The UK buy-to-let market is still going strong, despite the pressures of a deteriorating economic background. In the short term, however, falling rental rates may expose UK RMBS backed by buy-to-let mortgages to a surge in arrears.

Buy-to-let originations are on the rise. A recent report released by the Royal Institute of Chartered Surveyors (RICS) suggests that tenant demand for flats and houses has risen this year, particularly because the rise in property prices forced potential first-time buyers to rent. Demographical patterns indicate that, in the medium term, the demand for private rental properties will not diminish.

At the Council of Mortgage Lenders conference in London last month, key market drivers responsible for the continuing surge in rental demand were attributed to the increased number of students in higher education, higher levels of labor movement, population increase, and prohibitively high prices for first-time buyers. Nonetheless, nearly 40% of new buy-to-let originations are re-mortgages, reported analysts at Fitch Ratings, which indicates that lenders may be consuming each other's market share and driving down spreads as a result of the competition.

Estate agents have reported an increase in new lettings of rental properties, and while this increase is indicative of the recent boom, it may not reflect the current decrease in prospective tenants seeking accommodation. "Rents are falling, as are the tenancy - which means that landlords will take longer to make payments," said one market source. "In the short-term, it's a real possibility that this could translate into an up-tick in arrears."

RICS reported that the faltering economy is accompanied by a decrease in corporate lettings for overseas workers. Figures indicate that corporate lets in the second quarter of 2002 dropped to 16% of total lets in January 2001. In April 2002, a RICS survey indicated that the net percentage of letting agents in London reporting a rise in new tenants versus those reporting a fall was minus 40%, and the corresponding net percentage of those reporting a rise versus a fall in new instructions of rental properties was plus 88%. "The result has been a tenants' market with falling rents in London, and tenants having the pick-of-the-crop of rental property," explained Fitch.

It's unlikely, however, that a surge in arrears will translate into faltering performance of RMBS backed by such assets, said market analysts. "Up until now, arrears in the sector have been extremely low, so the threat of an increase in arrears in the coming months should be weathered well by transactions," said the market source.

The industry has recently benefited from a number of positive rating actions. In early November, Moody's Investors Service gave the class M notes of Paragon Mortgages 2 a one-notch rating upgrade to A1' from A2', noting that better-than-expected performance of the pool - with losses consistent to those in a prime residential transaction.

Last week, Fitch upgraded seven UK prime and buy-to-let RMBS bond tranches and affirmed 39, noting that the number of upgrades and the absence of downgrades reflect the steady delinquency and loss levels within the sector during the past twelve months, as well as the degree of accumulated credit enhancement.

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