping, but also that means that at average LTVs of below 60% there’s limited risk for lenders here, especially as landlords have started deleveraging by making bigger monthly payments or making equity injections to be able to refinance. This is exactly in line with what we’re hearing from the UK BTL lenders and how you would expect borrowers to behave, but it’s good to see the proof of this in the monthly loan tapes.
Is the rent increase persistent? We think so yes, not just because rents “need to increase” for landlords to pay for their mortgages (Moody’s reckon that rents needed to increase by 25% outside of the South East (30%) and London (37%) to comfortably refinance at stressed rates), but also as there will be a considerable number of landlords that will just move on and sell properties to free up their capital, further reducing the stock of rental properties and pushing rents up even further (adding further pressure to already persistently high inflation). Does that mean no landlords will face problems? No, certainly there will be problem cases that need hands on servicing (partial payments, payment plans, voluntary assisted sales, etc) , but our modelling shows that this is generally an equity problem and that rated RMBS bonds are very well protected.
So while record rent increases don’t make for a pretty headline and that more will likely follow, as an investor in (mostly professional) BTL RMBS, we take a great deal of comfort out of the improvements in income, incredibly low LTVs and the proactive nature of this type of borrower. Will they ever cut rents if rates drop? One can only dream!