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Buy To Let Investments – Not As Safe As Houses

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Tuesday 28th August 2012

Buy to let investors in the UK are setting themselves up for a fall if they continue to purchase overpriced properties.

If you imagine all the housing market as a sea and everybody involved in the property chain was a different life form.

Plankton, a minute microorganism without which the other higher life forms wouldn’t survive, in this case would be a first time buyer. Perhaps a young married couple who want to own their own home but have little capital to actually realise their dream.

When this is the case, the plankton disappears, they die or in this case they are no longer part of the housing ladder. And as property value is all based on supply and demand, the rise in property price would ease because unless the current homeowner has someone o sell his house to, he won’t be able to afford the house and this would have a knock on affect all way up the property ladder, even affecting the owners of the most expensive homes, or the sharks.

At the minute first time buyers aren’t doing well. Despite the rush to beat the stamp duty holiday creating a bit of a rush at the beginning of the year, they have now been priced out of the market.

They need big deposits to access the mortgages, but they can’t save them because their income is already strained as it is and if they do access the 95% mortgages, the rates are enough to put them off.

So if the first time buyers are no longer feeding the housing market, who is? That role is currently being fulfilled  by the private rental sector. As mentioned previously , prices are formulated based on supply and demand. In the 1990s high interest rates led to repossessions and this led to a flood of houses being brought on to the market, which pushed prices down.

As it stands, the private rental market is playing a major part in both the supply and demand of houses.

Firstly, we have the frustrated first time buyers who are being forced to rent which are pushing rental bills higher.

More and more people are in search of higher investment returns than just having their cash in the bank so the demand for buy to let properties is constantly increasing.

However, house prices are unlikely to rise anytime soon because of the lack of first time buyers (or plankton) and those investors looking for capital growth could be in for an unhappy time So investment demand could start to fall.

And it would seem that the majority of people are going in to property investment with an overly optimistic state of mind. A recent survey from Zoopla state that 65% of people believe that house prices are going to rise in the next six months.

Despite the fact that house prices and asking prices are falling in both nominal and real terms; that the economy is in tatters with and the IMF has just cut our growth forecast for the year to 0.2%; that the mortgage market is as tight as ever and that estate agents are reporting two sellers for every buyer. It wouldn’t be a stretch to say that these people are being overly optimistic.

Property investors may derive hope from the fact that more people are looking to rent but actually having the money to pay the rent is a different thing entirely.

The ARLA showed that 41.2% of its members saw a rising number of tenants struggling to meet their rental payments during the six months to March 2012.

Templeton LPA has said that 9% of all rents were in arrears.

If people aren’t paying the rent then it becomes a lot harder for their landlord to pay the mortgage. As we have seen, mortgage rates are going up and it may be the case that buy to let mortgage rates rise. This will make it even tougher for buy to let landlords to pay their mortgage costs which has two consequences. It will increase supply of rental properties being put on the market by struggling landlords but it will also lower the demand from buy to let investors.

This will obviously lead to prices plummeting, thousands of people in negative equity and all out market crash.

There is a solution to this. Firstly investors need to start purchasing within their means. Using the cash they have available and not trying to be greedy and overgear the property, because when those property prices fall. It those who have over geared who are in trouble. Part of this responsibility has to come down to the lenders.

For the past four decades, cheap credit has been the catalyst for property booms. In the early 1970s, when direct controls on lending were removed prices rose by 50% in 1973. In the years leading up to the financial crisis of 2007, borrowers could secure loans at high multiples of their income with few questions asked.

It’s now gone the other way, and lenders are cautious about who they lend to. Which is a good thing for cash investors.

But the most important thing in sorting out the stability of the property market is the need for buy-to-let investors to pay the right price for the property in the first place, they would protect their investment, they’ll generate higher yields and ultimately it will ensure the stability of the entire market.

In the last quarter of 2011, 5.6% of borrowers were in negative equity. In other words, the loans on their homes were worth more than the properties themselves. That’s deteriorated since the second quarter of 2010, when only 3.6% of homes were in negative equity.

The figure is far worse in the north of England, where 8.5% - not far off one in ten – homeowners is in negative equity.

But if people paid the right price for the property in the first place, they wouldn’t be in negative equity.

So how do you ascertain the true value of a property?

A lot of investors simply rely on the price given to them by the developer. But developers can overcharge, they over-design buildings in a bit to win awards and they are forced to overcharge for the buildings simply to break even.

Some savvier investors may base their investments on a search on one of the many internet property portals to find the property price.

The more experienced might also use sites like Property Beeto see how properties have been amended, re-listed, re-valued since their original posting. Some may look at MousePrice to see what price similar properties have sold for in the area.

However, these sites only give us the values that the vendors and the estate agents think that the property is worth. This isn’t reliable as the vendor clearly wants to obtain the maximum price, a strategy supported by the agent who normally works on a commission basis.

There is only one way for investors to ascertain a property’s value which is truly safe and that is to find a properties residual value. The residual value is based on the amount of net rental income it can generate – anything above 6% looks like a good investment.

For example, if a property brings in £6,000 rent per year after all costs have been taken in to account, that £6,000, based on a 6% net yield would give the property a value of £100,000.

That £100,000 would be the Residual Value of the property and it should be the focus for every investor going in to a deal. But at the minute investors ignore the residual and rely purely on the capital growth of a property which we’ve mentioned previously, is hopelessly optimistic.

Despite the residual value of a property being £100,000. The investor may pay £150,000 believing that the value of the property will increase and they can sell it for £200,000. But then if property prices start to fall slightly, he’s suddenly in negative equity and then the only price someone would be willing to pay for the property is the Residual Value and the investor will have lost £50,000.

The key to real successful  and safe investment is how you derive the 6% net yield which you have used to establish the property’s residual property.  By working out the 6% net yield using below market value rent it means that the investor will not have to contend with tenants struggling to pay rent. As rent continues to rise, there will always be a demand for properties charging below market value rent. First time buyers will be queuing round the block to save a £100 per month, yet the investor is still left with a 6% net yield because they have bought the property at residual value.

It also means that there will always be savvy investors looking to purchase a property residual value because they are not only purchasing a strong income stream, but they are purchasing a property at a price that will not be affected by market fluctuations or crashes.

The UK are going to have the dangling sword of overpriced properties over their heads for some time to come. It won’t be sorted over night, the Bank of England can't raise interest rates for fear of crippling the consumer and therefore the banking sector, by sparking another slide in house prices. But if inflation is to bring house prices back in line with earnings quickly, then wages have to start rising more rapidly than they are now. But if that happens, then the Bank will have no choice but to raise rates. And that in turn will hit house prices.

The sword will fall and it will burst the property bubble. The investors who have invested in residual value will be protected from the fall in house prices and when houses start to get repossessed and more people are forced in to the rental market, then their yields will go up even though they are still charging below market rent.

In the end, everybody will be relying on residual property valuations. It’s inevitably the future but there’s no reason why investors can’t take advantage of them now.

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Editorial Contact Details - Conor Shilling
0845 672 6000
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