Volatile markets and buy-to-let profitability

We must understand the behaviour of the buy-to-let sector better says Brian Hall, founder of The Model Works. Much of the data on which these investments are made currently is incomplete, inaccurate and biased and there is still too much subjective opinion from those with a vested interest and not enough independent analysis into profitability and risk. The Model Works has now upgraded its buy-to-let profitability index, following changes to Bank of England tables previously used. This upgrade includes utilising five dimensional motion charts to track profitability over time see www.themodelworks.com. This provides valuable insights into factors that investors should consider when evaluating their options. Three things really stand out from a historic analysis of the sector: Firstly, over the 30 years analysed, the buy-to-let market was surprisingly volatile and there were periods when profitability was marginal or even negative. There appears to be a naivety about how stable the market really is explains Hall. Profitability is falling and it may currently be negative for many landlords when all the costs are taken into account. Secondly, profits in the past have been driven through property price inflation. In a rising market, an investor benefits from increasing equity but there is also a correlation between prices and rent levels. As prices rise so can rents and prior to the Credit Crunch property prices tripled over a ten-year period. Fractionally higher gross rental yields today cannot compensate for the relatively stagnant property prices we are currently experiencing. Many economists claim that property prices are far too high and so another property price boom is unlikely any time soon, despite Funding for Lending scheme stimulation claims Hall. Reviewing historic figures to secure an insight, one gets the impression that the big profits were made when no one was looking, in circumstances very different from today. Thirdly, some landlords are extraordinarily vulnerable, particularly highly geared, amateur new-entrants, buying into an overpriced market, with interest only loans. They might get an shock if we entered their data into one of our models and invited them to project the possible outcomes claims Hall. Even established landlords might find it challenging. The Model Works will continue to drive this work forward. Understanding volatility and risk is common-place in the investments sector says Hall. With so many now choosing buy-tolet, instead of conventional investments, it is vital that these decisions are well founded. The Model Works is now planning to collaborate with savings and pensions providers to complete back-to-back comparisons of buy-to-let versus the regulated alternatives. Note to editors: For further information and to receive the new index, contact Brian Hall on 07785 954040 or brian.hall@themodelworks.com. Additional background on research into first time buyer exclusion and buy-to-let is available from www.themodelworks.com.

The Model Works 11 February 2013

Volatile markets and buy-to-let profitability

Appendix A Volatility of Buy-to-Let Returns (Reworking the Association of Residential Letting Agents Profitability Index)

Buy-to-Let 5 Year Return - Interest Only 75% LTV

500.00% 400.00%

300.00%

200.00%

100.00%

0.00% Q4 2002 Q3 2003 Q4 1987 Q3 1988 Q2 1989 Q1 1990 Q4 1990 Q3 1991 Q2 1992 Q1 1993 Q4 1993 Q3 1994 Q2 1995 Q1 1996 Q4 1996 Q3 1997 Q2 1998 Q1 1999 Q4 1999 Q3 2000 Q2 2001 Q1 2002 Q2 2004 Q1 2005 Q4 2005 Q3 2006 Q2 2007 Q1 2008 Q4 2008 Q3 2009 Q2 2010 Q1 2011 Q4 2011 Q3 2012

-100.00%

-200.00%

-300.00% Return (100% = Break Even)

The Model Works 11 February 2013

Volatile markets and buy-to-let profitability

Appendix B 5 Dimensional Buy-to-Let Profitability Chart of 5, 10, 15, 20 and 25-Year Buy-to-Let Interest Only Investments

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Buy-to-Let Index Q4 2012

Appendix C Profitability on Properties Sold Q4 2012

Repayment Geared Investor 5 Years Purchase Price Opening Balance Closing Balance Selling Price Redemption Amount Closing Equity Final Balance Return (100% = Break Even) Compound Rate of Interest 153,110 -40,574 -57,930 138,289 -107,256 30,924 -24,154 -59.53% Negative 10 Years 96,203 -25,494 -29,363 138,180 -55,317 84,696 53,609 210% 7.72% 15 Years 50,000 -12,750 5,862 138,180 -21,520 116,287 122,149 958% 16.26% 20 Years 39,408 -10,443 10,060 138,180 -10,367 127,857 137,917 1321% 13.77% 25 Years 35,582 -9,073 3,689 138,180 -542 137,735 141,424 1659% 11.89%

Interest Only Geared Investor 5 Years Purchase Price Opening Balance Closing Balance Selling Price Redemption Amount Closing Equity Final Balance Return (100% = Break Even) Compound Rate of Interest 153,110 -40,574 -45,791 138,289 -117,129 18,158 -24,632 -60.71% Negative 10 Years 96,203 -25,494 -13,812 138,180 -72,152 18,158 52,324 205% 7.46% 15 Years 50,000 -12,750 17,268 138,180 -37,311 100,039 117,307 920% 15.95% 20 Years 39,408 -10,443 22,166 138,180 -29,842 108,141 130,307 1248% 13.45% 25 Years 35,582 -9,073 18,533 138,180 -26,541 111,068 129,601 1428% 11.22%

Cash Buyer 5 Years Purchase Price Opening Balance Closing Balance Selling Price Redemption Amount Closing Equity Final Balance Return (100% = Break Even) Compound Rate of Interest 153,110 -157,703 -133,577 138,289 138,180 4,712 2.99% -50.45% 10 Years 96,203 -99,089 -49,971 138,180 138,180 88,318 89.13% -1.14% 15 Years 50,000 -51,000 10,770 138,180 138,289 149,059 292.27% 7.41% 20 Years 39,408 -40,591 29,194 138,180 138,289 167,483 412.62% 7.34% 25 Years 35,582 -36,294 41,945 138,180 138,289 180,233 596.59% 7.41%

Gearing 75% LTV, arrangement: 2% of mortgage, provisions for arrears, voids and management, maintenance and insurances: 2.5%, 5.75% and 15% of rent, interest at B0E rates, property prices from Nationwide, yields from ARLA

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Buy-to-Let Index Q4 2012

Appendix D - Methodology The Model Works Buy-to-Let Profitability Index provides a simple, quantitative assessment of the returns on investment in the private rental sector over time. The index provides profitability data for: 5, 10, 15, 20 and 25 year investment periods Cash buyers and geared investors with: o o A range loan to value ratios Mortgage types: Repayment Interest only

The index is published quarterly and provides profitability data back to 1983. Future releases will include mortgage interest tax relief and capital gains tax calculations and produce data on a regional basis. In addition to the index, which provides historic data, a model based on systems thinking principles will be published to project future outcomes. This paper documents where the data is sourced and how the index is calculated.

Overview The index is founded on the following source data: House prices from the Nationwide Building Societyi Mortgage rates from the Bank of Englandii Deposit rates from the Bank of Englandiii Rent and void levels from ARLAiv Stamp Duty rates from HMRCv

Mortgage repayment and balance calculations are from Mortgages Exposed.vi The index incorporates additional allowances for: Mortgage arrangement fees set to 2% of loan Provisions for arrears set to 2.5% of rental Management fees set to 15% of rent

The Model Works 11 February 2013

Buy-to-Let Index Q4 2012

Structure The index is based on two linked sets of calculations: 1. Capital Gain 2. Cashflow The Index works back from the selling date. For example, if the selling date is Q2 2012 and the index is calculating a five-year investment, the period under review will commence at Q2 2007. The calculation will take the average property price at this purchase date and any stamp duty and acquisition costs that apply at that time. This will create a negative balance on the buy-to-let investors account. Rental income and deductions, including mortgage repayments, are calculated quarterly and applied to the buy-to-let investors account, before the appropriate interest rate is applied to the resulting debit or credit balance. Finally the index identifies the property price as well as any selling costs, including the cost of redeeming any mortgage, at the selling date and calculates the resulting closing balance. If the closing balance is greater than the opening balance, this signifies a profit and the compound rate of return over the period is then calculated.

Comparisons The Model Works Index differs from other buy-to-let indices in several ways. Most indices concentrate on the net rental yield. A typical calculation will simply divide the annual rental income by the initial property price to produce a yield figure, but this is inadequate on several counts and the calculation excludes: Mortgage repayments and the opportunity costs of using funds that could be invested productively elsewhere are not incorporated A raft of other acquisition, maintenance and management costs, voids and arrears costs and selling costs are not taken into account

Generally other indices are far more optimistic and less volatile than that of The Model Works, which takes more factors into account and applies true historic data rather than assumed values.

Regional quarterly series by buyer type - First Time Buyers (Post 1983) Post 1995 IUMTLMV, Bank of England, monthly, combined bank and building society (from 1983 to 1995 BSA Yearbook 2011-2012 New Mortgage %) iii Post 2009 BoE IUMB6RH, Monthly interest rate of UK resident banks (excl. Central Bank) and building societies' sterling fixed rate bond deposits from households (in percent) not seasonally adjusted - 2 year (1996-2009 - BoE IUMWTFA, Monthly interest rate of UK monetary financial institutions (excl. Central Bank) sterling fixed rate bond deposits from households (in percent) not seasonally adjusted, 1995 - UMWTTA, Bank of England, monthly, sterling time deposits rates, from 1983 to 1995 BSA Yearbook 2011-2012 Ordinary Share %) iv Association of Residential Letting Agents - Buy to Let Review v www.hmrc.gov.uk/stats/stamp_duty/00ap_a9.htm vi www.mortgagesexposed.com/Book_Contents/Other_Formula.htm
ii

The Model Works 11 February 2013