The Future for Buy to Let is not so Sweet

CEO at Partridge Muir & Warren, Simon Lewis, weighs up the financial cost of forthcoming changes to the financial dynamics of buy to let investment and concludes that the future is not so sweet.

It doesn’t matter whether you have been naughty or nice, if you are (or are thinking of becoming) a buy to let investor there are some unwelcome surprises for you on the horizon.

Buy to let investors have enjoyed relatively bountiful returns over the last 7 years but the tailwinds of slow supply growth, cheap borrowing, and quantitative easing induced asset price inflation are unlikely to prevail for much longer. In fact, the Chancellor has already set his sights on more readily harvesting some of the profits accrued by such investors, the least contentious of which is a new requirement (from April 2019) for capital gains tax liabilities to be settled within 30 days of sale compared to the current grace period of up to 20 months. This new mechanism will help to reduce tax evasion as well as improve the Treasury’s cash flow. It will also apply to second homes.

However, the big changes to come relate to the impact of stamp duty land tax (SDLT) on the cost of purchase and the way that income tax is assessed on rental income. You might need a stiff drink before you read on.

November’s Autumn Statement announced a 3% SDLT surcharge for buy to let and second homes, to apply from April 2016. According to Rightmove, the average price of a terraced house in Surrey is £450,000. SDLT of £12,500 would currently be paid on its purchase.  However, this will increase to £22,250 from April and the extra £9,750 represents an increase of 78% in the tax paid.

New rules that will fundamentally change the way that tax relief is granted to buy to let mortgage interest payments will be phased in over 3 years from April 2017. Interest payments will no longer be deducted from rental income to determine taxable profit. Instead, a separate relief will be calculated by reference to basic rate income tax on the interest payments.

Because the effect of the new rules will restrict tax relief to the basic rate of income tax, you might conclude that they will not affect basic rate taxpayers. This is not the case. To illustrate the point, consider Wealthy Elf, who has established a portfolio of residential properties that generate income of £120,000 per annum net of expenses but before interest costs. He pays interest of £80,000 per annum on the associated buy to let mortgages. His taxable profit is therefore £40,000. After deduction of his personal allowance, he will pay tax of £5,880 (all at the basic rate).

If the new rules were now in effect, ‘not so’ Wealthy Elf would have a tax liability of £41,400 on income of £120,000. A basic rate tax reduction on the mortgage interest (£80,000 @20% = £16,000) would reduce the income tax payable to £25,400. His income tax bill has more than quadrupled and even Santa cannot make things better.

It is not only the Chancellor that appears to be taking a dim view of buy to let. In its December 2015 Financial Stability Report the Bank of England commented that since 2008, the aggregate value of residential property mortgages held by owner occupiers had increased by only 0.3% per annum on average. By comparison, the aggregate value of residential property mortgages held by buy to let investors has increased at an average of 5.9% per annum and more recently, the rate has increased to 10% per annum. In other words, much of the new lending from banks is to property investors rather than traditional homebuyers.

The Bank comments that credit losses (defaults) are running at roughly twice the rate of loans to owner occupiers and ominously concludes that there may be implications for financial stability. Such considerations are a likely precursor to intervention. The Bank’s Financial Policy Committee (FPC) has been weighing up whether to utilise macro prudential tools, for example by requiring retail banks to hold ever greater reserves against such defaults. This would discourage demand for further lending of this type by effectively increasing the interest rate differential charged by lenders.

Finally, it seems most likely that the US Federal Reserve will increase interest rates in December 2015 and assuming that they do, the UK base rate is likely to follow within 12 months or so. The cost of borrowing is therefore set to rise.

These headwinds will easily dissipate the current rental yield of about 3.5% on properties in the South East. Buy to let investors might well be saved by capital appreciation but this is by no means certain and of course, is not liquid. Increased rates of SDLT will also act to discourage portfolio turnover.

It probably makes sense to avoid highly leveraged situations at the moment although unleveraged property investment continues to have some attraction as part of a strategy of wealth diversification. Do bear in mind that property is no longer a one way bet – like pulling a Christmas cracker, you can never be sure what surprise is in store….