Loans outside the South East: A Lender’s View

By Bridging Loan Directory 7th January 2014

As a new entrant into the Bridging and Commercial lending market, strategy is continually at the forefront of every Funding 365 board meeting. It will, therefore, likely not surprise you to read that the two topics that we focus on most regularly are a) the outlook for UK house prices; and b) the areas of the UK we believe that we should be focusing on.

I have a strong belief that, at present, there are fundamental economic factors that actually support a focus on lending outside London and the South East (“London / SE”) – and Funding 365’s lending approach is based on this view. I realise that this is a slightly controversial stance given that, at present, a swathe of lenders are retreating from the wider UK market to focus only on London / SE.

Before I begin to lay out why we believe that a focus on ex-London / SE makes sense, let me perhaps reverse the question and ask why people believe that the property market in London / SE is going to remain strong and why prices will continue to increase. The only consistent response I get to this question is that, “people have been saying for the last 15 years that London property is too expensive and will have to fall soon – and they have been consistently wrong”. Is it the case that a consistently incorrect prediction about the occurrence of a particular event means that such an event will no longer happen in the future? No, of course not, fact patterns and economic realities continue to change. Any good investor will tell you that you have to analyse the facts as they currently stand, then make a judgement, invest in your judgement – and then hope you are right.

So, let me lay out the reasons that, I believe, currently make London / SE a more risky proposition for property investment than the rest of the UK.

Firstly, it is important to understand who is supporting the London / SE property market. Historically this used to be the financial workers of the City. Estate agents would lick their lips in anticipation of bonus day, when they would be inundated with City bankers eager to buy a new house with a big driveway in which they could park their new Porsche. I think we all recognise that those days are (for the moment) consigned to history. Compensation in the City is now smaller than it used to be and a much greater percentage of it is deferred for up to five years (in stock options or similar), which reduces the immediate buying power. Also, of course, the number of high-flying bankers has shrunk fairly significantly over the last five years – and with it, the purchasing power that this professional segment used to bring to the London property market.

The simple answer here is that the London / SE property market has been supported by foreign investment over the last 6 years (I like to call this “hot money”). Newspapers have been rife with the statistics, so I don’t need to quote all of them here – however, the headlines that stated that foreigners bought up to 75% of all new London properties in 2012, and approximately 49% of all properties worth over £1m tells us everything we need to know about where the cash influx is coming from.

So, now we have established where the money has come from, let’s answer another fundamental question – why have foreigners invested into the London / SE property market? The answer is fairly simple (and brief I’m sure you’ll be pleased to hear). In short;

1) The investment world over the last 6 years has been in turmoil – the London / SE property market was a sea of tranquillity in comparison to the traditional safe haven of US treasuries (which look frighteningly overvalued, and that’s according to Warren Buffet with whom I agree). Land rights are strong and property is open to foreign buyers without any punitive taxes.

2) According to data from Knight Frank, over half of the foreign property purchases in 2012 came from the Far East, specifically Singapore, Hong Kong, China and Malaysia. The massive depreciation of Sterling against most of these currencies actually makes London property much cheaper than it had been in years.

3) London has a booming rental market, so it is easy to actually get a return on your investment as well as have confidence that it is safe. We will come on to rental yields later, however given that 5 year US treasuries currently yield less than 1.5%, rental income is competitive with any other “safe” investment option.

Given the above fact pattern, why do I believe that London / SE pose a more risky investment option than the other areas of the UK? I have broken this down into a number of different, but related points:

1) Interest rates can only rise from their current historic lows. The improvement in affordability over the last 6 years has allowed London / SE borrowers to stretch to buy more expensive properties than they otherwise would have been able to (particularly given the pay contraction in the financial services sector). Clearly interest rates can only rise from their current historically low levels, and recent data points to a rise in interest rates sooner than previously expected. An increase in rates is going to curb borrowers’ appetite to move up the property ladder (diminishing demand for property) and will inevitably push some properties into repossession (increasing property supply).

Additionally, and this is a topic for another article, historically it has been the case on more than one occasion that interest rates, when they start to rise, do so rapidly. Today, most commentators expect a slow but steady ramp up of rates (e.g. 0.25% increases at a time, spread across many years). What if rates rise by e.g. 3% over a year? The shock factor of rapidly rising interest rates will lead to a surge of repossessed property being flooded onto the market (dramatically increasing supply).

2) Foreign exchange (“FX”) will start to deter foreign buyers, and encourage foreign owners to sell their London / SE properties to realise their profits (lowering demand and increasing supply). Tying into the first point above, when interest rates start to rise, Sterling will strengthen in tandem against other currencies. Let’s run a quick example. Imagine a Chinese buyer wanted to purchase a £1m house: in mid-2007 this would have cost him around 15m Yuan, in mid 2010 10.2m Yuan and today, around 9.75m Yuan. Obviously house prices have maybe risen 20% over this period – but a £1.2m house today would still only cost 11.7m Yuan (which is 22% cheaper than mid-2007 from a Chinese point of view).

This explains why foreigners piled into the London / SE property market, but why are they going to leave? Quite simply, FX rates are (in part) determined by the interest rates that a particular currency pays. As interest rates start to rise (or are expected to start to rise), so Sterling will strengthen. If this happens, let’s assume that FX rates move from today’s rough £1 : 10 Yuan to a level of about £1 : 15 Yuan (which is consistent with mid-2007), the £1.2m house purchased today for 11.7m Yuan would be worth 18m Yuan. At 18m Yuan, there will definitely be reluctance on the part of foreign buyers to buy any more UK property (diminishing demand). Also, given that I believe that a lot of funds that have flowed into the London / SE property market are “hot money”, I believe they will be quick to flow out too. When a foreign investor is sitting on a profit as demonstrated above, and they see any weakness in the property market, they will take their gains, sell the property and move on (increasing supply).

3) Buy to let investment will no longer make any sense (if it even does today). It is well documented that buy to let investment has grown dramatically over recent years. This is probably due to UK citizens distrust of shares and bonds given recent turmoil, as well as by the hot money that has flowed into the London / SE property market from foreign investors. However, if you stand back and look at the figures, they no longer make any sense as a long term investment.

After much research (mostly for personal reasons given my recent move into a rented house), it is clear that gross rental yields of prime London properties are in the region of 3.5%. If you have income of 3.5%, let’s imagine you have to pay the estate agent managing it around 0.4% and costs of maintenance of another, say, 0.3% – this leaves you with a net 2.8% income. But wait, this income is then taxed – let’s say your tax rate is 35% (although in reality if you are renting out a prime London property, you probably have a 45% tax rate) – this leaves you with a net income of just over 1.8%. Well that’s not too bad, right? Wrong. When inflation is running at over 2%, you are essentially losing money every year on your investment.

The above assumes that the property is mortgage free which clearly is not likely to be the case in the vast majority of situations. Therefore, overlay the scenario of increasing interest rates over this investment outcome and you will see that it will not take much before investors are actually making a loss on their rented out properties (decreasing demand and increasing supply).

Sophisticated investors run these numbers on a regular basis – and it will become clear over time that this is a losing long term strategy. The London / SE property market is fine as a “port in a storm” – but as a long term investment, it has no legs. When the global market looks calmer, expect the hot money investors to pull out of the market (increasing supply).

Rental yields observed throughout the rest of the UK however (see the rental yield heat map at www.home.co.uk) still provide a much more compelling buy to let investment proposition (7% is readily achievable outside London / SE). While it is clear that buy to let returns will still suffer outside London / SE should interest rates begin to rise, the additional yield attained versus London / SE will provide some support to the level of buy to let investor demand in those areas.

4) Government plans to tax foreign investors will result in sales of existing properties and reluctance to purchase going forward. Current Government plans to target foreign owners of UK property with capital gains tax on profits would change (for the worse) the dynamic of foreign investment into the UK property market.

Typically when new taxes are introduced, they are done so with some forewarning (which is why people rush to fill up their cars with petrol before the new budget taxes kick in). Such a forewarning will lead to some foreign investors looking to sell their UK property to avoid having to pay any such capital gains tax (increasing supply). Additionally, it will also weigh as a negative factor against other foreign investors looking to invest into the UK market (decreasing demand).

Of course, I am not saying that it is inevitable that the London / SE property market is in for a significant decline in prices. However, I do believe that the UK market outside London / SE has not been distorted by the same level of foreign investment and therefore the downside is not as significant in the event of material house price weakness. This is why Funding 365 continues to focus on and target the entire UK market rather than retreat to simply focus on London / SE.

I am keen to hear counter arguments to the above (including immigration levels, continued global uncertainty, higher property liquidity levels in London etc.), so please do get in touch.

Michael Strange, Director, Funding 365 Limited