Gavin gives his views on what the implications of tougher interest cover ratios and increased background checks will mean for landlords and buy to let lenders.
CP11/16, for those of you who care, is the reference number of the Prudential Regulation Authority's consultancy paper on the underwriting standards in the buy to let mortgage market issued back in March of this year.Jump forward six months and the Bank of England has now issued the Supervisory Statement (SS13/16) and the Policy Statement (PS28/16). As expected, the end results are pretty much as hinted in the consultation paper.
The overall aim of the PRA's review is to prevent any loosening in the underwriting standards relating to buy to let mortgages.As best it can, the PRA needs to ensure that we do not return to the days pre-credit crunch when it is widely acknowledged that underwriting standards were thrown out of the window.
As it seeks to stamp its authority, the PRA has set out stricter guidelines around rental stress tests and affordability checks. The PRA has a certain reach but it will be interesting to see how certain investment backed lenders not directly regulated by the PRA, act in the coming months.
On the whole it is the mainstream BTL lenders who are in the spotlight. SS13/16 confirms the exclusion of the specialist commercial lenders who, I guess, are deemed to already have sufficient underwriting processes in place. Looking at the size of some of our specialist lender files, I would tend to agree!
Buy to let remortgaging not affected
It is also good to note that the intention is that those looking to remortgage at the same level of borrowing will not be subject to stricter affordability tests. I am looking forward to seeing this in practice as I suspect that some lenders will look to apply a new set of "one size fits all" affordability rules.
So what does it all really mean?
Tougher Interest Cover Ratio
Lenders looking at rental cover requirements must demonstrate that they are taking into account all the management costs associated with the property along with the borrower’s tax position. With the reduction in mortgage interest relief for high and higher rate tax payers starting to take effect, the message behind the guidelines is that 125% cover is likely to be insufficient. There will be a general assumption that all borrowers are high rate tax payers and only the most sophisticated lenders will have the mechanisms to apply lower stress tests for basic rate tax payers. Over the last few months we have seen several lenders increase stress tests for personal borrowers from 125% to 145% whilst maintaining stress rates at 125% for those borrowing via a corporate vehicle (i.e. SPV limited company). In this regard, expect more lenders to follow suit!
More probing background checks
Those lenders which also consider personal income to top up rental coverage are also now required to undertake stronger assessments of income and expenditure to ensure that there is sufficient surplus income to meet the requirements.
5% notional rate longer sufficient
There has been much discussion also on the interest rate lenders should use when stressing the rental coverage. Back in the day 125% at 5% used to be good enough but with the reduction in mortgage interest relief and the effect on landlord income, it is time to think again. The guidance now is that a minimum rate of 5.5% should be used (or 2% above the pay rate if higher). The supervisory note states that lenders must take into account the market expectation in interest rates during the first five years. Stressing mortgages at five year fixed rates would still seem to be the best way of managing any interest rate uncertainty and I would therefore expect the trend towards these products to continue. However, lenders will need to bear in mind any refinancing risk after the five year period and if we do see lenders trying to get around rules with a flux of low five year products, the PRA is bound to have another look.
Lenders will need to have new stress tests and affordability checks in place by 1st January 2017.
More robust underwriting for “Portfolio Landlords”
In addition to the affordability checks, lenders are being asked to have robust underwriting processes in place for "Portfolio Landlords" the definition of which, is someone with just four or more mortgaged properties! I have always been of the belief that the more professional the landlord, the lower the risk. The more properties the landlord has, the less effect a void period has on income and I often discuss this paradox with lenders at a senior level. As always, lending policy is driven largely by past arrears cases and it only took a few large portfolios which went down at the crunch to mar the view of lenders and indeed the regulator.
Going forward landlords with large portfolios will be subject to further affordability checks. Lenders will look to stress background portfolios against new rules to ensure that landlords are not over committed and it is unlikely that they will rely on the borrower’s spreadsheet for details around rental income versus mortgage payments. All portfolio landlords should expect to be asked for bank statements, tax returns, SA302s, ASTs, rental accounts and potentially income and expenditure statements when applying for finance.
Business as usual for the specialist lenders
For those of us who are used to operating in the specialist lending space, this feels like business as usual. Challenger banks such as One Savings Bank, Aldermore Bank and Shawbrook Bank, and the specialist buy to let lenders such as Paragon Mortgages, Keystone Property Finance and Axis Bank, have always been more curious on background income and have the ability to underwrite portfolio landlord applications.
Changes for mainstream BTL lenders
The vanilla lenders will need to make some changes to underwriting standards so expect further moves from 125% to 145% ICR and split stress tests from those lenders who have buy to let products for limited companies.
It sounds like a lot of fuss but many lenders and certain specialist intermediaries are already underwriting to the required levels. In summary, I expect the following
- We will see a continued move towards landlords using limited company structures to purchase investment properties.
- Landlords will be pushed towards five year fixed rates to maximise gearing.
- Landlords used to dealing with mainstream vanilla lenders will need to provide more comprehensive supporting documentation in the future
- New lenders coming to market will need to ensure that they have the appropriate underwriting skills to meet new standards.
- Landlords will continue to seek higher yielding properties. Rents on standard properties may also rise.
- There may be a small spike in buy to let transactions in Q4 before stricter ICR rules kick in in January.
Lenders have until September 2017 to ensure that they have robust underwriting processes in place for portfolio landlords but I expect the majority of new rules to be in place with the ICR changes in January. At Mortgages for Business we love guiding landlords through the lenders’ various credit policies and all of our consultants are geared up to handle the most complex of transactions. We will continue to keep up to date with changes in the market and do get in touch if you need any help with an application.