Deutsche Bank has issued a really interesting (and very chunky) report on the state of the UK’s property market – and London in particular.
Deutsche warns that the London prices could be about to get hammered. And it’s got nothing to do with voting “in” or “out” at the EU referendum. Instead, it’s all about the recent changes to the tax rules surrounding buy-to-let.
So what’s the story?
Chancellor George Osborne has introduced two major tax changes that make buy-to-let far less attractive. There’s the stamp duty surcharge on second homes – that makes it much more expensive to buy a second (or third, or fourth) property to rent out.
And from 2017-2021, tax relief on mortgage interest is being slashed for landlords. So where you could once write off interest charges on a mortgage as a business cost, the relief is far, far less generous.
You can see already that these two factors must logically make buy-to-let less attractive. All else being equal, a landlord’s costs have been driven higher, and there’s no guarantee that rents can be pushed up to compensate (at any given time, rents should be roughly what the market can bear, rather than what the landlord would like the price to be).
Then you have to throw in the fact that rental yields have been driven down to meagre levels. This is not unique to the property market – it’s just another symptom of the frantic hunt for yield that central banks have sparked by keeping interest rates as low as they are.
But, says Deutsche, it does mean that it’s almost impossible for a new buyer to make a profit when you take the new rules into account.
Let’s say the gross rental yield is 3.5%. “A purchaser on an interest-only mortgage faces a net cash yield of 0%-0.5%… this reminds us of the 2006-2007 lending boom where net yields turned negative.”
In other words, unless you believe that property prices will keep soaring (which, let’s not forget, drives rental yields even lower), then you can’t make money off buy-to-let. Essentially, you’re betting on a bubble continuing, rather than making a sensible investment.
As Deutsche puts it: “If the running cash yield on a buy-to-let investment is negative, reliance on expected capital growth can only make the asset class more vulnerable to shocks”.
Landlords are a big source of demand in the London market
So what sort of impact might this have? Firstly, the number of buy-to-let purchases will fall. Even if a landlord is sufficiently green around the gills to think that buying a zero-cashflow property is a good idea, the bank that has to decide whether or not to lend them the money might not agree. So between tighter mortgage rules and less attractive returns, expect deals to fall.
Secondly, the new tax laws will force some landlords to sell up, as massively increased tax bills destroy the economic rationale for owning – “the earnings power of the underlying buy-to-let asset in London no longer supports the repayment of a mortgage in many cases”.
Does this matter? Well actually it does. Deutsche points out that the property market has been particularly illiquid since the days of the crash – “only 3.5% of stock turns over” per year.
Of that, homes bought with buy-to-let mortgages “represent as much as one third of London transactions”. So let’s say that source of demand dries up. You then have a group of squeezed landlords suddenly keen to get rid of their property millstones too. So supply goes up at that end.
So you have a situation where, in a section of the market that accounts for a significant chunk of all annual transactions, the number of buyers is falling and the number of sellers is going up. As a result, “buy-to-let potentially swings from a low turn segment to a material source of supply”.
This could “create a major shock to the market due to a significant decline in London buy-to-let demand, some selling… and incrementally more housing supply”.
To cut a long story short, while Deutsche Bank believes that the fundamentals of London property are good in the long run – global city, wealthy inhabitants, rising population, yada yada, you know the drill – right now, it’s ridiculously unaffordable, and due a big correction.
“If prices return to around 2012/13 affordability levels this would imply about 20% pricing downside.”
Now, we’ve heard predictions for lower property prices many times in the past, but this argument doesn’t depend on any change in interest rates. Indeed, Deutsche Bank notes that rising rates would make any fall in prices a lot bigger – a one percentage point rise in rates would correspond to another 10% drop in property prices, roughly.
Nor does it take account of the potential for rent control in London, as suggested by Sadiq Khan, the new mayor.
Instead, it’s all predicated on tax laws that are already in place. And it’s just a matter of time until landlords wake up to the implications and start to sell out.
This is good news for first-time buyers of course. Indeed, that was the point of Osborne’s changes. Will it have a knock-on effect elsewhere in the country?
As I wrote in a recent issue of MoneyWeek, house prices elsewhere in the UK are expensive by historic standards. But London is staggeringly so. So maybe the impact won’t be quite as great.
There again, once landlords generally get the sense that their asset class of choice is not such a great business plan – well, who knows how the sentiment will affect things?
Markets tend to overshoot both on the way up and on the way down. A muted or crashing London market certainly will make most people think twice before embarking on a career as an amateur landlord.