Times Get Tough For Landlords

Existing buy-to-letters are starting to feel the bite with a combination of payment shock, falling prices and diminishing returns.

It's been a bad week for the country's biggest buy-to-let lender, Bradford & Bingley.

The bank announced an £8m pre-tax loss in the first quarter of 2008 (compared to a £108m profit in the same period last year) and has since suffered a 19% drop in its share price.

One of B&B's troubles is that the number of its borrowers who have missed three monthly payments has jumped significantly, by more than a third between December 07 and April 08. This is much faster than the buy-to-let market average, which has nevertheless seen a chunky rise in three-month arrears -- they leapt a third in the last year, according to the Council of Mortgage Lenders.

But why are landlords increasingly falling behind on their mortgage? For many it's for the same reason as residential borrowers - payment shock.

Shock to the system

Payment shock is when you come to the end of a deal, for example a two-year fixed rate, and find that all the available mortgages are priced much higher than your current pay rate - either because of interest rate rises or because lenders have increased their margins, or both. But if you do nothing you will usually automatically revert to your lender's Standard Variable Rate (SVR), which could be priced even higher.

Those who are coming up for renewal on a two-year fixed or discounted buy-to-let mortgage would have taken out their deal when the Base Rate was 4.5% and lenders' margins were trimmed to the bone because of fierce competition. Typical rates for buy-to-let in May 2006 were between 5.25% and 5.75%.

When these borrowers renew over the next few months, they will have the choice of deals priced on average between 6.5% and 7% -- meaning much higher monthly repayments.

A landlord with a £150,000 interest-only mortgage coming off a 5.75% deal and having to renew at 7% would see their monthly repayment rise from £719 to £875 - that's £156 a month.

But that's not their only problem.

LTV squeeze

Average loan-to-value (LTV) ratios have also been squeezed in the last six months. This means lenders are only willing to offer mortgages to those with a significant deposit. While some lenders would offer mortgages at 90% of a property's value two years ago, now many will not go above 75% LTV. This could be a problem for landlords who have not seen their property's value rise by enough to give them sufficient equity in their property.

If you bought a buy-to-let property on a two-year deal for £100,000 two years ago and put down a £10,000 deposit you would have borrowed at 90% LTV. But in order to get a current deal at 75% LTV you would need to have 25% equity in your property - and this would mean your property would have had to have risen in value by around 20% to £120,000.

That won't have happened many areas of the UK, as average house prices have increased by approximately 6% in the last two years, according to Nationwide's house price index. And they are currently declining in many parts of the UK.

If you do not have enough equity to move onto another deal you could be forced onto your lender's SVR - and that will be even higher than most of the deals currently on the market, as typical buy-to-let SVRs range from 7% to 7.5%. On the example given above, that means monthly repayments of up to £937.

And there's more bad news...

Rising rental cover requirements

It's not the just the LTV that determines whether a lender will give you a mortgage or remortgage. Lenders impose a minimum rental income figure which means that the expected rental income from your property has to be equal or more than your monthly repayments.

In the last few years this figure had been creeping down to minimum rental income of 110% or even 100% of monthly repayments, as lenders became more flexible. But current cautious lending as a result of the credit crunch has led to a tightening of requirements and minimum cover has crept back up to 125% or even 130% of monthly repayments.

So if you are a victim of payment shock and your monthly repayment rises to £1,000, your rental income on that property will have to be at least £1,250 - and the figures may not stack up. Again this would rule out the option of remortgaging and leave you languishing on your lender's SVR.

There are still deals to be done at lower rates, higher LTVs or lower rental cover - as long as you know where to look. For example, Bank of Ireland will offer landlords a three-year fixed rate at up to 85% LTV requiring just 100% rental cover - at a rate of 6.99%. Those with a deposit of 25% can get the same deal at 6.79%. BM Solutions will go as low as 6.29% on its two-year fixed rate, but you will need a 25% deposit and rental cover of 125% of repayments. (You can compare these deals with other buy to let mortgages via The Motley Fool Mortgage Service.)

Silver linings?

It's been claimed (usually by those with a vested interest) that rents are expected to increase in many areas of the UK. The theory goes that a combination of falling house prices and tight mortgage criteria has put many first-time buyers off buying, forcing them to rent for longer. This increased demand could push up rents and this would enable landlords to fit the tighter rental cover requirements. Phew.

But are rents actually going up?

No, according to the Association of Residential Letting Agents, which shattered the myth that rents are soaring in its latest figures. The Q2 figures show that average rental returns for houses and flats were down from 5.0% to 4.8% over the last three months. Average weighted rents for houses were down 7% from Q1, and 9% for flats.

This all paints a pretty dreary picture for existing landlords. But of course, investing in property is for the long term, so there's really nothing to worry about just yet - as long as you can afford those increased buy-to-let mortgage payments, that is...

More: Has The Buy-To-Let Bubble Burst? | Cut The Costs Of Buy-To-Let

> Compare buy-to-let mortgages at Fool.co.uk