Making sense of the new buy-to-let landscape
If you are a landlord you have probably been feeling a little hard done-by of late. Sweeping changes to tax relief, to be phased in from April 2017, and the introduction on 1 April of a 3 per cent stamp duty surcharge on investment properties and second homes have made the buy-to-let business an uncomfortable place to be in recent months.
According to the National Landlords Association, buy-to-let investors plan to sell more than 500,000 properties over the next 12 months as a result of the former chancellor's plans. This raises the question: is this the end for residential property as an investment proposition?
'There's no denying that government changes have made buy to let less profitable for many landlords,' says Ying Tan, property investor and managing director at brokerage The Buy to Let Business.
PLENTY OF POTENTIAL IN BUY TO LET
'However, despite the challenges, there is still plenty of potential in the market, because tenant demand is high. The rental market is still incredibly buoyant.'
A report released by estate agent Savills earlier this year estimates that one million new homes will be needed in the private rented sector over the next five years.
Contrary to popular belief, adds Ying, such buoyancy is not entirely a result of would-be homeowners being forced into the rental market as they struggle to buy a property.
'The mortgage market has slowed down somewhat of late, largely as a result of changes to regulation and, of course, the uncertainty caused by the EU referendum result. But even when people start buying properties again, there will still be huge demand for rental properties,' he says.
'The fact that some people actively choose to rent is often ignored. They're not forced into it because they can't buy a house.
'They like the flexibility it affords them and the benefits they can enjoy with renting that they might have to sacrifice should they buy, such as being able to live in prime locations.'
But while potential still exists for buy to let, market changes have forced investors to be more diligent in their approach to property investment. What was once seen as a relatively fuss-free investment now needs more effort.
'Potential investors should consider buy to let as a business rather than a "buy and forget" investment,' says Danny Cox, chartered financial planner at Hargreaves Lansdown.
'Running such a business successfully requires time, effort and expense. Included in their business plans should be the additional tax costs of buying and the erosion of tax relief on mortgage interest over the next few years. If the sums don't add up, it's not a good idea.
'Importantly, investors need to plan ahead for whatever the end game is going to be.
'When a second property is sold, capital gains tax is due on the growth in value of the property at 28 per cent for higher-rate taxpayers, and this cost is on top of the time and expense of estate agents, solicitors' fees and energy reports.'
LOCATION IS KEY
Location, always a key consideration in any property purchase, is now more important than ever, particularly for investors using mortgage finance to buy a property.
That's because in recent months, lenders have reacted to the tax relief changes and stamp duty hikes by increasing their rental coverage requirements. In short, investors need to be able to secure much higher rental income relative to the cost of the mortgage.
For many property investors, however, buy to let is about capital appreciation rather than yield, particularly in London and the south east. Many buyers purchase rental properties as a long-term supplement to their pension funds.
However, even if the property is bought as part of a capital growth strategy, rather than a means of producing an income now, the changing lender requirements mean that new investors will need to pay close attention to yields.
Buyers reliant on significant mortgage loans should look to buy in areas with low prices and high yields, so properties in the north of the UK are attractive at the moment. Lower-yielding areas are less appealing.
Rob Bence, founder of property investment specialist RMP Properties, says: 'If you're investing in northern towns and cities, which are more attractive for property investment at the moment, you can expect a net return on your investment of 6-10 per cent (excluding capital growth), which, even after the changes in tax are rolled out, is still very attractive and higher than returns from most other traditional investment asset classes.'
However, independent property expert Henry Pryor says investors need to recognise the risks involved in investing in these areas, particularly in the wake of the UK's decision to exit the EU.
'It's important to understand that the yield you receive is recognition of the risk you take,' explains Pryor. 'If you invest in spaceflight, you'll receive a much better yield because it's deemed a riskier investment than investing in an oil company or cigarette manufacturer.
'The higher yields available in Manchester or Liverpool reflect the fact that investors feel they are taking a bigger risk. Should the economy turn, the north west is likely to be hit harder than the south east.'
Pryor says the risk in investing in the north has grown as a result of the Brexit vote. 'No amount of HS2 (the proposed high-speed rail service) or talk of a northern powerhouse will negate that,' he says.
For investors seeking an income from their investment, residential property may not be the best option.
Kate Faulkner, managing director and property analyst at independent property advice site propertychecklists.co.uk, says that unless you're a cash buyer or the property is specialist, for example a multiple-occupancy house (which comes with its own set of rules and requirements), residential property shouldn't be thought of as an income producer.
The purpose of the rental payments is to cover the mortgage, with capital growth the primary objective.
'Commercial property has always been a better income earner, but with the changes on the high street with the technology revolution, it's a risk,' she says.
'However, because you don't have to pay the 3 per cent extra stamp duty on mixed-use properties, a combined commercial/residential investment might offer a useful balance, depending on whether you own the freehold or not.'
Simon Collins, product technical manager at brokerage John Charcol, agrees that yield should not be the principal focus, at least for younger investors.
'When you're buying an investment property, the first priority is the potential for capital appreciation. Many borrowers may have sufficient income to not be worried about the lower yield,' he says.
DOES BUY TO LET MAKE SENSE FOR YOU?
Buy to let is still a sound option for some investors
Cash buyers can avoid the mortgage interest relief pitfall and the need to meet higher rental coverage requirements, so they may still find buy-to-let investing attractive.
If you own property through a limited company - or special purpose vehicle - you can avoid paying income tax by instead paying corporation tax (at 18 per cent, or 28 per cent for higher-rate taxpayers).
Furthermore, you can offset costs against the rental income you make, which makes buy to let lucrative.
Bear in mind, however, that setting up a company involves costs, including accountant's fees and administration costs.
Also mortgages for limited companies can cost more than mortgages for individuals. If you've only got one or two properties, you'll need to weigh up whether setting up a company is worth the cost.
For parents who are less interested in making big profits than finding a safe home for their money while helping their children (by providing inexpensive student accommodation for them or an affordable rental property while they save for a mortgage), buy to let will always be appealing.
THE TAX RELIEF CUTS EXPLAINED
At the moment, landlords can claim tax relief on their mortgage interest payments at their marginal rate of tax.
However, under new plans introduced by former chancellor George Osborne in his 2015 summer Budget, tax relief will be cut to a marginal rate of 20 per cent and landlords will have to pay tax on their rental income before costs (mortgage interest) have been subtracted.
The new system is being phased in from 2017. By 2020, when the rules are fully in place, some landlords will face dire consequences.
A landlord has a loan of £150,000 at 5 per cent and brings in £1,000 a month in rent. Annual income is £12,000, of which £7,500 is spent on mortgage payments and £4,500 is profit.
Under the current rules, since the mortgage cost attracts full tax relief, 40 per cent income tax only applies to the £4,500 profit - an income tax bill of £1,800. After tax, that leaves the landlord with £2,700 net profit for the year.
Under the new rules, in 2020, the entire £12,000 income will be taxable, but there's relief of up to 20 per cent for the mortgage.
So there's a full liability of 40 per cent on £12,000 (£4,800), but the landlord can claim 20 per cent relief on the £7,500 spent on the mortgage (£1,500), cutting the tax bill to £3,300. So from that £4,500 profit the landlord now gets just £1,200 after tax.
'The fact that the full income is taxable means people may be pushed into a higher tax band,' says Peter Gettins, product manager at London & Country.
'Under the current rules, only the profit is considered for tax purposes. So a basic-rate taxpayer earning a £35,000 salary plus that £4,500 of profit would have £39,500 of taxable income.
'With the new rules, that landlord with a £35,000 salary would also have the full £12,000 of rental income counted: a total taxable income of £47,000, which would push them into the higher-rate tax band.'