A new report by Moodys on buy-to-let (BTL) residential mortgage-backed securities (RMBS) has estimated that as interest rates continue to rise through 2023, the likelihood of BTL borrowers being unable to refinance at their reset date will continue growing, thus raising refinancing risk within BTL RMBS pools.
To be eligible to refinance, BTL borrowers must meet affordability criteria, namely a minimum interest coverage ratio (ICR), which rising interest rates can erode. However, several factors, including low LTVs and increasing rents, help mitigate the risk that BTL borrowers will not be able to refinance when their fixed-rate period ends.
Refinancing risk remains elevated
However, as interest rates continue to rise through 2023, BTL loan borrowers will face greater refinancing risk and, consequently, a higher probability of default. This risk is particularly relevant for loans originated in 2018 and 2019, as their reset dates (on five-year fixed-rate deals) will occur within the next two years. To qualify for refinancing after their initial fixed-rate payment period, BTL borrowers must meet a minimum ICR requirement, which is the ratio of gross rental income-to-periodic interest payments.
Typically, the initial fixed-rate period for a BTL loan ends five years after origination, after which, unless borrowers refinance, they would switch to variable rates (often referred to as Standard Variable Rates, or SVR) that are now averaging at around 7.8%.
Moodys explains its evaluation process: ‘For this report, we assume ICR requirements of 145% for higher-rate taxpayers and 125% for limited companies or basic-rate taxpayers. In addition, we also highlight ICRs of 110% as refinancing options diminish substantially once ICRs fall below this threshold. Our sample is the 47,549 fixed-rate UK BTL loans that back 44 UK BTL RMBS transactions we rate. Within this sample, 10.9% of the total current balance has reset dates before the end of 2023, while 24.5% has reset dates in 2024, which is when we forecast interest rates will peak.
‘For calculations shown in this report, we indexed the loans' gross annual rental income up to June 2023 and have considered three interest rate scenarios at reset dates: increases of 3.5%, 4.0% and 4.5% on top of the current fixed rates. The current fixed weighted average interest rate in our sample is 3.4%, with 75.5% of the total current balance of the loans having fixed rates ranging from 3% to 4%.
‘For loans originated in 2023, the weighted average interest rate is 5.6%, embedding the already increased interest rates, however, current SVR reversionary rate stands on average at about 7.8%. Moreover, the stress rates used to underwrite borrowers remortgaging their loans are often 1% or 2% higher when compared to rates offered to new borrowers.’
Currently, Moodys says that 97% of loans in the sample meet the minimum ICR requirement. ‘We recalculated ICRs for each year end under the three interest rate scenarios, assuming increases from the indexed rental income to June 2023, 4% to 23% of the current balance would have ICRs below 110%, depending on the magnitude and duration of interest rate increases. However, there has been a decline in the quantity of loans with interest coverage ratios (ICRs) below 110% since our previous analysis in October 2022.
‘This reduction is primarily attributable to rising rental incomes. Currently loans with ICRs below 110% by the end of 2023 account for only 4% of the current balance in the +3.5% interest rate increase scenario, down from 11.5% in our previous analysis in October 2022. ICRs below 110% would render the loans ineligible for refinancing, therefore the borrower’s ability to sustain their mortgage payments will depend on further future rental increases and their ability to leverage cash flows from other properties.’
Borrowers continue to bolster ICRs with rental hikes and equity injections
Along with home price appreciation, rent increases will help aid borrowers and mitigate rising refinancing risk. Rents across the UK have been rising in line with financing expenses and from March 2020 to June 2023, the UK rent price index increased 10.1% because of several factors, including the heightened demand for rental housing following the easing of COVID-19 restrictions in late 2021.
Moodys adds: ‘In London, which accounts for 43% of the loans in our sample, residential rent growth was substantial in the first half of 2023. Rent prices in London have increased by 2.8% during the first six months of 2023, a jump from the 1.7% growth in the same period in 2022. Rent hikes bolster borrowers' ICRs because they transfer a portion of rising costs to tenants and, if rents continue to rise, they will continue to support borrowers’ ICRs.’
However, the report also found that, among the loans with ICRs currently below 110%, approximately 75% of the total current balance of the properties are situated in London, while 14% are located in the South East region. Although, Scottish legislators recently approved a 3% rent cap law until end of September 2023, with the option to extend for another six-months if required, loans there account for just 3% of the total current balance of the sample, and none of those loans have ICRs below 110%.
