Thinking about buy-to-let?
More importantly, can you still make money from it?
I’ve read a lot of personal finance books this year, and I’ve lost count of the number that recommend investing in property. Get yourself a rental property and sit back and watch the pounds rolling in each month (it’s a nice stream of ‘passive income’ i.e. it comes in regularly without a great deal of effort on your part), with the cherry on the icing on the cake being when you sell it for a profit a few years down the line. The big rise in property prices over the past few years has meant that people have made a lot of money from doing just this, and the bonus if you’re looking for results quickly is that it’s possible to do so in a relatively short space of time.
- Worried about your pension pot?
- Savings earning close to nothing because of persistently low interest rates?
- Compound interest not really adding up to much, because you don’t have the required number of years available in which to build up these amazing compound returns?
For me, it’s yes, yes, and yes again.
I realised a few weeks ago that I wanted to be able to retire by 55, which is 13 years from now. This month I started on the path of seeing whether any of the vague money-making ideas in my head might actually be worthy of a second look, and buy-to-let was top of the list.
If you too are part of the slightly-scared mid-life club, and looking for a quick-fix, is property investing the answer to our prayers?
Haves and have-nots
Buy-to-let no longer seems extraordinary. I have friends and colleagues who have done it, maybe they managed to hang onto their first home when moving on, or are thinking of doing it.
Yet at the same time, huge numbers of people can’t get on the property ladder at all. If you read Skint Dad’s recent post he describes exactly how this feels for those trapped renting who want to buy.
Any buy-to-let property I could afford would be exactly the sort of property someone looking to buy their first home would be interested in. Lack of affordable housing is one reason why the government has, rightly so in my opinion, recently introduced changes to the buy-to-let market. So is it still worth considering?
How much do you need?
Is £50,000 enough for example? Should I use my savings as a deposit, should I take equity from my home and borrow more to take advantage of the low interest rates?
First things first, where do you plan to buy? Most lenders ask for a minimum 25% deposit, so if you have £50,000 deposit you’ll be able to afford a £200,000 property. This assumes you have extra cash to pay for stamp duty and other up-front costs. If you don’t, they’ll come out of your £50,000, and the amount you’ll have available for a deposit and therefore can borrow will be less.
If, like me, you find the prospect of buying close to home less daunting (so you can view it and keep tabs on it in person), then are there any suitable properties for £200,000 or less nearby? For me, my local buy-to-let journey stops before it has started! £40,000 to £50,000 is a lot of money in my eyes, but I live in London. One afternoon spent visiting estate agents showed me that there are hardly any properties for this price in the area. Only one 1-bedroom flat in recent times and, more to the point, the market rate for the rent on that flat would not have been enough for a lender to grant me a mortgage.
What is your lender looking for?
Assuming there are actually properties in your price range, you’ll need to show your lender that you can afford the mortgage. Lenders currently look to ensure that there is a 125% rent / repayment ratio, which means the rental income must cover 125% of the mortgage payments.
This is likely to become stricter – more on that below – but if you can’t meet that basic requirement then they probably won’t lend the money. You can try The Mortgage Works ‘rental income required calculator’. You put in the purchase price, and the loan required, and it gives you an idea of what rental income you would need to get from the property.
Why does leverage increase your return?
Assuming you’re not buying your property outright, the reason why using leverage (i.e. borrowing) to do so can be such a good investment is that you are using someone else’s money (the bank’s) to help you make a profit, while your tenant pays your mortgage debt each month. Returns are higher than if you buy a property outright.
For example, if you bought a £100,000 house, and it had increased in value to £110,000 when you sold it, you’d have made a gain of £10,000, which is a return of 10%.
The same house bought with a 25% deposit and 75% mortgage would give you a 40%, not 10%, return. The house has still increased by £10,000, but on your initial investment of just £25,000.
The risk is that the opposite happens if house prices fall. If you bought a house worth £100,000 with cash and it fell in price to £90,000, you’d have lost £10,000 or 10%. The same house with a 25% deposit, 75% mortgage, would mean you’d lost 40% of your initial £25,000 investment.
Both the potential gains and losses are higher if you borrow to buy your investment.
New policy changes
There has been a lot of press coverage of the recent policy changes designed to discourage buy-to-let investing, with many advising it’s uneconomical to jump in. The main changes are:
- An extra 3% on stamp duty was introduced on 1 April for those buying a second property. You can check the stamp duty rates and find a stamp duty calculator on the Knight Frank website. This accounts for the big spike in buy-to-let property purchases just before April to avoid this extra cost.
- 10% of rental income could previously be offset for wear and tear costs, regardless of whether costs were actually incurred. This has now changed, and investors will only be able to deduct costs actually incurred in the upkeep of the property.
- Mortgage interest payments could previously be deducted from rental income, with tax at marginal rate (your highest tax rate) paid on any profit you made. This is being phased out so tax will be paid on rental income NOT your profit. Investors can apply a tax credit of just 20% to their interest payments, even if they pay tax at the higher rate of 40%. There’s also some speculation that this is a move towards a 0% tax credit.
- Proposals are underway for stricter lending criteria to be applied for buy-to-let mortgages. In addition to the 125% rent / repayment ratio I mentioned above, new proposals include checking affordability should interest rates rise to 5.5%, possibly as high as 6.5%, also possibly including personal income.
Can you make a profit?
Which leads me on to the most important part of a buy-to-let search: can you actually make money from it?
Addidi (a financial advice firm) published an excellent newsletter in May called ‘The fall and decline of buy-to-let’. It has a worked example of the impact of the tax changes on profit for a higher rate tax payer buying a £350,000 property. I’ve extracted part of this to show the effect once fully implemented in 4 years’ time:
|Stamp duty (includes extra 3%)||£18,000|
|Fees & costs||£1,000|
|Mortgage arrangement fee||£500|
|Loan interest rate||3.5%|
|Owner's marginal tax rate||40%|
|Profit & loss|
|Gross annual rental income received||£14,000||£14,000|
|Less maintenance costs||-£1,400||-£1,400|
|Net rental income||£12,600||£12,600|
|Profit before tax||£2,800||£2,800|
|Interest relief %||100%||0%|
|Interest not deductible||£0||£9,800|
|Less 20% tax credit||£0||-£1,960|
|Net profit after tax||£1,680||-£280|
I amended the figures for a £100,000 and £200,000 property, 75% mortgage, and discovered I’d make a loss each month! This working is based on a yield of 4% (yield is the annual rent as a % of the purchase price). If the yield went up to 6% I’d make a profit – but that’s unlikely in my local area where the agents told me a good yield is 5%.
It also doesn’t take into account the other expenses involved in buying-to-let. Here’s a long list of initial costs…..at least one month without a tenant, buying the white goods tenants typically expect (fridge freezer, washing machine, oven), possibly a bed, paint to freshen up the place, other unexpected maintenance costs, landlord insurance, gas and electricity safety certificates, service charge and ground rent if buying a flat, managing agent fees. You get the picture. Interest rates could also increase. In my examples, any minimal profit would easily be wiped out.
Buy-to-let is not going to be an easy solution to my pension shortfall! Buying would involve committing thousands of pounds up front, making a loss each month (hardly what I’m looking for!), and a 28% tax on capital gains should the property increase in value when it’s sold. I’ve not discounted the possibility of investing outside of my local area, or of looking at alternative ways of investing in property, but the changes definitely seem to alter the appeal of the sector.
On 6 October, Cherie Blair, on behalf of landlords, is bringing to court a challenge against the tax changes relating to mortgage interest expenses. They may or may not then be allowed to bring a judicial review, so we’ll have to wait and see what happens. I wouldn’t mind though if the changes stay. Housing is a basic need, and I would rather everyone is able to afford to buy a first home, than that people can make a tidy profit on their second or third homes.