A Model For Buy-To-Let Pricing

[Bland Unsight]

Since last July I've been thinking on and off about what Donald Kohn, External Member of the FPC said at the Treasury Select Committee hearings on the June 2014 Financial Stability Report:

Q45 John Mann: Are you confident that the data that is feeding in is sufficiently detailed to properly analyse the housing market, in particular the phenomenal growth in buy-to-let and the potential impact of indebtedness on the multiple numbers who are newish to the buy-to-let market?

Donald Kohn: We took a close look at buy-to-let and its role in the mortgage market; talked about it. We also have said that this is something we are going to have to keep an eye on if our constraints begin to bite on homeowners’ ability to purchase homes, get mortgages, whether the buy-to-let market wouldn’t absorb some of the risk. Mr Bailey and the PRA will be looking at that. We have asked him to report back to us, so we are very aware that the buy-to-let market is a potential safety valve that might not be totally safe.

Source: Parliament website

For context, it is at the June 2014 FSR that Carney announced the soft cap on high-LTI lending to owner-occupiers, as per the Telegraph piece.

There isn't really much before or after to make clear exactly what he means by the "risk", but it seems to me that the natural interpretation is that if lending restraints to owner-occupiers bite then prices might fall, so the risk is the risk of house prices falling. Then we can interpret the buy-to-let safety valve as the existence of a pool of willing buyers to step in and put some support under prices. But in what way is this safety valve not safe? And then this March at the House of Lords Select Committee on Economic Affairs we had Lord Rowe Beddoe asking about the sensitivity of buy-to-let to interest rates.

I've been minded for a little while to build a toy model to elucidate how present levels of interest rates, mortgage covers and LTVs set the maximum price at which BTLers can transact and I finally got round to it this week. The reason for the thread is that I was curious as to how close prices are in hpcers local markets to these 'valuations'. The long and short of it is that you multiply the pcm rent by 320. This is underpinned by assuming a 75% LTV interest-only mortgages at a 4% interest rate and the mortgage lender requiring a 125% rental cover on the monthly mortgage payment, (if you fancy reading some elementary mathematical modelling done by an idiot the detail is here).

For the place I rent, which I think might fetch £240,000 in the current market, my model suggests that an aggressive BTLer would be able to pay £268,000.

The fun part of the model is that it spits out an enormous sensitivity to interest rates near the lower rate bound. If the mortgage rate, which as stated earlier is assumed to be 4.0%, ticks up to 4.5% the aggressive buyer would only be able to pay about £240,000. My reading of that is though £30,000 feels like a lot when you think of trying to save it up rather than borrow it into existence, the reality is that we are already within a whisker of these prices. As those prices are the maximum a BTLer can pay, which is basically well above what most FTBers can pay, it also explains the massively obvious answer to the FTBer affordability mystery. If BTL mortgage rates fall further, then prices can rise, and significantly, even on static rents. But if BTL mortgage rates are pushed up, even by trivial amounts, shit gets ugly fast near the lower rate bound.

Edited May 21, 2015 by bland unsight

[Exiled Canadian]

Here's a question for you:

Assuming that a tenant can sensibly pay 30% of pre tax income out in rent (or some other number if, as an OO I'm having a politicians "price of milk moment") what level of house-price could said renter afford for the same property based on MMR criteria with (say) a 10% deposit?

If the model can then be flexed to reflect various interest rates for BTL and OO mortgages we could then solve for the "equivalence spread" - ie. the premium that would have to be applied to BTL mortgages to level the playing field for OO's.

Or if (sensibly) you can't be bovvered tell me to do it myself and I'll get exel cranked up!

edit: One more thing - you've ignored any return requirement for the BTL borrower on their equity. Whilst you might sensibly argue that observed behaviour might imply that in many instances this is nil (or in fact negative), ignoring this does mean that your current model will behave oddly in that reducing the LTV available will increase the maximum price the landlord is prepared to pay for a property - which is a bit counter intuitive.

Edited May 21, 2015 by Exiled Canadian

[Si1]

Doesn't he mean by "absorbing some of the risk" that it takes some of the risk off banks and the government.

Ie politically acceptable to foreclose on btlrs and chase for debt without special measures to help them out, more so then on owner occupiers?

Personally I see them as amplifying the risk, as are more likely to see houses as liquidatable compared to owner occupiers, and therefore more ir sensitive as you say

Edited May 21, 2015 by Si1

[wotnocrash]

The model is way out for my BTL. Rent is £1350 pcm, purchase price was £270k and 3.5% interest bought a few months ago, whereas your model suggests a max price of £432k at 4%. That's in London too, where rent-price ratio is supposedly most out of line.

It always used to be that the weekly rent roughly approximates to the price in £k, which would be closer but still a bit too high.

Edited May 21, 2015 by wotnocrash

[Bland Unsight]

The model is way out for my BTL. Rent is £1350 pcm, purchase price was £270k and 3.5% interest bought a few months ago, whereas your model suggests a max price of £432k at 4%. That's in London too, where rent-price ratio is supposedly most out of line.

It always used to be that the weekly rent roughly approximates to the price in £k, which would be closer but still a bit too high.

The model says that a tick in interest rates from 4% to 4.5% from where you are knocks about £54k of that maximum, so you're probably in trouble price wise if BTL rates move by about 2%.

[Venger]

The model is way out for my BTL. Rent is £1350 pcm, purchase price was £270k and 3.5% interest bought a few months ago, whereas your model suggests a max price of £432k at 4%. That's in London too, where rent-price ratio is supposedly most out of line.

It always used to be that the weekly rent roughly approximates to the price in £k, which would be closer but still a bit too high.

Nice of you to pick a 'non-investment' BTL, future home for your 20 month year old daughter. T***.

It's easy to get a BTL mortgage in retirement, as the assessment is based on the rental income, not your salary or pension

Mortgage works criteria is must be under 70 and proof of income is only required if you don't own another property either as a BTL or OO. Pension income (including state pension) qualifies too.

We looked at moving out of London last year but with both of us working in the City it made no sense from a time or cost perspective. It only really makes sense if you can also work away from London. We were also put off by the prospect of not being able to afford to buy back in the capital if we didn't like it out in the sticks.

There are still plenty of places in London where someone on £70k can buy. I bought a 3 bed flat in a leafy part of zone 4 for £270k a couple of months back.

It's also much cheaper to buy than rent. This flat is a BTL, it brings in £1300pm and costs me £580 in mortgage interest, it would be cheaper still with an owner occupier mortgage

Deposit is the standard 25%, rate is 3.5% fixed for 3 years.

We intend to keep it indefinitely, in fact the plan is to hand it to our daughter mortgage free when she is 21 (she is 20 months now!) to help her get a foot on the ladder.

You have to compare like with like, the capital opportunity is a lot less with other assets, as you don't benefit from leverage which currently gives us about a 12% return on our deposit sum invested.

Anyway, we didn't buy it as an investment, it is a future home for our daughter

What are you talking about. You quoted me, I responded saying you hadn't considered the benefit of leverage

***t

[wotnocrash]

I bought it and I let it so technically it is a BTL, but yes it is for my daughter, hence the price now or in the future is irrelevant to me. Does that make my experience irelevant when compared to his model? No - so f*** off back under whatever (rented) stone you crawled out from.

[Venger]

I bought it and I let it so technically it is a BTL, but yes it is for my daughter, hence the price now or in the future is irrelevant to me. Does that make my experience irelevant when compared to his model? No - so f*** off back under whatever (rented) stone you crawled out from.

The only thing more annoying than all your types in the world, are the excuses givers for your types, who keep worrying about HPC on your circumstances, and for years class you as a victim.

Turnip.

[Venger]

We must be close now. All these types need to be stripped of their equity in a Real HPC without mercy.

[wotnocrash]

The only thing more annoying than all your types in the world, are the excuses givers for your types, who keep worrying about HPC on your circumstances, and for years class you as a victim.

Turnip.

I am not going to apologise for looking out for my daughter's future. Am I worried about a HPC? No - we have a low LTV in our main house and a mortgage 1times joint income. For me a crash would be a buying opportunity to trade up both our house and the flat for our daughter. I bought my first place in 2006 so I know how it feels to be screwed over by the ridiculous increase in prices.

[Venger]

I am not going to apologise for looking out for my daughter's future. Am I worried about a HPC? No - we have a low LTV in our main house and a mortgage 1times joint income. For me a crash would be a buying opportunity to trade up both our house and the flat for our daughter. I bought my first place in 2006 so I know how it feels to be screwed over by the ridiculous increase in prices.

As many other BTLers were doing the same in the run up to mini HPC 2008. Your daughter in 21 years time is going to love you, isn't she. I'm positioned for my family too, against house prices and you rentiers.

And of course, to fill your boots, like all the other BTL heads including RXE who keeps telling of his concern about other investments than his BTL/investment-property and his house, that can crash 90% like the stockmarket which can't happen to houses like.

Who won't have any money and will recoil into the HPC.. Why were you originally looking to move out of the City last year? To upsize? Anyway I'm out. Bland Unsight's 'toy-model' seems to needs rates to increase or money to tighten, not there yet.

- I just don't see the prospect of a decent crash in the SE at least. Demand remains huge (loads of people needing a roof over their heads), just as the prices are insane. Everything that is built is bought rapidly, at all levels of the market. There's an awful lot of foreign money looking for a home, as direct investment, and this will not exit quickly - it is long term. If it was short term, they'd be buying something far more tradeable. And to be clear, if there was a proper crash, I would fill my boots this time round.

Do I see a justification for price rises to infinity - outside London, not at all. Inside London, I'm not sure as London is utterly detached from reality. Do I worry about a crash - only in the wider economic context. I have zero debt, and no intention of getting into debt.

[Venger]

If you were so cashed up to upsize your own home and the BTL flat you've just bought, into a future HPC, I'm surprised you even need a mortgage for the BTL.

I'm keeping my eye on credit/lending in the USA, thinking perhaps a move, or strain, will manifest itself before it does in UK and our HPI/BTL party.

US/California housing forum:

Jim. May 19, 2015: Working in the mortgage biz, my phones have gone silent with just a .50% increase in rates. Going from 3.5% to 4.5% (we are half way there) could mean a very quiet summer for me and others in the RE industries. Time to wax up my surfboards and hit the beach so I don’t go bonkers with boredom.

Robert. May 20, 2015: Bankers Monday morning meetings, "Keep up the denying of loans, we don’t want to lock in 30 years at 4% do we, when we can get 5% and above then we start the loaning understand, no lending till we get higher rates”.

Mortgage rates bounced up from lows in January. There are at least some concerns with brokers, for direction of rates, the hard bounce from lows recently surprising many. They associate weak data with lower rates / no base rate rises / more stimulus, holding to view if stimulus takes it will raise rates, whereas weak growth data will result in more magic stimulus.

We're in the middle of the 2nd big, ugly bounce so far this year and once again forced to confront the possibility that this will be a big-picture, long-lasting correction. http://www.mortgagenewsdaily.com/consumer_rates/473586.aspx

[Bland Unsight]

I am not going to apologise for looking out for my daughter's future. Am I worried about a HPC? No - we have a low LTV in our main house and a mortgage 1times joint income. For me a crash would be a buying opportunity to trade up both our house and the flat for our daughter. I bought my first place in 2006 so I know how it feels to be screwed over by the ridiculous increase in prices.

But what if what your what your daughter will want, in the fullness of time, is to grow up and make her own way in the world? To meet a young man, or a young woman, and establish her independence from you, so that she can meet you as an equal. Will the flat you've gifted be a dowry or sorts, or will she be encouraged to make a love match only with people who own their own homes, and not some loser who has crawled out from under their rented rock?

Life is a rich web of connections. An apparently hyper-rational decision, informed by love, can have disastrous consequences. Just as the tracers of the incipient lightning strike work their way through disparate cascades towards the ground, a society that seeks to escape its debt problem by loading itself up with debts it cannot pay seeks only its own destruction. If that's what you really want for your daughter, are you right, or are you a monster? Seventy-months and counting on so-called emergency interest rates...

[Wurzel Of Highbridge]

Seventy-months and counting on so-called emergency interest rates...

Yeah and i'm still waiting for the 'temporary' income tax act 1842 at the rate of 3% to end.... Can't be long now.

[Guest_growlers_*]

But what if what your what your daughter will want, in the fullness of time, is to grow up and make her own way in the world? To meet a young man, or a young woman, and establish her independence from you, so that she can meet you as an equal. Will the flat you've gifted be a dowry or sorts, or will she be encouraged to make a love match only with people who own their own homes, and not some loser who has crawled out from under their rented rock?

Life is a rich web of connections. An apparently hyper-rational decision, informed by love, can have disastrous consequences. Just as the tracers of the incipient lightning strike work their way through disparate cascades towards the ground, a society that seeks to escape its debt problem by loading itself up with debts it cannot pay seeks only its own destruction. If that's what you really want for your daughter, are you right, or are you a monster? Seventy-months and counting on so-called emergency interest rates...

Interesting model. Do you have a background in econ?

[darwin]

Interesting model. Do you have a background in econ?

[lastlaugh]

Since last July I've been thinking on and off about what Donald Kohn, External Member of the FPC said at the Treasury Select Committee hearings on the June 2014 Financial Stability Report:

The fun part of the model is that it spits out an enormous sensitivity to interest rates near the lower rate bound. If the mortgage rate, which as stated earlier is assumed to be 4.0%, ticks up to 4.5% the aggressive buyer would only be able to pay about £240,000. My reading of that is though £30,000 feels like a lot when you think of trying to save it up rather than borrow it into existence, the reality is that we are already within a whisker of these prices. As those prices are the maximum a BTLer can pay, which is basically well above what most FTBers can pay, it also explains the massively obvious answer to the FTBer affordability mystery. If BTL mortgage rates fall further, then prices can rise, and significantly, even on static rents. But if BTL mortgage rates are pushed up, even by trivial amounts, shit gets ugly fast near the lower rate bound.

Good work BU, and thanks for the link to the detailed model.

It"s occurred to me for some time that HPs seem to be set by the BTLer who can stomach the most risk, and massive HPI is nothing more than BTL interest rates approaching the zero bound. But I've never seen the maths so eloquently, so thanks. It nicely explains why yields are so low, and will remain so.

It also seems to me that rents are set by the BTLer who has the least risk, with a floor of the LHA rate. Hence in practice, rents coalesce around the LHA rate. As LHA rates don't differ too much now in the South East, and London especially, HP in all but the most prime areas are fairly uniform. This has given the illusion of previously down-at-heel areas booming, when in fact it is just the BTL brigade arbitraging the LHA.

However, I don't share your opinion that Carney considers the BTL brigade as being a force to stabilise HP - your safety valve. Quite the opposite in fact. HP aren't sustainable from future incomes, and as your model shows, BTL is the most unstable aspect. I think Carney is expecting BTL to absorb most of the pain of a HPC, which will leave the broader system safe.

[Exiled Canadian]

One thing the modelling does show is that in a low interest rate environment the ability to borrow on an interest only basis hands a huge advantage to the BTL landlord in terms of being able to fund purchases.

Ignoring for the moment whether an OO borrower would be wise to buy at current prices this does create an unfair playing field.

It seems that the BoE has decided that IO lending to OO's is dangerous from a macro-prudential regulation point of view.

Is it the case that the BoE has concluded that IO lending does not reflect a macro-prudential risk in the case of a BTL borrower? I don't recall seeing such a pronouncement, has anyone else?

If IO lending to fund BTL was outlawed the impact upon the BTL model would be quite spectacular.

Edited May 22, 2015 by Exiled Canadian

[Venger]

However, I don't share your opinion that Carney considers the BTL brigade as being a force to stabilise HP - your safety valve. Quite the opposite in fact. HP aren't sustainable from future incomes, and as your model shows, BTL is the most unstable aspect. I think Carney is expecting BTL to absorb most of the pain of a HPC, which will leave the broader system safe.

That's what Bland Unsight is suggesting too, I am pretty certain. BTLers to take the brunt of the HPC, and then the cascade to their main homes too, and all the others, including those baby-boomers sitting on £Trillions in outright/near outright owned equity... who many say aren't interested in cashing in on £500K/£750K/£1m+ homes to downsize. The bed-blockers of the market hogging family homes.

Baby-boomers with mortgages all paid of yonks ago? All equity locked in and safe from HPC. Maybe safe from repo, but not safe from deep value correction. And look at Timak's parents-in-law. Sitting pretty with their house all paid off, feeling affronted that they had 'several hundred thousands pounds earning no interest in the bank' - so went into BTL, claiming yes BTL is unfair, but more unfair they get no interest on their mega money top-flight position. Let's hope the market makes them wish they'd not bought into a bubble house price market for BTL. Markets can cascade back and reignite everything again, including owner-outright seeing big value drops.

An incredible YouTube video shows what may be the coolest party trick you ever see: blowing out a candle and then relighting it through its smoke. The "trick" has a little bit of science behind it. When a wick is lit, the flame vaporizes the candle wax and turns it into heat and light. As soon as you blow it out, the trail of smoke released by the smoldering wick still contains a bit of wax that hasn't fully burned. When you hold a fire source up to the wisps, they can reignite and cascade back down to relight the candle. YouTube's Slow Mo Guys also investigated the phenomenon in a video released earlier this month, filming the re-ignition at 2,500 frames per second. Science, man.

[Bland Unsight]

...

However, I don't share your opinion that Carney considers the BTL brigade as being a force to stabilise HP - your safety valve. Quite the opposite in fact. HP aren't sustainable from future incomes, and as your model shows, BTL is the most unstable aspect. I think Carney is expecting BTL to absorb most of the pain of a HPC, which will leave the broader system safe.

I'll buy that.

Initially, the Bank aren't too worried about the health of post-MMR BTL because they suppose it's just relatively stronger borrowers, with assets, displacing potentially more over-stretched borrowers with no assets, hence it is a safety valve at static real prices because it offsets a diminution of demand from MMR constrained OOers, hence reducing the risk of and potential severity of a crash and will behave well in the event of a crash, from the lenders' POV.

However, in the fullness of time as BTL lending just keeps growing and prices take off, and OOers LTIs take off as they chase after BTLers financing IO at low rates, the Bank of England realise that it's not a safety valve at all, it's just a bubble pump which will frustrate their attempts to get the secured lending to GDP ratio back to a safer and more sustainable level.

[Bland Unsight]

That's what Bland Unsight is suggesting too, I am pretty certain. BTLers to take the brunt of the HPC,...

That's definitely what I think is going to be the case, though I've been on both sides of the fence at different times regarding whether the Bank of England see BTL as just idiotic foam for the runway or an acceptable part of a reconfigured UK market for residential accommodation with an important role to play in digging us out of the hole we're in over the next ten to twenty years.

[Bland Unsight]

Interesting model. Do you have a background in econ?

Nope. Maths, physics and philosophy.

[Fairyland]

Could it be possible that they have brought potentially vulnerable owner occupiers on the safe shore using help to buy. BTL can fend themselves - don't need to be rehoused by councils in case of a surge in repossessions.

[Guest_northshore_*]

The fun part of the model is that it spits out an enormous sensitivity to interest rates near the lower rate bound. If the mortgage rate, which as stated earlier is assumed to be 4.0%, ticks up to 4.5% the aggressive buyer would only be able to pay about £240,000...

If you like that sort of thing, might want to look into bond duration and convexity. Generally from a yield perspective, which is what you seem to be doing, the sensitivity of prices to yields is referred to as duration, and sensitivity of duration to yields (second derivative) as convexity. Not quite the same for land and mortgages given different optionality/volatility/maturity/principal profiles, but all interwoven. I think it's difficult to define interest rate optionality and risk in our brave new uber deterministic housing market mess - thus difficult to assess whose risk matters - borrower, lender, mortgage security issuer, mortgage security buyer, Government etc - but as you highlight it's definitely not linear. There's also related areas like real option pricing and analysis (options are convex); for example the effect of volatility on an option to build, and consequential development and price impacts.

[Bland Unsight]

If you like that sort of thing, might want to look into bond duration and convexity. Generally from a yield perspective, which is what you seem to be doing, the sensitivity of prices to yields is referred to as duration, and sensitivity of duration to yields (second derivative) as convexity. Not quite the same for land and mortgages given different optionality/volatility/maturity/principal profiles, but all interwoven. I think it's difficult to define interest rate optionality and risk in our brave new uber deterministic housing market mess - thus difficult to assess whose risk matters - borrower, lender, mortgage security issuer, mortgage security buyer, Government etc - but as you highlight it's definitely not linear. There's also related areas like real option pricing and analysis (options are convex); for example the effect of volatility on an option to build, and consequential development and price impacts.

Thanks for all that - I've got a couple of fat textbooks on derivatives pricing that someone off-loaded at the local Oxfam bookshop, but I haven't the mathematical facility to just read them like I'd read a novel. (If I get the time and energy to learn anything new and difficult, it'll be tensor calculus and a bit more General Relativity.) I do appreciate the steer, but I intentionally badged it as a mad 'toy' model. It's supposed to be a convenient 'canary in the coal mine', i.e. if your local rental market is anywhere near 320 times pcm rent then prices are being set by BTLers running a negative carry trade and taking enormous risks with regard to interest rates on BTL mortgages, (presumably all predicated on the inevitability of a massive capital gain...). Ever thus to deadbeats.

Edited May 23, 2015 by bland unsight