The Buy-To-Let Boom Isn't Over Yet

House prices are falling and mortgage costs are rising. But are buy-to-let landlords suffering?

I was having lunch the other day with a fellow Fool, a techie called Keith who works in our software development team. And for once, we weren't talking about the peculiarity of the English (Keith's American), we were actually being quite Foolish and talking about investments.

The conversation started because Keith said: "It's madness to invest in property now! Buy-to-let landlords are nuts! They should be investing in shares instead!"

(He really does talk in exclamations like that!)

And  in many ways, Keith's argument makes a lot of sense. Now that the housing market is cooling down after years of boom, you would expect buy-to-let investments to become far less attractive propositions.

But is this actually the case, I wondered. Is now really such a terrible time to get into buy-to-let? How badly have buy-to-let landlords been hit by the credit crunch - and how will this impact on the rest of the housing market? 

The Golden Rule Of Successful Investing

Every investor knows that, sometimes, to make money you have to spend money.

In buy-to-let this is crystallised through a strategy known as `gearing'. It works like this: You stump up a small deposit on your first property, and wait for prices to rise. Once the property is worth significantly more than you paid for it, you remortgage and release as much equity as possible.

You use this money to put down a deposit on another property, and again wait for prices to rise - this time on both properties. You can then remortgage both properties again, release more equity, and use this to buy more properties, and do the whole thing again (only quicker).

Eventually, this strategy will probably leave you with several heavily mortgaged properties in which you have relatively small equity stakes.

And this is great, as long as property prices keep going up. It would, however, be pretty catastrophic if all your properties fell in price, even by a relatively small amount. This could wipe out all your equity stakes, and leave you pretty vulnerable should you need to sell.

Wave Goodbye To Cheap Mortgage Deals

As if that wasn't bad enough, mortgage lenders nowadays are far less willing to take the risks they used to take on buy-to-let investors. Three of the biggest buy-to-let mortgage providers - Paragon, Northern Rock and GMAC-RFC - are now hardly competing at all for business in this marketplace, while others have significantly tightened their lending criteria.

Woolwich, for example, will now only lend to investors with a 25% deposit, while Coventry Building Society  has gone even further and specified that investors must have a 50% deposit to buy a new build property. This is a dramatic shift from a year ago, when some specialist lenders (typically sub-prime lenders) were happy to lend buy-to-let investors 90% of the property value.

A reduction in competition for business means that the few remaining lenders who are still willing to accept 15% deposits, have put their mortgage rates up.

Bradford & Bingley, for example, will lend 85% of the property value as long as the rent covers 125% of the monthly mortgage payments, but is happy to be "one of the pack" rather than the market-leader when it comes to rates.

Like Alliance & Leicester in the residential mortgage market, it seems buy-to-let lenders are not aggressively seeking market share in the way they once were. You really need to speak to a broker now if you want to have any hope of bagging a competitive rate.

All these changes are making life difficult for buy-to-let investors who want to remortgage and gear up, never mind buy a new property. And with house prices coming down and mortgage costs going up, the risk/reward ratio is not looking as healthy as it once did, to say the least.

No wonder the Royal Institution of Chartered Surveyors (RICS) recently reported that new instructions to let properties declined for the first time in the survey's 10-year history.

The Good News

OK, so that's the bad news. But the situation is not entirely gloomy. In January Paragon reported that rents were rising at their fastest rate on record - up 19% in 2007 and 8% in the last quarter alone. RICS also reported that rental demand was strong, pushing up rental yields to a record two-year peak.  

According to buy-to-let specialist Bradford & Bingley, this is partly because demand from students and immigrants remains strong, and partly because first-time buyers who fear a crash or are no longer eligible for a competitive mortgage deal are renting instead.

If B&B's analysis is correct, there's icing on the cake for investors. With fewer first-time buyers jumping on the ladder, there will be less competition for the `first home'-type properties which make good buy-to-let investments.

What's more, with prices slipping, it's a buyer's market. That puts chain-free investors in a particularly strong position. And due to the credit crunch, repossessions are on the up, which means there is greater potential to snap up a bargain, especially at a property auction (as my Foolish friend Szu Ping Chan explains in How To Buy At Auction).

Furthermore, most buy-to-let landlords take a long-term approach to their investments, and do not plan or need to sell during the current dip in the market.

Consequently, many long-term investors will see the current economic climate as far from problematic - in fact, some may view it as a landscape full of opportunity. Research from property investment consultancy Property For Life claims 80% are bullishly confident, and believe now is a good time to invest. Personally, however, I am a little sceptical that confidence among buy to let investors remains at such a high level and of course, this figure somewhat contradicts the RICS findings.

Still, I can see why, in some circumstances, making a buy-to-let investment right now might not be such a terrible idea after all. It seems, Keith, the buy-to-let boom is probably not quite over yet. In a few years' time, I expect some investors will still be wringing their hands with glee, rather than despair...

More: Find a magnificent buy-to-let mortgage with The Motley Fool Mortgage Service | Cut The Costs Of Buy-To-Let