Buy-to-let mortgages have until recently escaped "conduct of business" regulation in the UK. Since March 2016 the FCA's regulatory perimeter has broadened to include some regulation of buy-to-let mortgages, although it is still possible to avoid the more onerous regulatory obligations for many buy-to-let mortgage borrowers. This article considers the scope of the new regulatory regime and some broader changes affecting landlords and lenders operating in the buy-to-let market.
A brief history of BTL mortgage regulation
Prior to 21 March 2016 a mortgage in the UK was generally only regulated if it was either a regulated mortgage contract (RMC) under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO) or a consumer credit agreement under the Consumer Credit Act 1974 (CCA).
Buy-to-let (BTL) mortgages fell outside the scope of the CCA either because the mortgage was for a principal amount of more than £25,000 and/or because it was able to benefit from the exemption for agreements entered into for the purposes of business or the exemption relating to investment properties. Similarly, most BTL mortgages fell outside the scope of the RAO because it did not apply to mortgages where more than 60 per cent of the property was let out, even if the borrower also occupied part of the property. These exemptions continue to apply but now participants in the structured finance market considering the acquisition of portfolios of loans that contain BTL mortgages also need to consider the application of the new BTL "light-touch" regulatory regime introduced on 21 March 2016.
How did the regulation of BTL mortgages change in March 2016?
The Mortgage Credit Directive (2014/17/EU) (MCD) introduced a new regulatory framework for firms selling all types of mortgages to consumers, including BTL mortgages. However, the MCD provided member states with the option to exempt BTL lending from its requirements; the UK government used this option and set up a new framework for consumer buy-to-let (CBTL) mortgages, which sits outside the full RAO framework.
The CBTL regime is set out in Part 3 of the Mortgage Credit Directive Order2015 (SI 2015/910) (MCD Order). The MCD Order contains a set of conduct standards that apply to firms conducting broking or lending activity with a BTL consumer.
However, firms do not have to apply MCD requirements to a customer who has made a declaration that he is acting by way of business as a borrower in respect of a BTL mortgage and that he understands that he is waiving protections offered by the legislation to consumers. This exemption from the new CBTL regime can be relied upon where the borrower has signed such a declaration and where the lender does not have reasonable cause to suspect that the loan is not for a business purpose. To address the use of this declaration the MCD Order introduced new definitions of a CBTL mortgage contract and a BTL mortgage contract.
A CBTL mortgage contract is therefore a "buy-to-let mortgage contract which is not entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower".
Examples of acting for the purposes of business include where the borrower:
- uses the mortgage to purchase a property, intending to rent it out;
- has previously purchased the property intending to let it out and neither he nor his relatives have lived there; or
- already owns another property that has been let out on a rental basis.
Further, and unlike the regime prior to 21 March 2016, a BTL mortgage is only permitted to be exempt from the full requirements of the MCD where no part of the property may be occupied at any time by the borrower or a family member and where this is stated as part of the contract.
As a consequence of this new category of CBTL mortgages, there are three possible approaches for lending in respect of a BTL property; the category into which a loan falls is primarily dependent on the circumstances of the mortgage applicant when arranging the finance. The three categories are:
- an RMC subject to the FCA's Mortgage Conduct of Business Rules in the same way as most residential mortgages (e.g. because the property will also be occupied by the borrower);
- a mortgage regulated under the MCD Order as a CBTL contract (because it is not for a business purpose); or
- an unregulated BTL loan if the primary purpose of the mortgage is for business.
The Council of Mortgage Lenders (CML) expects that most BTL mortgages will fall into the third category and so continue to be unregulated as most BTL mortgages are where a borrower (the landlord) intends to let the property to a tenant for a commercial gain, which makes the mortgage primarily for business purposes. Most BTL mortgages also prohibit the borrower from occupying the property. For these reasons, the vast majority of BTL mortgages continue to fall outside of the jurisdiction of the FCA.
What does this mean for due diligence?
Lenders (including firms engaging in pre-contractual activities), administrators, intermediaries, arrangers and advisers involved in activities relating to CBTL mortgages (collectively known as CBTL firms) must register with the FCA. Failure to register may mean that those firms engaged in CBTL commit a criminal offence and that any CBTL-related agreement they enter into is unenforceable. Ascertaining the CBTL registration status of all businesses engaged in CBTL activities is therefore a crucial part of any due diligence exercise in any structured finance transaction.
Similarly, those lenders who have purported to rely on the borrower declaration to avoid the CBTL regime should be able to demonstrate by reference to the borrower documentation that borrowers' circumstances and the reason for the property purchase accord with the statutory regime.
CBTL firms fall within the compulsory jurisdiction of the Financial Ombudsman Service (FOS). Therefore for those firms engaged in undertaking CBTL business it will be important to ensure that their complaints processes and records accord with FCA Handbook Dispute Resolution rules and that recorded complaints do not reveal any underlying issues with a proposed portfolio. Similarly, CBTL lenders must report high-level aggregated lending, performance and complaints data to the FCA using a new standalone CBTL reporting return, which must be submitted quarterly; this will be a key source for ascertaining the reported CBTL regulated mortgages a lender has originated.
An assessment of the status of a BTL loan under the RMC and CCA regimes will also still need to be undertaken for loans originated after March 2016. Thus the CBTL regime has simply added another layer of due diligence assessment, rather than neatly consolidating BTL loans into one entirely separate regulatory regime.
BTL tax changes for landlords
In August 2015 the government announced that in future private landlords would be unable to deduct their full mortgage interest costs from their rental income before calculating their tax bill. Instead, from 2017, private landlords will have mortgage interest relief in the form of a tax credit restricted to 20 per cent rather than the current 40 per cent or 45 per cent. While this primarily affects property investors who are higher-rate taxpayers (those paying 40 per cent or 45 per cent), normal-rate taxpayers may also move up a tax band meaning that they lose the associated benefits of lower tax bands.
These tax changes started to be phased in this year, with landlords currently being able to offset 75 per cent of their tax bill. Next year, landlords will only be able to offset 50 per cent of their tax bill, and this will continue to be reduced by 25 per cent each year until 2020, when they will lose the ability to offset their costs against their income entirely. From 2020 landlords will pay tax on turnover rather than profit, which could result in tax becoming due on non-existent income. As an additional "dampener" on the BTL market, an extra 3 per cent has been added to stamp duty on BTL purchases.
As a result of these tax changes investors may start to liquidate their rental property portfolios or seek to mitigate their tax bill by incorporating a company through which to make their investments (as landlords in BTL companies are not affected by these changes). Landlords who choose not to sell their rental properties may well seek to increase the rents they are charging to maintain their original anticipated profit margin under the previous tax regime.
More changes in the pipeline for lenders – restrictions on BTL lending
The Prudential Regulation Authority (PRA) has recently announced that from 1 January 2017 it will impose new minimum affordability thresholds on BTL lending. This will mean that borrowers who make less than 25 per cent profit from their investment property, or who would not be able to afford mortgage repayments in the event that interest rates were to rise to 5.5 per cent, will be denied financing.
The effect of this will be that property investors are able to borrow far less to fund the purchase of investment properties, and this may lead to a reduction in BTL lending as some landlords are effectively cut out of the market altogether. The government has indicated that the purpose of these changes is to promote financial stability following a rise in the number of people investing in residential property as a profitable place to save money.
These changes apply to all firms regulated by the PRA that undertake BTL lending. This includes banks and building societies within the UK and subsidiaries of internationally headquartered banks and branches of non-EEA banks (both of which need to be authorised by the PRA).