Welcome to another issue of Net Interest, where I distil 25+ years of experience analysing and investing in financial stocks into a weekly newsletter. This week’s topic is housing, specifically in the UK, where the market is very highly financialised. For paying subscribers, there is also content on Trafigura, Sberbank and FlatexDEGIRO, plus ongoing access to the extensive archive. To join the fun, sign up as a subscriber here:

“As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce.” — Adam Smith

All around the world, higher interest rates are making their presence felt in financial markets. We’ve looked at a few of the places they’ve shown up in previous issues of Net Interest – in fatter margins at banks, lower valuations at private companies, the dismantling of speculative excess in crypto. This week, we look at housing, using the UK as a case study. 

The link between interest rates and housing is pretty straightforward. Higher rates push up the cost of mortgage finance, which makes housing less affordable for borrowers. Given that most home purchases utilise some form of mortgage finance, that is going to have an impact. So in this context, it’s no surprise that house prices have already started to fall. Over the past year, the Bank of England has lifted its benchmark lending rate eight times from 0.1% up to 3%. The rate on a two-year fixed rate mortgage in the UK has correspondingly risen to over 6% – twice the level it was not long ago.

And sure enough, home prices are reacting. This week, two of the country’s biggest mortgage lenders reported a drop in prices. According to Halifax, prices fell by 2.3% in November, their third consecutive monthly fall and the largest drop since October 2008 (when Halifax’s parent company had to be bailed out by the government). Nationwide reported a similar decline, with its CFO warning that in a worst-case scenario, house prices could fall by 30%. Others agree: A recent survey conducted by the Royal Institution of Chartered Surveyors shows a big swing in the number of market professionals anticipating further price declines.

Predicting the future path of house prices is never easy, but it is complicated in the UK because the structure of the market has changed since the last major interest rate cycle. Home ownership peaked at 71% in 2003 and since then private landlords have taken an increased share – a segment more sensitive to the cost of finance. Over the past 20 years, a new asset class has grown to serve them – the buy-to-let mortgage. One of the largest specialist banks in the space, Paragon, acknowledges the uncertainty created by the shift in its annual report (emphasis added):

While high interest rate and inflation scenarios have occurred in the UK in the past, market conditions, products and regulatory expectations have moved on considerably in the meantime, and most such observations would pre-date the existence of buy-to-let mortgages as a distinct asset class. This means that the value of past history as a guide to future credit performance is reduced.

To understand the current market, it’s worth going back in time to see how we got here. Housing markets have uniquely local characteristics, influenced by the paths they take in response to policy interventions. We’ve discussed the Chinese housing market here before, and also the US housing market. The UK is different. In the past, it fell somewhere between a market-based and state-centred welfare model. Today, it is one of the most financialised models in the world.

From Private to Social and Back Again

At the beginning of the twentieth century, most UK residents lived in rented accommodation. Nine out of ten households rented from private landlords, most of whom were unregulated. The lack of regulation led to a sharp backlash during the First World War. Steep rent hikes and an increase in evictions among those who couldn’t pay prompted tenants in Glasgow to organise a rent strike. Around 25,000 participated, forcing the government to introduce measures to help tenants whose labour was crucial for the war effort. Rent controls were put in place and tenant protections enhanced. 

Following the War, the private rental market began to shrink. Rent controls made it harder to sell tenanted homes, and the bad press that private landlords had drawn during the War made it a less attractive job. Renters also became more politically active. At the same time, widening access to mortgage finance and a house building boom in the 1930s created more opportunities for people to own their own homes. In the years between 1919 and 1939, the share of owner-occupied homes in the UK rose to 33%. 

In the aftermath of the Second World War, demand for more and better housing intensified. Private renters made up around half of the electorate so weakening rent controls to incentivise the private sector to fill the void was not an option. Instead, the state stepped in. 

Under the auspices of local authorities and housing associations, the UK government built 4.4 million “council homes” in the 35 years following the War. In the 1950s, over 180,000 new homes were built per year, ratcheting up to 350,000 by 1968. By 1979, a third of all households lived in homes provided by local councils. 

Throughout this period, though, the drive to get people to own their own homes gathered momentum. Nor was it a policy only of the right. The Labour Party’s 1959 manifesto proposed giving council tenants a “chance to buy” their home. Yet it was the Conservative Party under prime minister Margaret Thatcher that eventually introduced such a scheme. In 1981, her government launched “Right to Buy” giving council tenants an opportunity to buy their rented homes at a discount. 

Council tenants resident in a property for at least three years were given the right to buy it at a 33% discount to the market price. For every additional year they had been living at the property, there was a further 1% reduction, up to a maximum of 50%. The discounts could contribute towards a deposit on a mortgage, so homebuyers did not need to have significant savings to participate. In many cases, mortgage repayments would be similar or even lower than rent, making it hugely popular. Between 1980 and 2015, the scheme resulted in the sale of more than 2.8 million dwellings, making it potentially the most significant act of privatisation of any UK government. 

While Right to Buy shifted the mix of housing in the UK from social rental to owner occupation, it did nothing to boost the private rental market. That came later, with the 1988 Housing Act. 

Boosting Liquidity

Since being introduced during the First World War, rent controls were regularly tweaked by successive governments, alternating between strict and loose interpretations. They were relaxed briefly in 1957 but by the time Margaret Thatcher came to power, they were very tight again. Most private tenants rented their home on ‘regulated tenancies’, which gave them strong security of tenure and allowed rent officers from local government to oversee rental agreements. Tenancies could even be passed to the next generation, making it a very attractive offer for the tenant but an increasing burden on the landlord. Mrs Thatcher herself had been a beneficiary years earlier, as she told Parliament:

I was a rent-controlled protected tenant and had for years enjoyed the privilege of paying low rent with total protection. When the 1957 [Rent] Act took effect my husband and I decided—thank goodness—to go in for owner-occupation. The reason why a substantial number of properties went out of the privately rented sector at that time was that since 1915 the landlords had had a raw deal with controlled rents. The moment those properties came out of control for the first time—and some out of security of tenure—the landlords could sell them. Naturally, landlords who had received a very reduced rent for a great many years took advantage of the decontrol to turn their property to good account. 

The Housing Act reduced security of tenure and deregulated rent on all new lettings, which were structured either as “assured tenancies” or “assured shorthold tenancies”. The advantage of the latter is that they carried fixed terms of between six months and five years, after which the landlord had the right to regain possession. Their flexibility made assured shorthold tenancies the most popular agreement for landlords. 

Although the Act reignited activity in the private rental market, it took a few more years for it to ramp up. The Act allowed landlords to let properties at market rents and by attaching much weaker security of tenure to homes, it increased the liquidity of rental housing as an investment. But the housing market crash of 1990 derailed growth and lenders also remained worried over whether amateur landlords had picked the right assured tenancy agreement. In 1996, an amendment to the Housing Act made the shorthold tenancy the default agreement, and alongside that a new financing mechanism was launched. 

Buy-to-Let

The financing mechanism was the buy-to-let mortgage. Previously, the only legitimate way to finance a property portfolio was through a commercial mortgage, but interest rates on commercial mortgages were high and loan-to-value ratios were low. Many landlords used standard residential mortgages, even though these were in breach of the terms.

The buy-to-let mortgage was devised by the Association of Residential Letting Agents in partnership with several banks to allow borrowers to finance up to 75% of the value of their property, assessed on the income the property generated. For lenders, the trigger was the assured shorthold tenancy agreement. No lender wants the burden of a sitting tenant in a repossessed home; the short-term nature of the new tenancy agreements mitigated that risk. A new, financeable asset class had been created.

Over the next ten years, financed by buy-to-let mortgages, the private rental sector grew. But following the financial crisis in 2008, it really got a fillip. Risk-averse lenders demanded higher deposits from borrowers and buy-to-let landlords were better equipped to oblige than first-time buyers. By 2014, the number of loans granted to landlords outstripped the number given to first-time buyers – nearly 200,000 buy-to-let mortgages were approved in one year alone. Between 2005 and 2015, almost every net new home added to England’s housing stock ended up in the private rented sector.

As at the end of September 2022, there were 2.05 million buy-to-let mortgages outstanding in the UK, compared with 8.92 million homeowner mortgages. That’s a record high. Those mortgages represent £240 billion of outstanding volume, equivalent to 16% of the market. The total may actually understate the amount of financing in the private rental market, since around 14% of landlords utilise other sources of finance, according to a government survey. The net result: around 19% of UK households now get their housing provision from the private rental sector.

One of the pioneers of the buy-to-let mortgage was Paragon Banking Group PLC. Over the years it has originated £27.3 billion of volume and currently has a book of £12.1 billion. Prior to the financial crisis, the company had built up a 10% share in the market, but when its wholesale-funded model came under pressure, it was forced to recapitalise. Just over 70% of its current book was originated post-2010 with the rest representing legacy (and acquired) assets that predate the crisis. 

The loan-to-value ratio on Paragon’s portfolio is 57.9%, down from 61.2% a year ago as home price inflation has injected more of a cushion. Reflecting the buoyant market of the recent past, arrears are currently very low, at just 0.09% in the financial year ended September 2022 on the post-2010 book (0.15% overall).  

Nevertheless, the company admits that the market is getting more difficult. “Landlord’s [sic] expectations for their businesses appear more pessimistic than this performance data would suggest,” it noted in its results announcement this week. 

Indeed, since 2015, the government has made it more difficult for private landlords. Tax relief on mortgage finance costs was restricted, a “wear and tear” maintenance allowance was removed and stamp duties were added for new property purchases. Some landlords were already looking to exit before the recent hike in rates. Paragon acknowledges in its latest business review that “the Group’s experience over the past year is that some smaller amateur landlords are leaving the market in the face of economic pressures and regulatory changes”.

Recent rate hikes are likely to accelerate the trend. Latest Bank of England data puts the current 75% loan-to-value two-year buy-to-let rate at 5.96%. For remortgaging landlords, this presents a problem. Coupled with the impact of inflation on maintenance costs, their profits are getting squeezed. For tenants, that spells higher rents. In London, asking rents on new listings are up almost a third since 2019 according to one report. ¹

But there is a limit to how much rent can be hiked and the net result is that many more landlords may leave the market. As the marginal sellers, this could have an impact on the overall market. When Margaret Thatcher moved out of rented accommodation in 1957 to buy her own home, she paid £5,000. These days, suburban houses like hers are not affordable to first time buyers. If buy-to-let landlords become sellers rather than buyers, then the clearing price will have to adjust to give the next generation of homeowners a step on the ladder.

Several books are available on the theme, albeit they come at it from a social perspective: Generation Rent by Chloe Timperley, Tenants by Vicky Spratt and A Home of One’s Own by Hashi Mohamed.