PRA underwriting changes

Bank of England

The second roll-out of Prudential Regulation Authority (PRA) changes to buy-to-let mortgage underwriting impacted portfolio lending and had to be implemented by lenders they regulate by 30th September, 2017.

The new rules resulted in “portfolio landlords” (defined as those who own more than three buy-to-let mortgaged properties), having to provide lenders with greater detail as to the finances of their property business when making applications for further borrowing.

Lenders were also required to tighten affordability calculations for portfolio landlords.

These measures garnered the greatest focus for the industry, however, the PRA also changed the way lenders calculate the capital they need to hold against buy-to-let borrowing, a point that went largely unreported.

What prompted a change in the underwriting of portfolio lending?

All of the changes to the underwriting of buy-to-let mortgages by the PRA came about after a review in 2015/16 of standards across the lender marketplace.

From 1st January, 2017, tighter checks on interest coverage ratios and interest rate affordability were implemented with PRA regulated buy-to-let lenders.

Having assessed the nature of buy-to-let portfolios, the PRA concluded that their complicated financial structure and variety of associated risks, warranted special underwriting measures aimed at helping to protect the borrower from financial vulnerability.

How does the PRA define a “portfolio landlord”?

You may think of portfolio landlords as those with tens of properties, however, the PRA defines portfolio landlords as those with:

“…four or more mortgaged buy-to-let properties across all lenders in aggregate”

Source: Chapter 3, point 3.1. “Policy Statement | PS28/16. Underwriting standards for buy-to-let mortgage contracts. September 2016”

Why did the PRA define portfolio landlords as those with 4+ properties?

The PRA arrived at this definition having analysed research that showed:

  1. The rate of the risk of arrears increased as portfolio size grew
  2. Lenders already implemented specialist underwriting measures where portfolios exceeded a given size
  3. The significant impact of changes in personal tax upon landlords

During the consultation period for the legislation, respondents felt that a definition based on number of properties alone was not necessarily a true reflection of a complex portfolio situation.

The response from the PRA placed responsibility for any further criteria, to define portfolio landlords, in the hands of the lender.

Extra underwriting measures

Buy to let mortgage applicants have always had to demonstrate that the repayments on their borrowing are affordable for them.

However, post review, the PRA concluded the complexity of the financial structure of a portfolio required a more detailed level of assessment by lenders, to inform lending decisions.

The calculation used to demonstrate affordability was also tightened.

The types of information that the PRA suggested lenders should gather (as outlined in their Supervisory Statement) included, but were not limited to:

  • the borrower’s experience in the buy-to-let market and their full portfolio of properties and outstanding mortgages;
  • the assets and liabilities of the borrower, including any tax liability;
  • the merits of any new lending in the context of the borrower’s existing buy-to-let portfolio together with their business plan; and
  • historical and future expected cash flows associated with all of the borrower’s properties.

Stricter borrowing criteria for portfolio landlords

In addition to changes to the amount of paperwork portfolio landlords will have to provide, affected lenders were also required by the PRA to introduce stricter assessment of affordability on mortgage repayments, often referred to as the interest coverage ratio (ICR).

In the past, lenders applied much lower ratios, with landlords having to prove that their rental income could cover 125% of their mortgage repayments at an assumed interest rate of 5% or 5.5%.

However, the PRA rules imposed an expectation that lenders would apply a much stricter assessment from January 2017 and landlords typically had to prove that rental income could cover 145% of mortgage repayments at an assumed rate of 5.5%.

As a result, some landlords who have more highly geared portfolios have struggled to meet the new affordability requirements and obtain borrowing at the level they require.

Furthermore, lenders now have to assess income and equity across an entire portfolio; so if one or more of the properties is not performing as well as others, this could potentially compromise a landlord’s application.

The PRA guidance has been interpreted in different ways, resulting in a variety of lender approaches. A specialist broker can help investors navigate these complexities.

Disincentive to buy-to-let lenders

The final rule imposed on lenders, via the second phase of PRA underwriting changes, is that they have an expectation that the SME supporting factor included in the Capital Requirements Regulation of the Basel III banking regulation should not apply to buy-to-let lending.

What is Basel III?

The Basel Committee on Banking Supervision was set up to improve banking on a worldwide scale in order to “enhance financial stability”.

Basel III is a framework aimed at achieving better and more resilient banks and banking systems.

The Basel III regulations made it likely that SMEs (Small to Medium Enterprises) looking to borrow money would be negatively impacted, which was an unattractive prospect given the contribution that SME’s make at times of economic recovery. To mitigate that impact, an incentive was introduced which rebalanced the benefits of extending credit to SME companies.

The incentive comes in the form of a provision that allows lenders to apply a preferential ‘supporting factor’ to the risk weighting applied to capital exposure to SMEs; this supporting factor took effect on January 2014.

The potential impact of this change

By setting an expectation that this supporting factor should not be applied to buy-to-let lending, the PRA is potentially making it less attractive to lend for this purpose, because it means that lenders will have to hold more capital against this type of lending. Holding a greater amount of capital has an associated cost to the lender.

The result may be that, in order to recoup the cost of holding additional capital, lenders increase the cost of lending to the customer, or they reduce the overall funding they lend via this avenue.

Knowledge is power

At Commercial Trust, we work closely with a wide variety of PRA-regulated lenders and understand their differing requirements on portfolio landlord applications. We also work with non PRA-regulated lenders.

We can help you to identify the best product on the market for your circumstances.

If that product is provided by a PRA-regulated lender, we can provide guidance on what information they will need you to provide.

We also work with lenders who are not PRA regulated and may offer you the flexibility you need for your specific borrowing needs.

There are alternatives to first charge buy to let borrowing, more on this in our article: “Raising capital quickly using a second charge loan”. 

The PRA rules have certainly changed the buy to let landscape for portfolio landlords, but the challenges are not insurmountable.

If you would like the team here to take a look at your current or planned buy-to-let borrowing, do get in touch, we would be delighted to help.

This information should not be interpreted as financial advice. Mortgage and loan rates are subject to change.