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The Btl Paradox

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OK, I know I've floated this before, but now that the tide's changed I'd be interesting in reactions...

Quite simply, BTL isn't, and never was, a business in any sort of traditional sense. To make a success of BTL you need a supply of tenants who are prepared to pay about 130% of the mortgage payments. Forget capital appreciation for a minute, and assume that prices remain static in real terms; meaning, for the sake of argument, that they remain static relative to incomes (ie it's wage inflation that matters).

If these conditions obtained, most people would buy, because it's entirely rational to buy. There would be a rental sector for a small number of people who have some reason not to buy - company lets, contract workers, and so on, and also for people who for one reason or another can't buy property. In the past many of the latter would have ended up in social housing.

In unemployment theory there's so-called "frictional" unemployment - people between jobs for whatever reason. Rentals aimed at people with decent incomes, and companies, would count as "frictional" renting, and these would, of course, constitute a small but specialist business sector.

Then there's "structural" unemployment, where people are, for one reason or another, shut out of the labour market. In rental terms this corresponds to people who don't earn enough to buy for whatever reason (including long-term illness/disability). A rental market for these people is unlikely to be economically viable unless they are heavily subsidised by the state, which on the face of it makes no sense. Unless of course the state is obsessed by the private sector and thinks everything should be privatised. But we'll waive that with the remark that only state support will make this sort of rental financially viable for property owners.

So where does BTL fit into this? Well, some BTL will be shrewd cookies seeing opportunities for "frictional" renting and jumping into the market - housing construction workers in Stratford, say. Otherwise, though, BTL makes no sense because those who earn enough will buy, and those who don't will come with a whole raft of problems. So, you might ask, why did BTL start and why did it flourish?

Of course it started when the 130% returns did apply because people were reluctant to buy houses, at the bottom of the last dip ('95/'96). As prices rose the 130% rule failed to obtain in more and more areas, until now it probably only applies where you can make money from "frictional" renting - and this is the traditional rental market that always applies. So when LL and TTRTR pipe up that they can make money if they do the research etc, they're right - but this is traditional renting as a business, not BTL. But take heart, this is not BTL as we know it.

At some point in this rise it should have been obvious that BTL was no longer viable, and it should have petered out. There would have been some last-minute fools but rationally it should have petered out before now. So what kept it going? Simple - capital appreciation (or at least the hope of it). What doesn't seem to be widely appreciated is how devastatingly flawed this is.

Here's a precondition for widespread BTL - prices have to be such that 130% return applies. Here's the paradox - if it does there will be no BTL as such, only "frictional" (and of course "structural") rentals. For BTL to get off the ground in substantial numbers, the 130% rule has to go by the wayside. Which is why we're now seeing 100% BTL mortgages (100% of rental income covers mortgage). This is a way of suckering in bigger fools. But what this does is price out those who would otherwise have bought. This is the rub - BTL only works when people on decent wages are priced out of buying - but this requires widespread breaking of the 130% rule. Hence what props up BTL, in fact what brought the monster into being, is capital appreciation. (I'm ignoring deposits, because these are irrelevant as far as the business model goes; there has to be a return on the deposit equal to the return that could be made on it elsewhere. It's 130% return on a mortgage that represents 100% of the cost of the property matters.)

In short BTL is INHERENTLY speculative and will ALWAYS drive prices above a level that is justified by the wages of would-be FTBs (those who would otherwise buy BTL properties). At least in the short to medium term.

Here's the problem with capital appreciation. BTL is, make no mistake, good old-fashioned leveraged buy-out. You put up a bit of cash yourself and then secure the loan against the income of someone else - your tenant. You mortgage their income stream to pay off your loan; hence the "why pay rent, you're just paying someone else's mortgage". The flaw in this should be beginning to be apparent. As prices are forced up beyond the 130% level, each new BTLer buying into the market is mortgaging an income stream that's unsufficient to make the BTL viable. So the BTLer has, one way or another, to put money of their own into the property; either directly, by subsidising the mortgage, or indirectly, by paying maintenance, upkeep, etc.

In other words the capital appreciation of one tranche of BTLers makes the exercise non-viable for the next tranche; an unstable market that should stop at some point. Which is perhaps where we are now. BUT - it gets worse, for the BTLer!

The reason is that, remember, BTLing involves mortgaging the next generation's (your tenants) income stream. As BTL has progressively priced out people who would otherwise have bought (as opposed to "frictional" and, more importantly in this context, "structural" renters) - ie the better-quality, financially-viable tenants - so it has, en masse, already mortgaged their income streams. If these people, however it happens, get into a position where they can buy - small wage rises, savings, inheritance, HPI stuck at 0%, say - in other words, the so-called "soft landing" - then the money they will buy with is an income stream that has already been mortgaged, by a BTLer. In practice the money they inject into the housing market, and thus into the wider economy, has already been spent. This should worry BTLers - in a stagnant market there is no new money, because the better tenants buy with money that has, in practice, already been spent. No fractional reserve banking increases in the money supply here, and no prospect of capital increases for a very very long time.

In short BTL represents a compression of maybe ten years' worth of new money injected into the housing market in the last five. This I think is a reason why we've seen such a massive increase in indebtedness and such a huge boom in the last few years. It isn't just DrBubb's four years of spendinh in three, it's a massive proportion of the money that would have been injected into the housing market in ten years shoved in in maybe five. Problem is BTL can't be a business (as opposed to "frictional" and "structural" renting, the former at least of which certainly is). It also means that it will be a long, painful process of unwinding this, and a lot of people will lose a lot of money.

Meanwhile all those newbuilds intended to supply the BTL market are going absolutely nowhere, fast.

OK, so I've rambled on a bit, but what do you think? Comments appreciated...

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I know you asked not to mention capital appreciation, but any BTL landlord/lady worth their salt will buy way BMV, in which case appreciation is worth a mention. And of course, buying BMV means far better rental yield

Rental yields generated from new build apartments will be negative - won't they!

There is still scope for successful BTL but not without a lot of hard work.

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Whereabouts are you in the country?

In London there is an enormous amount of migrant labour that aren't going to buy property.

When did you last meet a Londoner who was born in London? They hardly exist.

There is a very definite need for accommodation for people on a short term basis.

If you're just here for a few years to make some money, it doesn't make sense to buy.

Rental property does make sense, and even more now in an overheated market.

Thank god for BTL landlords, otherwise I'd be forced to buy.

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Munro, I think you are spot on. BTL can never work in the long run because it relies primarily on CAPITAL appreciation (what BTL'r do you know who Buys in order to just get rent?). Of course capital appreciation goes in cycles, and now we are entering a falling market, the only reason to rent property out is the "old" and rather good way, which was to provide a service and make a bit of cash on a property that is wholly or mostly paid off.

BTL's are not interested in this. They want tenants merely to keep them just about afloat while they wait for inflation to make them their pile. But once inflation stops, they have no reason to be in the game.

The current state of BTL will without doubt surely demonstrate that, in the end, you cannot make real profit without work. Already large numbers of new houses and flats are attracting only enough rent to pay for barely half the mortgage costs. Multiply this by thousands, perhaps hundreds of thousands, and you see clearly why we are waiting for an almighty crash.

Furthermore, many BTL'rs have wildly overstretched themselves. Picture someone with five 80-90% mortgages on an off-plan new build. They paid around 200k for five flats and owe a total of one million quid. The monthly payments on 80-90% of that are around, say, £6000. But the rents don't match this....typically they might be £3000 after expenses are taken off (agent's fees etc). So every month there is a gaping hole of £3000, which is £36,000 a year, plus the LOSS of capital in a falling market.

Unless the average BTL "investor" has access to a stash of gold, thousands of them are going to go spectacularly bankrupt in two years time or less. At that point rents will plummet even lower due to the enormous increase of repossessed properties flooding the market, and selling prices should go the same way.

Do I care.....no...not for BTL's. They had it coming. That'll teach 'em to be greedy!


Edited by VacantPossession

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Thanks for replies.

Enworb, my point is that BTL not only isn't a business proposition, it isn't viable for all but the earliest entrants unless there is capital appreciation. To my mind that's not a business, that's speculation pure and simple, which is fine if you get the timing right. In a way this is a response to the BBC pundit who said following the demise of sipps people should buy a limited company and put property in that as a pension fund...none of this is business as a day-to-day enterprise with cash-flow, turnover and, hopefully, profit. As far as BMV goes, if BTL speculation is driving prices up what looks to be BMV isn't - as in so many respects BTL wrecks the fundamentals and obscures the price signals that any functioning market needs.

Bandwagon, I agree with you completely. I live in Cambridge which isn't that dissimilar to London in this respect. My point is that BTL speculation has driven the market to ludicrous levels because it is INHERENTLY speculative - so in one sense it's a benefit to people who would rent anyway because there's a supply of property. But BTL is making renting brutally expensive, as I'm all too well aware.

VP - all the whinging in the press from the sipps debacle just makes it clear how greedy the British middle class seem to have become! 'Nuff said.

DrBubb, my point is about speculation and losing sight of fundamentals...but do you think the idea of BTL leveraging in money in the short term that would have been spent in the long term in any case is true? This is the point I'm primarily interested in, because of it is it means BTL speculation has ramped the market beyond reasonable levels AND has distorted the wider economy by pulling forward spending. In which case there'll be a double-whammy effect of a contracting money supply/contracting economy AND falls in house prices exacerbated by a shortage of demand (buyers with real money, ie FTBs) which will damage the BTL model even further...and so on. Does this sound reasonable to you?

FWIW my own view is we've had the trigger and something in the air has changed...only I don't think it's very clear what it is. More like a cocktail of excess finally hitting a brick wall of reality (if that isn't too odd!)

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Munro, I personally think that you just posted the single best post ever seen on this crazy hill 'o beans we call HPC.

I STRONGLY urge you to go post it all over the show (www.mortgagedown.com, squealingpig.com etc springs to mind) because you just explained something eloquently and simply that has been bugging me and lots of people I know for ages. Bl**dy well done mate! It'as actually a captive business, and as such shouldn't be touched with a bargepole!


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