Financing Your Property Business
Please note: this is a landlord/developer’s perspective, you should always seek professional advice on financial matters.
Whether you’re a seasoned landlord or an enthusiastic newbie looking to learn the ropes, financing property has transformed over the past few years. The financial crash of 2008 saw lending tighten and mortgage rates rose considerably. The 85% LTV buy to let mortgage was largely replaced by the 75% LTV mortgage, but by 2012 mortgage rates were starting to become competitive again. The government’s response to the crash was to tighten regulation and deter landlords by introducing punitive tax measures.
The 2014 mortgage market review made getting a residential loan on the home where you live much stricter. In particular we saw detailed affordability assessments, restrictions on interest only lending and the death of self certification mortgages that had been so useful for self employed applicants. in 2015, the then Chancellor George Osborne announced that landlords would be taxed on their turnover rather than on their profit. Furthermore, after a 4 year transition period landlords would only be able to claim tax relief against their finance expenses at the basic tax rate of 20% even if they actually paid tax at the higher rates of 40% and 45%. In 2016, he introduced the additional 3% stamp duty that investors now have to pay on purchases. The Bank of England then introduced minimum stress testing for buy to let mortgages in 2017 and later that year an additional set of criteria for ‘portfolio landlords.’ It is crucial to understand these before investing in property.
The minimum stress test has been set at 125% x 5.5%. Imagine you want to borrow £100,000 at 2%, your monthly interest only payment would be £167. The stress test means that the rent must cover 125% of the monthly mortgage payment as if the mortgage were at 5.5%. That works out at £573. Imagine the property you were purchasing will only rent for £500. You will only be able to borrow £87,000, potentially scuppering your investment plans. There are further complications – the Bank of England said that lenders must take account of the borrower’s tax circumstances so many apply a stress test of 145% x 5.5% for higher and additional rate tax payers, which would mean they could only borrow £75,000 for the above scenario.
The stress test can be relaxed for remortgages where there is no additional capital raising beyond just replacing the existing mortgage, lenders often apply 5% instead of 5.5% in these cases. The greatest amount of flexibility is reserved for 5 year fixes where the lender can apply 125% x payrate, which is the actual rate that you will pay for the loan, in this case 2%. That would allow you to borrow the full £100,000. But many lenders stress test 5 year fixes at or around 4.5% instead of the payrate. This has led specialist lenders to offer more expensive 5 year fixes for example at 3.39%, but they do stress test at the actual payrate. For most people this is really complicated and confusing and it’s why we are increasingly turning to brokers for help. If you do, make sure they specialise in the buy to let market.
The Bank of England has also stipulated that borrowers with four properties or more must be assessed as portfolio landlords. So if you have three properties and you are looking to get a mortgage for a fourth, you will be assessed as a portfolio landlord. That usually means that a stress test will be applied to the whole of your portfolio. These vary greatly. For Leek United it’s a punitive 140% x 5.5% across your whole portfolio, whilst for TMW it’s 145% x 4.5% as long as you have no more than ten properties. Some lenders are also offering more expensive products to portfolio landlords or ‘larger landlords’ with 10 properties or more. You may also be asked to provide a brief business plan and more details on your assets and liabilities. Most lenders provide proformas for this and a good broker should quickly be able to tell you whether you will fall within or outside the portfolio stress test criteria of each lender.
I want to flag up some criteria niggles that you need to be aware of, as again they could scupper your investment plans. Most lenders will not lend on a property that has been owned by the vendor for less than 6 months and you won’t get a remortgage on a property unless you have owned it for 6 months. Buying a property from a vendor and then renting it back to them has been outlawed. There are often particular criteria about private purchases from friends, family and contacts and any discounts that you might get. The lender will want evidence that your deposit has come from a legitimate source that is acceptable to them. Many buy to let lenders will require you to have a minimum of £25,000 income from sources other than rent. Very few will accept first time landlords who do not already own a property. Many lenders apply a cap (or maximum aggregate lending) to the number of properties that you own in total and/or the number of properties that they have lent money to you on. There are often restrictions on the type of tenants. Very few will allow tenants on benefits, some only accept 12 month tenancy agreements and many allow a maximum of 4 people on one contract. There can be restrictions on the number of properties you can own in a particular postcode or building. Generally owning more than one property within the same building, buying properties over commercial units and letting to bedsit style HMOs will require specialist lending and advice from a broker.
Landlords also have the added complication of deciding whether to buy personally or through a limited company. Limited companies can set aside all of their finance costs against their rental profits and lenders will typically apply a 125% x 5.5% stress test as the limited company will pay the corporation tax rate of 19%. That means you might be able to borrow more. But limited company mortgage rates are higher so you will need to decide whether the savings on tax outweigh the extra mortgage costs. Don’t buy a property in a limited company if you think you will ever live in it as you will be lumbered with an additional tax burden known as ATED (You must change your mortgage from buy to let to residential if you intend to move into an investment property). Remember that if you wish to withdraw rental profits you will need to pay dividend tax. Limited companies are useful if you intend to save up the rental profits to use as a deposit for the next purchase. You therefore won’t need to withdraw the profits and won’t pay dividend tax, the company will use the profits to buy its next property.
There are four types of lender, although boundaries between them is becoming increasingly blurred. The vanilla or mainstream buy to let lender will typically lend at highly competitive rates on properties that are ready to let, but will not entertain HMOs or multiple units. If you want your business to be profitable, these are probably the lenders to aim for. They tend to be building societies and high street banks.
The second type of lender is the specialist lender. Kent Reliance and Paragon are long standing examples. Precise, Landbay, SBI, Aldermore and Shawbrook are examples of new entrants. They will typically charge higher rates and arrangement fees but will have much more flexible criteria. Most will have a product range for HMOs, multiple units and limited companies.
The third type of lender is the Commercial lender – often high street banks. In the past they would lend for refurbishment and commercial purchases and they would also lend across a landlords whole portfolio or provide second charge lending. As many retreated from this business after the 2008 crash, many of the new specialist lenders have moved into their territory.
The fourth type of lender is the short term lender – previously known as bridging or auction finance. They will typically lend at or just below 1% per month and tend to be a lender of last resort where a property requires major works. Again specialist lenders have also moved into this territory, providing refurbishment buy to let loans which start out as short term and then transition onto long term buy to let terms. Specialist lenders will also allow top slicing of your earned income to cover a rental shortfall. Precise is the obvious example for all of these options, they are fast and flexible, but you will pay for the privilege.
A quick look at mortgage rates across the four segments in August 2019. The mainstream vanilla segment has mortgage rates starting at 1.44% with a £1995 fee for a 2 year tracker at 65% LTV. 75% LTV rates begin at around 1.94% with a £1995 fee. HMO mortgages start at 2.84% with a 2% fee and limited companies loans at 2.84% with a £1995 fee. Most of the cheapest rates are with the Mortgageworks, but be aware that their switch rates after your 2 year fix are really mediocre. Specialist lenders tend to offer products well over 3%, the cheapest is SBI but they are fussy and notoriously leisurely in their processing. Expect fees of 1-2% from most specialist lenders. Commercial lenders will often start at Libor plus 3.25% with a 1% or 1.5% fee. My favorite short term lender is Commercial Acceptances as they don’t charge arrangement or exit fees, making them more competitive overall.
Managing your credit file is an important consideration. Lenders will either do a credit search that just looks for adverse credit – that is missed payments or use complex credit scoring schemes. Credit scores will be carried out automatically when the lender produces a decision in principle known as a DIP. You may need a higher score for higher LTV products. Note the difference between quotation and application searches on your credit file. An application search will be made when you make your application. You need to have as few of these as possible in any six month period. This is because application searches are shown to other lenders who will assume you are making lots of applications for credit and therefore are a higher risk. Quotation searches, sometimes called soft footprints, are not seen by other lenders. I recommended having a discussion with your lender about the type of search they will make and managing this carefully. I recently asked a lender not to carry out a credit search until the valuation had been carried out. Sure enough the valuer gave too low a figure for me to want to proceed so I withdrew my application without having suffered an application search on my credit file.
Other factors that will affect your score: common ones are a discrepancy with your electoral role information or your financial connections with other people. Note that having 0% balance transfers on credit cards can lower your credit sore. Imagine the credit limits on all of your credit cards total £20,000 and you have a 0% balance of £10,000 on one credit card. The lender will assume that because you are using 50% of your available unsecured credit, you are credit hungry and therefore a higher risk. The fact that you may be wisely parking a small amount of debt at 0% does not compute I’m afraid! It’s a very flawed system because lenders encourage us to use debt and then when we do so we are automatically seen as a higher risk. The moral of this tale is that it is always best to hold debt as secured borrowing – i.e. in mortgages.
If you are starting out as a landlord, your main challenge will be getting at least a 25% deposit. This may be easier if you already own a property as you may be able to raise capital by remortgaging your home. You will be able to raise up to 4 and sometimes 5 times your sole income – different multiples apply if you are a couple – and the lender will carry out an affordability assessment of your overall income and expenditure and check your credit file. Let’s imagine your home is worth £300,000 and you have a mortgage of £100,000. If your salary is £50,000 you might be able to increase your mortgage to £200,000, that will give you £100,000 as a deposit on a buy to let property worth £400,000. If your income does not fulfil your home lender’s criteria, you may be able to get a second charge loan from another, usually specialist lender. They could lend you funds secured on your home through a second charge – the original mortgage is the first charge. The rate will typically be higher than a regular mortgage but if you can generate enough cash for a deposit and to kick start your business, it could be worth it. Check the allowable purposes for capital raising as some lenders are quite specific about what they do and don’t allow.
In recent years, some people have set up ‘rent to rent’ businesses. This is where they rent a house from a landlord – perhaps with 3 beds and 2 receptions and then they rent out all of the rooms individually. If you do this you will need the permission of the landlord and to comply with all relevant legislation including HMO regulations and possible local authority licensing. Some local authorities prevent the creation of shared accommodation like this through Article 4 planning directions. In effect you are acting as a letting agent, you can save up your rental profits and build up enough capital to use as a deposit on your own buy to let purchase.
Joint ventures are another option if you don’t have enough cash for a deposit. This is where a third party – perhaps a friend or family member – loans you money. You can either pay them interest, or a percentage of profits on the rent, or on the value of the property when you sell it. Make sure you have a written agreement. You would expect to pay an interest rate commensurate with the level of risk, between 6 and 10% are typical rates. You can get 85% loan to value mortgages at high interest rates and this might be more cost effective than a joint venture, as long as you can meet the stress test. One option would be to get a cheaper 75% loan and fund the remaining 10% through a personal loan or a joint venture. Be aware that you will need to declare the source of the deposit to the lender and comply with their criteria.
If you are already a landlord and are hoping to add to your portfolio then you may have more options. You may have bought wisely and are sitting on healthy capital growth from the past decade or added value to your properties to create equity – which you can now take out through capital raising. It is also important to ensure strong cashflow when building your portfolio – if your rental income only just covers your mortgage payment, you will have little room for manoeuvre.
The classic model for expanding your portfolio is to capital raise on existing properties. This will give you funds to use as a deposit to buy further properties – just like the example I gave earlier. Be aware that you will probably have to look to specialist lenders and five year fixes now to raise any substantial sums. Another way to build up funds for a deposit is to save surplus rental profits, perhaps into an ISA. When building your portfolio, you should always maintain a balance between cashflow and capital growth. Ideally the properties you buy will give you both, but you might decide to use up capital as a deposit to buy a commercial development, for example, where the rent is much higher than the mortgage payment. You may not be able to add value to the property but the extra cashflow it provides means that you are cushioned against void periods on other properties or can supplement your income and spend more time on developing your property business.
© 2019 Richard Blanco