Ahead of the Chancellor’s Budget set to be published on March 16, there is a lot of speculation that he may announce other measures to cool down the buy-to-let property market. I don’t think he will need to: the market will cool down pretty rapidly once the regulatory changes that are coming for banks are understood by buyers. Admittedly, that will take a while. This article is for those who want to stay ahead of the game.
First, let’s get the “known knowns” out of the way: the additional stamp duty tax coming into force for buyers of a second property from April, the gradual removal of tax relief for interest rates on buy-to-let loans and the requirement that landlords present proof of repairs carried out in order to qualify for tax relief for wear and tear, rather than automatically being able to deduct 10% of the rent no matter if they carried out the repairs or not.
Despite those announced measures, enthusiasm for buy-to-let – seen as a “pension” for such a long time that it has now become almost an obligatory investment for the middle class — did not die down.
On the contrary, many future “landlords” rushed to buy properties before the 3% stamp duty surcharge takes effect in April. There were reports of a stampede of buyers before this deadline.
If these people had read the Bank for International Settlement’s website, they would not have rushed to buy – if anything, they would have rushed to sell any buy-to-let properties they already own.
The common reason given for the increases in house prices is “supply and demand” – there are so many people willing to buy a home, and so few houses due to planning restrictions and other obstacles, that there is huge demand and therefore prices are set to rise and rise. Add to this the foreign and domestic investors and the pressure just means the only way for property prices is up.
That’s the pretty, easy-to-follow argument. There is another explanation offered for the big rise in house prices, but because it is too technical, it has mainly been confined to specialised blogs, such as Julien Noizet’s “Spontaneous Finance”. He aptly explains in this article from 2013 how risk weights imposed under the Basel II regulatory system for banks have distorted lending and created real estate price bubbles.
How new Basel rules will change buy-to-let
The Basel system assigns various risk weights to various loans that commercial banks make, and until now it has been doing so in a standardised way.
Mortgages have a risk weight of 35% — in other words, only 35% of a bank’s mortgage loan portfolio is taken into account when calculating assets against which it must keep capital – whereas loans to small and medium sized enterprises have a risk weight of 100%.
Naturally, then, banks will prefer to lend money to those purchasing houses than to those developing a business. These regulations have been a big part of the reason why property prices keep going up despite lack of investment by businesses and stagnant salaries.
This is what the Basel III regulations will change. Proposals to review the approach to credit risk published on the BIS website show that the BIS is now thinking of assigning different weights to different types of mortgages, to reflect their different degrees of risk (as it would have been normal all along).
For buy-to-let buyers in the UK, this could turn out to be a big problem. The risk will be higher the smaller the deposit they contribute, but also the more the repayment of the loan depends on the cash flows generated by the property.
The proposals also set stringent criteria regarding the valuation of the property by the lenders: “To ensure that the value of the property is appraised in a prudently conservative manner, this value must exclude expectations on price increases and must be adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan.”
In other words, when valuing a property to lend against, banks will often value it at a much lower price than the one it is advertised at and will not take into account any estimates of future house price inflation. In London especially, where property prices have been increasing at double-digit annual rates, that is set to put a brake on the pace of growth, to put it mildly.
In addition under the new proposals, a regular, owner-occupier mortgage where the borrower puts up less than 20% of the value of the loan as a deposit would be risk-weighted at 45% compared with the current 35%. For a buy-to-let property — that is, when the repayment of the mortgage “materially depends on the cash flows generated by the property” – with a similar deposit, that risk weighting jumps to 120%.
This will force banks to reduce their risk exposure to these types of loans, tightening access and increasing interest rates to compensate for the additional costs. Of course, this is just a project by the BIS, for which the deadline to submit observations just expired last Friday. Nevertheless, it clearly is a sign of things to come for the buy-to-let market. It’s time for landlords to think of alternative pensions.