Buyer Beware: The Curious Case of Income Supplemented BTL (Bigley/Eakins)

Background

As highlighted by S&P Global Ratings in its report called New U.K. Buy-To-Let Mortgage Rules Will Change The Face Of The Lending And Securitization Markets (available by clicking here and navigating to the Thought Leadership tab), the U.K. buy-to-let (BTL) mortgage market is currently undergoing significant changes. We highlighted that changes in the regulatory landscape rarely pass without a response from lenders, and in the case of the BTL market, we anticipate that regulatory changes will likely lead to an evolution in BTL products or a shift by lenders along the credit curve. Ultimately, credit institutions are risk-taking entities that need to lend and need to leverage in order to make money. Larger diversified lenders have the option to lend in other asset classes; however, monoline lenders—those who are narrowly focused on residential based lending—have little choice in the short term but to evolve their product offering as a response to regulation.

The Issue

As a consequence, there have been a number of recent product innovations, the most notable of which is the re-emergence of "Income Supplemented" BTL, otherwise known as "top-slicing" of income. Income Supplemented BTL is a loan for which the affordability assessment is performed by taking into account both income from the rental of the property and the borrower’s earned/other income (e.g. from a salary). The income taken into account is typically deemed to be "excess" income. In this context, excess is the net income after taking into account a borrower's other credit commitments, such as residential mortgages, car loans, and costs of living.

Prima facie, a borrower who has surplus income may have greater capacity to deal with unexpected costs of property ownership and rental void periods, when compared to a borrower who does not have excess income. Indeed, it is partly for this reason that many lenders have minimum borrower income requirements for BTL products, even when they assess a BTL loan's affordability using only rental income.

The explicit use of excess income in the assessment of affordability can be problematic from a credit perspective for two reasons.

Firstly, it may be possible to spot only if a borrower's other BTL properties do not yield enough rental income to pass affordability tests when the lender checks rental income of all a borrowers total portfolio, including ones the lender does not lend on. Not all lenders routinely perform such a check, and checking the financial viability of a borrower’s portfolio becomes mandatory only once a borrower has four or more BTL mortgage loans.

In practical terms, therefore, the same surplus income could be double- or triple-counted. S&P Global Ratings considers that although it is not impossible for earned income to be used for portfolio BTL lending (portfolio defined when the borrower has four or more properties), the requirement to assess the income and expenditure for the whole portfolio means that the risk of different lenders utilizing the same income is reduced. By way of an example, a mortgage lender may decide that a borrower has £300/month of excess income, and all of this £300 is needed to pass the lender’s affordability tests to advance a loan at the requested LTV ratio advance amount. It is therefore possible for the borrower to approach three different lenders and all use the £300 in their affordability calculations. In this example, the lenders are collectively assuming that there is £900 of surplus income when there is in reality only £300. Depending on the terms and conditions of each lender, it is possible that a borrower behaving in this way is a breach of the mortgage contract; but this is unlikely to be a deterrent for all borrowers, given the possible upside of leveraged gains. Although it is not necessarily the case that rent is below the mortgage payment for such loans on day-one, it does mean that they are less likely to be able to absorb interest rate rises and rental void periods. It is for this reason S&P Global Ratings expects relatively worse performance of income supported BTL, and for transactions with a high exposure to such originations to have higher default and delinquency rates.

Secondly, the fact that a loan is being underwritten using an income-supplemented approach indicates that the rental yield is not sufficient for the lender to originate a loan compliantly using the Bank of England’s stressed rate requirements. Therefore, even without multiple counting of the same surplus income, such loans are exposed to events that may not be correlated to stress in the rental market, such as borrower illness, divorce, change in lifestyle, and unemployment.

Rating Approach

In its published RMBS methodology, Methodology And Assumptions: Assessing Pools Of European Residential Loans (available here), S&P Global Ratings applies different adjustments to Foreclosure Frequencies for loans that have an affordability assessed using a borrower’s income compared to BTL loans for which the affordability has been assessed using only rental income. In addition, we may make adjustments to the Foreclosure Frequency of loans using the Originator Adjustment based on an assessment of the lender's origination practices. S&P Global Ratings believes the specific details of the underwriting process will become critical in calibrating expected default rates in RMBS transaction exposed to income supplemented BTL. Of particular interest will be whether lenders check the rental income of a borrower's other properties, not just the one the lender is lending on. Also of interest is degree to which income can supplement a loan: for example, whether a loan may be loss-making accounting only for rental income and the nature and the stability of earned income considered when underwriting income supplemented BTL.