So – welcome to the supplement, and an eventful week in the macro markets, and the stock market (and in some speculative markets too – it hasn’t been that nifty for the NFTs, if you missed the headlines). There’s a few things I want to consider today, with a bit of a walk down “economic memory lane”, followed by some tactical moves that I believe landlords and investors generally should be considering at this time.
The media has gone mad, as they do in these situations or whenever they get half a chance, about the report from the Bank of England monetary policy meeting this month. Every other meeting involves a refresh of the monetary policy committee report, and this was one of those. You’d have to be under a rock to know that the base rate hasn’t moved to 1%, its highest rate in 13 years (since March 2009). You might also note that in the 315 years before that, the Bank has set the base rate, since 1694, the rate has never been anywhere near as low as 1%. As always, context is so important.
If 1% base is putting anyone in trouble, they were in trouble anyway. But it does bring some interesting pressures onto the table. Firstly, I would like to be clear that the direction of travel is of much more concern than the actual rate itself. The markets consider 2.5% to be the likely base rate by the middle of 2023, just over 12 months away – i.e. 6 more rate hikes in that time. The Bank are clever in these situations – what they do is they say “well, the market is a better forecaster of all of these things than anyone else, in the long run” – and then they model unemployment, inflation, and GDP growth (amongst other metrics) based on what the market is saying.
Their forecast then shows that GDP will lose 0.25% in 2023. This may or may not be a technical recession, if this is to happen. The technical definition being, remember, two consecutive quarters of negative growth. Either way, this is a very fragile situation, according to the bank’s modellers.
You also have the remainder of what I’ve affectionately called the zombie landlords over the years. Mortgages taken out with 20 and 25 year terms in 2003-2007. They are on tracker rates, usually at around 1% to 2.5% above base. Since their fixed terms expired, they’ve not dealt with base at 1%. Remember – a huge majority of these landlords also have section 24 taxation to contend with – so as mortgage interest goes up, they take a proportionately larger hit than anyone else because of the “turnover taxation” element of the partial withdrawal of mortgage interest rate relief.
For some of these landlords, who can sometimes be poorly organised and often have spent all of the money they have made in rent/cashflow over this time, a couple more rises really could be a bridge too far. They may not even realise until their 2022-23 tax return goes in, of course, but they will see the bank balance changing, not going up as it was, or even going down. This could lead to disposals.
It is then sensible to look at two examples at either end of the spectrum as we sit in 2022 – firstly, the aspiring entrant to the investment or buy-to-let market. A theoretical person, with a theoretical deposit or some working capital. Let us say £100k. Their biggest danger, right now, is inflation at 10%+ eroding that working capital significantly. They have a year before it is worth £90k, or, sector dependent, potentially a lot less than that. Their biggest weapon would be sensible exposure to some fixed rate nominal debt that will depreciate in real terms thanks to this inflation – this is what they are really missing out on if they are not in the market right now.
Remember my favourite saying in these situations though – do NOT be a motivated buyer. A mistake in a market like this could cost you more than 10% – so prudence is still the very most important factor. Return OF investment before return ON investment (sorry, a broken record I know).
At the other end of the spectrum might be a portfolio landlord with 40 properties. Perhaps with some considerable floating rate exposure as I mentioned above, either by choice or by accident. Personally, we carry about 20% floating rate debt as that’s a number I’ve been comfortable with, and it has garnered us considerable margin in the low interest rate environment. The proportion of floating rate debt will be important.
With floating rates you have things to consider. Covenants – around loan to value (which has provided absolutely no issue in the past few years, and is unlikely to do so) – but also around debt service coverage.
When I look at the major risks still out there, on a market or macro level, as far as investment property is concerned, the relatively slim debt service coverage ratios imposed by the regulators are one of them. Let us just revise those for a moment. Firstly, at 5-year fixed rates and beyond, this can be stress tested at the pay rate (i.e. the mortgage rate) and be as low as 125%. So, if the rent is £1000, the mortgage can be £800 per month. If you use an agent, and the building has any age to it whatsoever, you are extremely unlikely to be in positive cashflow territory at that level – it is nearly impossible.
Now, many of the floating rate lenders set their covenants a lot higher. If you are not fixed for more than 5 years, the debt service coverage is at 145% – so with a rent of £1000, they will allow for a c. £690 per month mortgage payment. 25% in costs is considered a typical figure (although with inflation on maintenance and the labour to perform it, 30% might be more prudent) – which still leaves very little or no cashflow. As the rates go up, 0.25% at a time, that payment goes up and bang go the covenants.
This needs to be worked through quite carefully if you are a portfolio landlord reading this with exposure to these covenants. Where are the quick wins? Well, you will still be able to fix on limited company mortgages in the low 3s right now, or on personal name BTLs perhaps in the mid to high 2s (I must confess I don’t watch those rates too closely as they don’t pertain to me). There are probably 3-4 months left in that time window – so that might be a pretty good idea.
You can also look at disposal – of course. I like to watch return on equity as a metric – we have achieved some fantastic figures over the past few years thanks to the upswing in the market, but the result of massive capital growth (perhaps 40% in 3 years in some areas) is that yields inevitably suffer if rents don’t go up so quickly (and we have had some 40% rises on turnover of tenancies, despite curating rents every year, but they are the very highest, our average is in the low teens). If yields are low, covenants are closer to being breached – and if there is “lazy equity” within a property, you might want to redeploy it, if you manage to add a lot of value on the way into a purchase (that’s tended to be my model). We are in a market where refinancing for a remortgage might lead to a £230k valuation on a property that is easily worth £250k now, and might well sell at £260k-£270k on the open market (that’s a live example from our portfolio right now).
Curating the rents to somewhere near market levels is also absolutely critical. Rate increases mean margin squeezes – either you take it, or you share the burden with the tenant. Every other business in the world operates like this. It might feel very difficult at the moment with the cost of living being squeezed – and those are the choices that you face. If you can afford to be altruistic – then that’s fantastic.
Hold on though. Surely I can’t be advocating building up a cash pile in the bank? When inflation is 10%+? Am I mad? The answer to that is it depends (as always). One thing I learned when doing my MBA at business school is that those two words – it depends – are the answer to almost every question worth asking (arguably, even, “Would you marry me?” – although I wouldn’t recommend that answer to that question, if you get asked it…….)
It chiefly depends on your own personal cash position. Back to our one example – no assets, savings of 100k, wanting to get into the investment market – inflation is very damaging. Back to our other example, portfolio landlord with under 50k in the bank, millions in debt, and a ton of paper money after the past few years – it needs to be remembered, you can’t eat paper! Potential squeeze coming – definite squeeze coming in terms of rates going upwards.
I would consider looking at this as a ratio. 50k in the bank, £1m in debt – a 20:1 ratio. If you do nothing with that 50k – and most investors and developers will laugh, because it doesn’t tend to hang around in the bank for long even if you are lucky enough to have it, let’s face it – then at 10% it loses £5k of purchasing power in 12 months. However, that £1m of debt loses £100k of its quantum, in real terms, in the same time period. That’s a net £95k thanks to inflation!
Changing that ratio downwards means less “inflation leverage” – but a bigger margin of safety. With the “R” word (recession) all over the papers, a likely event is a self-fulfilling prophecy. It’s fair to say I am closer to 75% probability of a recession – or a period of negative GDP growth, whether it is a technical recession or not – than the 50% I was at only a week ago. I underestimated the press reaction and also the candour of the bank in terms of admitting >10% inflation, which alongside a few others I’ve been predicting for 2022 for a few months now.
So all of this needs to be considered very carefully. I cannot emphasise enough – every situation is different, and your own circumstances are effectively bespoke. There are two ends of the spectrum above, but I can’t remember a better time to be looking very carefully at the figures in your portfolio and seeking to make the economic conditions – particularly the inflation – work in your favour rather than against you. Investors are in a privileged position – borrowing has been a better move than saving for the past 15 years – and whilst rates are going up, it may still right now be the best time yet to be borrowing – with the caveat that 5+ year fixed rates (watch the early repayment charges on the longer loans, always) are by far the best way to be borrowing right now.
The window is open – be philosophical about your own early repayment charges, and go for it……..because when it slams shut, you don’t want to be outside. In terms of the important metric at the moment – it isn’t the 1% base rate, it is the 10%+ inflation rate – but more important than all is the direction of travel. So it turns out that size does matter, darling, but the direction is where it is really at……..until next week………keep calm and carry on!