This article explains why I firmly believe that in the UK context, the best option for most folks is to buy a residential property. I also explain how your residential property can generate returns to kick-start your property investment journey.
Why Is This Even A Question?
House prices, particularly in London and the Southeast are super high relative to most young people’s income. Based on data as at 30th September 2019, the average house in the UK costs more than 8-times average earnings. We might think that we are in unprecedented times, but history shows us that there was a time when things were a lot worse (see graph here).
It’s tough out there. You save and save but your deposit and salary multiple (see explanation later) is just not enough to buy a property in the area where you live. You then begin to consider if there is an alternative route to get onto the property ladder. You search the internet for general advice on the matter and find lots of YouTube videos and blogs telling you that you’re better off buying an investment (Buy2Let) property in an area where prices are more affordable as a way of getting on the property ladder.
The idea sounds good, purchase a Buy2Let property, the tenant pays the mortgage and after all costs, there’s a net profit to save each year. At the end of say 3 years, you might have three sources of savings:
Money saved from your main job
Saved net profit from rental income
Equity in the Buy2Let property via growth in the house price
These savings might just be enough to finally buy your home to live in (residential property). Sadly, things are not that straightforward and a lot of thought needs to go into this decision. Let’s start with an overview of the property affordability basics for residential and Buy2Let properties.
The Property Affordability Basics
QUICK NOTE to say that what I’m covering here is just a generalisation based on what I’ve observed. Mortgage Lenders are in business to make money and therefore could relax rules, albeit subject to any Financial Conduct Authority (FCA) limitations. You should therefore consult an INDEPENDENT, WHOLE OF MARKET (i.e. sources mortgages from the whole of the UK market) mortgage broker to find out what options are available to you. Please don’t simply go to the high street/online bank you bank with. A good mortgage broker can work ‘wonders’ for you.
Residential Mortgage for a home to live in
Generally speaking, most people are only allowed one residential mortgage (although theoretically a wealthy aristocrat could have a main residence and a holiday home – both on residential mortgages). To buy a property, you need to put down a deposit and then get the bank to loan you the remaining amount. Deposits of 5% to 15% are often needed for your 1st residential property, although economic stresses such as that induced by the COVID-19 pandemic, may limit product availability. So, if a property is selling for £200,000 and you have £10,000 to £30,000 saved, you are half-way there.
I say half-way there because you still need to consider your SALARY MULTIPLE. Most mortgage lenders use a salary multiple of 4 to 4.5 times your salary. Some lenders use 5 times your salary and a very small number of lenders use 6 times. Note that I’m using the term salary multiple since most people have income from one source - their main job. However, if you can prove income from other sources in addition to your main job, this gets added to the ‘salary multiple’. A young person earning £30,000 a year can borrow £120k (x4), £135k (x4.5) or £150k (x5). You can see that this salary multiple won’t be enough to buy the £200,000 property in the example above, even if you could put down say a £25,000 deposit (£25,000 deposit + £150,000 mortgage = £175,000). A way around this is to partner up with a boy/girlfriend, friend, relative e.tc so that the combined income covers the required salary multiple.
One final thing to consider is the interest rate on the mortgage, which determines how much you’ll be paying monthly and over the lifetime of the mortgage. Generally, the higher the deposit you put down as a percentage of the value of the property you intend to buy, the better the interest rate. The measure is called Loan to Value (LTV). Let’s take the £200,000 property example again. 90% LTV means your deposit is 10% (£20k) and the Mortgage lender lends 90% (£180k); 75% LTV means your deposit is 25% (£50k) and the Mortgage lender lends 75% (£150k). The 75% LTV mortgage would typically have a better interest rate than the 90% LTV mortgage. Do remember that this section only covers the basics. There are other things to consider such as your credit score, the lifetime of the mortgage, fixed rate or variable rate mortgages, ‘cleaning up’ your bank statements 6 months before applying e.tc.
Buy2Let for an investment property
Most mortgage lenders would like to see that you earn at least £25,000 a year from your main job. Other than that, the mortgage lender is more concerned with the viability of the investment property. Sadly, the pool of lenders available for people buying a Buy2Let without already having a residential property is very small. But it is possible.
The Buy2Let lending criteria has been tightened somewhat since the financial crisis of 2008. Lenders will typically check that the value of the property as determined by their surveyor matches or is greater than the selling price; that the Interest Cover Ratio (ICR) is 125% OR 145% (see explanation below) at an assumed interest rate of 5.5% and that the LTV is 75%.
For example, say a property is selling for £100,000 and the estimated monthly rent is £500. You will need to pay £25,000 deposit (25% of £100,000) and the mortgage lender will lend you £75,000 (75% of £100,000). Note that there are other costs such as solicitor’s costs, stamp duty, arrangement fees e.tc. I’ve shared the costs associated with a typical Buy2Let property in an article I wrote about understanding Return on Invesment.
INTEREST COVER RATIO (ICR)
This is used to assess Buy2Let affordability. It’s best explained using an example. Say a property is selling for £100,000 and the estimated monthly rent is £500. Let’s assume that the monthly mortgage is £300. The lender wants to be sure that the monthly rent covers the monthly mortgage and more. How much more? Depending on the lender and their assessment of your situation, it could be 25% more (i.e. 125%) or 45% more (i.e. 145%). This is partly in response to the raft of aggressive landlord tax changes introduced during the Osborne budget of 2015.
Calculation for 125% ICR is as follows: £300 + (25% of £300) = £375
Calculation for 145% ICR is as follows £300 + (45% of £300) = £435
In this example, the borrower would likely meet the ICR affordability test of the lender as the calculation yields numbers that are less than the £500 rent. However, it gets a little more complicated since the interest rate they use to work this out is 5.5%, regardless of the actual rate you pay. The Lenders’ reasoning is that interest rates are currently at record lows and they want to be sure that even if interest rates were to rise to typical rates of 5.5%, that you would still be able to afford the mortgage – a stress test.
Now let’s have a look at 3 main considerations to help your thought process
1 Where Are You Now & Where Do You Want to Be?
It all starts with YOU: where you are now and where you want to be. The decision to buy your 1st property as a residential property or Buy2Let, very much depends on your personal situation and your plans. For example, if your salary is likely to grow considerably over the next 3-5 years and perhaps you can save a lot because you live with your parents, then it may make sense to wait and buy a residential property in a few years. This way, you can optimise your 1st time buyer status (I’ll explain this later).
If you’re in a relationship and it’s getting serious to the point that you might get married or move in together in a few years, then once again you might opt to wait to buy a residential property together. If on the other hand, you’ve got kids in a local school and you are renting in an area you can never afford to buy, then you might consider buying a Buy2let property. This is clearly not an exhaustive list of scenarios. I’d encourage you to sit down with a pen and paper and jot down your current situation and your future plans.
Do also consider whether you want to become a property investor or not. If your goal is to gradually build a property portfolio, then it might make sense to purchase a Buy2let property as your 1st property. However, if you just intend to buy a Buy2let and hold till you buy your main residence, this may not be a good idea. The property investment market has gotten considerably more challenging in the last 6-7 years due to a raft of changes introduced by the government and the effect has been to make life difficult for amateur landlords. It’s now much harder to dip your toe in. You’d need to fully commit to learning all the rules and stay on top of further changes.
2 Don’t Waste Your First Time Buyer Status
The first-time buyer seems to have a special space in the government’s ‘heart’. Every political party agrees that more should be done to help first-time buyers. This includes reduced stamp duty rates for 1st time buyers buying residential properties costing less than £500k. This was introduced in the 2017 autumn budget: 1st time buyers pay 0% stamp duty up to £300k and 5% between £300k and £500k. Note that this does NOT apply to Buy2Let properties, even if it is your 1st property. Nb- the government also introduced a short-term stamp duty perk for ALL buyers until 1st April 2021, but this isn’t relevant for this discussion.
Another current (as at 2020-21) special gift to 1st time buyers is the Help to Buy Scheme, in which the government lends you up to 20% of the purchase price (40% in London), interest free for 5 years. You only need to put down 5% deposit to access this scheme. You can only buy a new-build home with this and the maximum property price depends on where you are buying. For example, in London the maximum is £600k. Again, you can’t use this scheme to buy a Buy2let property, even if it is your 1st property.
Heaven knows what else the government is going to do that will make it even easier for 1st time buyers. Uncle Rishi (current Chancellor of the Exchequer) could suddenly start dishing out more ‘property sweets’ to 1st time buyers during one of his budget announcements. So why would you want to waste these perks by buying a Buy2Let property as your 1st property? You can only use your 1st time buyer status ONCE, and after that………… it is gone FOREVER
3 You’d Be Insane Not to Factor CAPITAL GAINS TAX (CGT)
It is really important to consider the jurisdiction you are in for tax purposes when pondering on general advice received from your favourite property guru via his/her book or YouTube video. Buying an investment property as your 1st property may make sense in another country, but in the UK context, you’d be INSANE not to factor Capital Gains Tax (CGT).
CGT is a tax on the profit when you sell an asset that has increased in value. For Buy2let property, you’ll pay 28% tax on your profit if you are a higher rate tax payer or 18% tax if you are a basic rate tax payer. There is also an annual Capital Gains tax-free allowance of £12,300 (at the time of writing), which means that you only pay CGT if your profit is more than this. Do speak to an accountant to get the most accurate explanation. I’m only providing a general guide here. Unlike with Buy2let property, you typically DO NOT pay CGT when you sell your own home.
Now let’s imagine a situation where you buy a Buy2let property as your 1st property. If it were to rise in value and you decided to sell it to fund the purchase of your residential property, you would have to pay CGT on any amount over the Capital Gains tax-free allowance. It gets worse though: the Osborne budget of 2015 introduced a rule called Section 24, which loosely translates to property investors paying more tax. Basically, the government took a shotgun and blasted through a fundamental business rule that any interest on borrowing is accounted for before profit is worked out. If your mortgage is £300 a month and your rent is £500, the rules state that your profit is £500 (ignoring other expenses for a second) and not £200 (£500 - £300). Then a mortgage interest relief, which depends on whether you are a basic rate or higher rate tax payer, is applied to this so called profit of £500. Here’s the problem: this rule can quickly push you into the higher rate tax band, even if you are a basic rate tax payer in your main job. So rather than paying 18% CGT when you sell your Buy2Let property, you may have to pay 28%.......I want to Cry...
It’s not all doom and gloom. A good accountant and or tax adviser can help you to navigate the CGT challenge, but it won’t be straightforward. It’s different if you decide to keep the Buy2Let rather than sell it. You may be able to re-mortgage the Buy2Let and release some money, which typically does not trigger CGT as it’s a further loan from the bank. Some readers may be quick to point out that you could purchase the Buy2Let in a limited company and avoid Section 24 altogether. However, do remember that Joe Bloggs Property limited is a completely separate entity to Joe Bloggs. It is not within the scope of this article to go into the detail of how this would work but suffice to say that there are ways to minimise the tax burden, albeit with a bit more paperwork.
Hopefully you’re beginning to piece together the complex jigsaw of factors to consider. It is far simpler and tidier to buy a residential property as your 1st property. I reflected on what I might do if I was starting out again in today’s market and here are some thoughts. Please note that this is NOT a recommendation to follow this course of action, but rather something to think about as you make YOUR OWN decision based on your own INDIVIDUAL CIRMCUMSTANCE
What I Might Do In Today’s Market If I Was Starting Out
I started out as a pharmacist and pharmacists do earn a relatively decent income. Furthermore, pharmacists willing and crazy enough can work as many hours as they want if they are prepared to travel anywhere in the country. Therefore, although it’s hard on the body and on the brain, they can save quite a bit of money. So, it is likely that I would have saved aggressively and bought a residential property in a cheaper area that is a commutable distance from my family/main job/ social network. If I was looking to settle down and have kids soon, I’d be targeting an area with a good enough environment to raise kids, just in case I got stuck and couldn’t move to a better area once the kids arrive.
Depending on how desperate I was to get onto the property ladder quickly, I might decide to go further afield instead. Rather than save for many years to buy in Greater London or the surrounding areas such as Kent and Essex, I might buy a 2-3 bedroom property in an economically active city such as Manchester or Leeds. I could find a decent property for around £150,000 and put down 10% deposit (£15k) and my income would be enough for the salary multiple of x 4.5. My interest rate would be much lower than it would have been as a Buy2let property.
I wouldn’t have to pay stamp duty … yippee... I could target a property that has extendibility. It would probably be a house, so that I could consider adding extra bedrooms, which would increase the value of the house. I could start rubbing my palms with glee knowing that unlike a Buy2let property, any gains made won’t be subject to CGT. All gains are mine to keep and if I do a good job with my planning and building extension, I might be able to add a whole year's salary worth of value. It gets better, I could later decide to re-mortgage my residential property to release equity and buy a new residential property and then change the old one to a Buy2let. If I did this, I wouldn’t pay any CGT on the gains made up to the point the property was no longer my principle private residence and for 18 months (9 months from April 2020-21 Tax Year) after. (Don’t worry if I’ve lost you. The application of this perk is a little complex and probably requires a discussion with an accountant or tax adviser – for now just google ‘Private Residence Relief from CGT’).
Say my work was in London and I’d bought a residential property in Leeds. I could live with my parents/friends/family in London during the week and even pay them something and then go to my house in Leeds for the weekend. Kind of like what MPs with constituencies far away from London have to do. Over time, I might be able to find a job closer to my home in Leeds. Why on earth would I do all this? Well, I’m young and hungry to learn. I didn’t just choose any area to buy my residential property, I chose what I believe is my gold mine area. I want to learn as much as possible about the area in preparation for my next property move. So it makes sense to spend my weekends there.
My residential property in Leeds is also generating me a return. It’s a 3 bed house and I managed to get two lodgers (via spareroom) each paying me £300 a month. That’s £600 x 12 = £7,200 a year TAX FREE. Why is it tax free? Because the government’s rent a room scheme allows me to earn up to a threshold of £7,500 per year tax-free from letting out furnished accommodation in my home. No paperwork required.
A special gift from Her Majesty's Revenue and Customs
I empathise with those friends who bought a Buy2Let property in Leeds as their 1st property because they got excited over some podcast they listened to. Some of them might need to earn at least £10,000 gross income before they come close to matching my Tax free £7,200. Of course, I’m NOT like that DODGY lady I met who told me she did what I did and bought a residential property in Leeds as her 1st property. But (unlike me), she lets all 3 bedrooms out and collects the rent as cash. She pays the council tax bill and all utilities and is on the electoral register so she’s got the papers to prove to anyone that she lives there, even though she doesn’t. She makes £350 a month per room (£12,600 a year). She's probably breaking her mortgage terms as she doesn't live in the property and she probably doesn't declare her income for tax purposes. Hey ho - to each their own. As for me, I'll stay within the rules.
One of my friends who bought a Buy2let property as his 1st property has been educating me, through his pain. He didn’t follow the government’s strict rules to give an energy performance certificate, how to rent guide and gas safety certificate to the tenant when she moved in. Now she’s not paying the rent and he is struggling to evict her. I’m so glad when I learn that I’m unlikely to face this problem as I have lodgers living with me and not a tenant renting a whole house off me. I recall that my mortgage lender did say I could take on lodgers when I asked them, on the proviso that the lodger is not given security of tenure. Now I understand why. Easier Life.
I thought I understood properties but now I realise that I don’t – although I’m learning. The other day, the roof started leaking and I had to fix it. I’m learning all sorts. I’m glad to be testing my appetite for property investment in a low-risk way. Soon I will start my extension and increase the number of rooms. Looks like I’ll be able to eek out a 4-bed house from this 3-bed. I might make the 4th bedroom super amazing, with an ensuite so that I can start generating even more income from Airbnb stays.
Conclusion
Having read this article, I’m pretty confident that you’ll agree with me that for most people, it makes sense to buy a residential property as your 1st property. I recognise that YOUR situation could be very different and that there are probably a host of other factors that I could have included in this article. However, I sincerely hope that this article has given you food for thought. You may need to read this article again and stop periodically to google some of the points I raised. I’ve deliberately weaved the main points into a story as stories are generally more memorable than lists.
Most importantly, I’d strongly encourage you to speak to an independent mortgage broker NOW: this conversation could be the impetus that drives you to increase your savings and put together a 3-5 year plan.
That’s it for this article folks, but before I go, I’d like to dedicate this post to my younger brother, a super hardworking dude with a warm heart and a good head on his shoulders.
Wishing all readers Merry Christmas and Happy New Year if you’re reading this at the end of 2020
Love
Bemi Odunlami
Comments