Buy-to-let can be profitable - but beware the pitfalls

A lack of mortgage finance for first-time buyers has helped the buy-to-let market. Rob Griffin finds the experts are upbeat

Buy-to-let is enjoying a return to favour among investors as more people than ever turn to renting. In fact, figures from the Communities and Local Government Department published this week revealed a 55 per cent increase in the last six years in the number of people renting privately-owned accommodation.

The number of private renters increased from 2.15 million in 2003-2004 to 3.35 million in 2009-10 as potential homebuyers have discovered they simply can't afford to raise the deposit to buy a home, especially what the best mortgage deals require a 25 per cent deposit or more.

The increase in the number of people choosing to rent their homes has seen a resurgence of interest from prospective landlords hoping to profit from rising rental yields, while acquiring a decent asset. It means buy-to-let, which has effectively spent the last three years banished to the wilderness, has come back with an increase in both the number of mortgages available and confidence levels among potential buyers.

Industry commentators claim the area is recovering well from the devastation caused by the credit crunch which resulted in a lot of lenders falling by the wayside – and those that remained having to dramatically tighten their lending criteria.

Steve Reid, retail director for Clydesdale and Yorkshire Banks, says the Australian-owned lender hasn't stopped offering buy-to-let loans, but warns potential borrowers to think carefully before signing up. "The key to buy-to-let, like any investment, is solid research," Reid says. He's quite positive about the current market as "demand for rental properties is outstripping supply and the market has seen an upturn in the yields being achieved."

David Hollingworth, of the mortgage broker London & Country, is also upbeat. "A number of lenders have returned to the market and new names are appearing," he said. "Although nothing moves too rapidly in this market, the rates on offer are getting a bit more competitive."

His claims are backed up by figures from the Council of Mortgage Lenders which reveal that new buy-to-let mortgage lending totalled £2.9bn across 27,600 loans in the first three months of 2011 – up on the £2.1bn and 22,000 loans during the first quarter a year ago.

Michael Coogan, CML director, was also optimistic about future prospects when he announced the figures. "Demand for rental property remains strong, and as more funding becomes available we would expect to see buy-to-let lending increasing," he said.

Buy-to-let basics

The definition of buy-to-let is a form of residential investment where you buy a property – normally with the aid of a specialist buy-to-let mortgage – and then rent it out. As well as generating an income from the rent, potential investors hope the capital value of the property will rise over time.

In the best-case scenario, therefore, the property will be earning money for its owner on two fronts: A steady income stream which covers the mortgage payments as well as providing something extra, and the longer-term benefit of buying something which you will be able to sell for a profit.

An analysis of the buy-to-let market over the past decade certainly paints a picture of rapid growth, even when you take into account the problems encountered over the last few years. At the end of 2000 there were 73,200 outstanding loans worth £5.4bn. By the end of 2010 there were more than 1.3 million mortgages valued at £151bn, according to CML data.

IIt may be growing in popularity but does it stack up as a viable investment? Is now the time to consider putting money into this area again or are there still too many potential downsides?

Geoff Penrice, an independent financial adviser with Honister Partners, has conflicting views on whether his clients should consider it. While willing to buy into the longer-term story, he is troubled by shorter-term issues that are influencing the market.

"Properties will increase in value due to the shortage in supply so it may prove a worthwhile investment," he says. "However, I don't believe we will see the sort of returns that we have done recently and there will be some downward pressure in the short term as real incomes are falling."

Is buy-to-let right for you?

Regardless of the market environment you need to decide if buy-to-let is for you. So ask yourself a series of questions. Do you have sufficient capital at your disposal? Are you happy to tie up this capital for a number of years? Have you the resources to manage the property?

If the answer to any of these is no, then it's not worth getting involved. However, if you're still keen to proceed, then you need to do your research. Be realistic about how much you can afford, remembering to have cash to cover unexpected costs and for periods when the property is empty.

There are clear pros and cons about getting involved in buy-to-let, according to Geoff Penrice. Anyone considering going down this route will have to weigh these up carefully before committing their time and money.

"People need to live somewhere so there will always be demand, property is tangible so you can see and touch it, and prices should also increase over the longer term," he says. "However, it also seems quite expensive relative to earnings at the moment and interest rates can only rise from here."

In addition, there is the risk that existing homeowners may end up having too much tied up in one area, rather than diversifying their assets. "There is also the liquidity risk as it can be very difficult and expensive to sell a property should you wish to release your capital," adds Penrice.

Finding a property

It is very important to research your market. Ask local letting agents what type of properties are in demand from tenants so you don't end up buying a two-bedroom cottage out in the sticks when everyone wants a city centre flat.

Ideally, choose a property in a good location with a range of local amenities and access routes. Visit potential properties at different times of the day to get a feel for the area and put addresses through the Google search engine to provide more information.

Securing finance

Although the situation has improved, getting finance can still be a challenge, according to David Hollingworth. "A couple of lenders will stretch to 80-85 per cent loan-to-value but generally you'll need to put down a 25 per cent deposit, and some of the keener rates will only be available to those that are only looking to borrow around 60 per cent."

Arrangement costs can be particularly steep – as much as 3.5 per cent of the mortgage – while even lenders offering flat fees will be demanding up to £2,000.

"How much you can borrow will depend on the rental income the property can generate, with lenders looking for about 125 per cent coverage of the mortgage interest," he adds. "The interest rates charged will be roughly one per cent higher than in the residential market."

Being a landlord

Anyone that harbours dreams of owning a buy-to-let property will also need to face up to the very harsh realities of becoming a landlord, warns Tessa Shepperson, a specialist solicitor and author on residential landlord and tenant law.

"Becoming a landlord is perceived as being easy money but that's not necessarily the case," she says. "If you know what you're doing, get it right and are lucky with your tenants, you can make money for not a lot of effort, but it doesn't always work out like that."

People tend to spend a lot of time thinking about the financial side of getting involved in buy-to-let but relatively little of the actual business itself, such as how they should go about it, what responsibilities they have, and the rights of their tenants.

The key is finding a decent tenant. "Most normal, responsible people that are respectful of others will abide an agreement they have signed," she adds. "That's why getting a good tenancy agreement is important, but so is the choice of tenant, as not everyone isthe same."

There is no shortage of anecdotal nightmare stories of tenants causing amateur landlords – and those that are doing it full-time – endless frustration, she points out.

"If you're unlucky enough to be stuck with one of these people that don't pay the rent nor look after the property properly, it can take you six months to get them out of your property. You want a good tenant that's going to pay their rent and is responsible and will look after the place."

Before letting anyone through the door you will need to check them out. Ask for references, meet them face-to-face, get them credit checked and talk to their employers. Of course, even doing all this is no guarantee you'll have a trouble-free tenancy but, it will certainly improve your chances.

Conclusion

So where does this all leave the would-be landlord? There are thousands of people across the country enjoying a decent rent each month – and this is possible as long as you take your time, research the market, buy a property for a decent price and find a reliable tenant.

Letting agents: cowboys or guardian angels?

In exchange for a fee, lettings agents will take find tenants, collect deposits and rent, and ensure that these individuals are taking care with your property.

In the best-case scenarios these firms can provide a stress-free solution, but the fact this industry is not regulated by the Government – meaning anyone can set up as an agent, regardless of whether or not they have any experience – is a potential hazard for would-be landlords.

According to the Association of Residential Letting Agents, a growing number of both tenants and landlords are losing out to cowboy agents through everything from poor advice, no commitment to best practice and losing money when they go into administration.

In a bid to help combat the problem, ARLA introduced its own licensing scheme for members two years ago which requires them to abide by a number of rules, including having client money protection schemes in place and professional indemnity insurance in place.