Credit Crunch Impact on UK Residential Property and Buy-to-Let

Introduction

The twenty-first century has brought about a wide array of challenges for the modern population. It is a time of massive technological developments that affect all aspects of life, as well as a time in which globalization leaves its deepest mark, even as cultural differences and terrorism pose serious threats.

At an economic level, the century has produced one of the most severe crises in modern history, easily compared to the Great Depression of 1929–1933. It commenced within the United States real estate sector and gradually expanded to encompass the entirety of the American economy, eventually spreading throughout the rest of the world.

The root cause was the issuance of subprime mortgages by American banks, which snowballed into one of the greatest crises of the modern era (Rayner, 2008). The crisis was first felt in the United States in the third quarter of 2007, within the American financial industry. At that point, the first shock waves were sent to the rest of the world. The immediate impact was that banking institutions restricted their operations, increased the costs of borrowing, and generally reduced the circulation of liquidity in the market.

Countries were affected at various degrees by the crisis. A notable trend was that nations with highly liberalized economies — those which activated intensely within the international market and relied heavily on the stability of their trading partners — suffered the most severe impacts. States that maintained greater distance from international markets and implemented more prudential policies suffered comparatively less.

The United Kingdom was severely impacted by the internationalized economic crisis, and its manifestation there resembled that in the United States. Specifically, the crisis commenced within the real estate sector, compounded by problems in the financial sector. The first major victim was Northern Rock, the fifth-largest mortgage lender in the United Kingdom. The institution became unable to financially support itself and its customers, and sought assistance from the Bank of England. As a matter of prudential policy, however, the Bank of England declined to lend money to Northern Rock, precipitating its collapse and forcing its ultimate nationalization (Giles, 2003).

At a national level, the housing industry in England followed a descending path, as financial institutions became more restrictive in granting mortgages. The unavoidable effect was a decrease in real estate market activity as demand fell. Halifax, a major mortgage lender, reported a drop in real estate property prices of 10.9 per cent (HBOS, 2008).

In this context, a central question arises regarding the specific ways in which the internationalized economic crisis has affected the real estate sector in Great Britain, with special emphasis on the South East of England. Additionally, the paper examines whether the downturn in the real estate industry has created an opportunity for a specific sector to develop — that of buy-to-let. In order to answer these questions, the paper proceeds through several stages: background information, a literature review, a description of the research methodology, a presentation of findings, a discussion, and concluding remarks.

Background: The British Real Estate Sector

The British real estate sector is a complex one with a long history. It not only developed on its own terms but also set the foundation for real estate sectors in four major countries: the United States, Canada, New Zealand, and Australia. Over the centuries, legislation governing real estate has undergone various modifications, but its origins can be traced back to a feudal system in which land was the sole measure of wealth and property rights were reserved exclusively for the king. Gradually, property rights were extended to the nobility and eventually to the broader population that could afford to purchase properties. From Great Britain, these values were transferred through colonization to the United States, Australia, New Zealand, and Canada, setting the basis for their own real estate sectors (World Wide Legal Information Alliance, 2010).

Today, the British real estate market is considered one of the most developed in the world. It can be broadly divided into the residential market and the commercial market. This paper focuses on the residential sector, in which the main goods and services are represented by properties, mortgages, and financial services. There are also several adjacent products and services, such as legal services upon purchase or rental, construction services, and furnishing and electronics products. The real estate sector functions as an engine for economic development, which explains why difficulties in the sector produced a chain reaction across the broader national economy.

The peak of real estate prices was reached during the 1980s, driven by rapid economic development and increasing access to financial resources. At the same time, the construction industry was delivering an abundance of housing units at higher qualities than before, expanding supply. It is also noteworthy that this period saw the development of council housing — a system through which people in need of housing could apply for it from public institutions. The buildings were often of inferior quality and the rental process was rigid and burdensome. The system persists today; in 2005, it was estimated that 20 per cent of all housing units in the country were owned by local councils or housing associations (Word IQ, 2010).

The end of the 1980s and the first half of the 1990s were characterized by declining prices for residential properties, the result of an economic recession. The international downturn generated socioeconomic difficulties for the British population, who became unable to pay their mortgages. As a result, the period witnessed numerous repossessions by banks (Word IQ, 2010).

In terms of occupation rates, in 1992 it was estimated that out of approximately 23 million housing units, 66.3 per cent were owner-occupied, with the remaining 33.7 per cent (some 7,751,000 units) occupied by renters. Investment from institutions in residential property was uncommon, and the dominant social preference was for ownership rather than renting. Julian Roche (1995) explains:

"Institutions do not invest in UK residential property for several historical reasons, mainly concerned with the high level of home ownership and the low status associated with renting: private landlords, whether corporate or individual, have never had a good press in the UK since Rachman in the 1950s, and institutions do not want anything other than high-grade tenants" (Roche, 1995, p. 9).

By 1996, retail prices for residential properties were rising at rates as high as 20 per cent per annum. By 2005, however, prices gained more balance and remained relatively stable; in some cases they even declined. At that time, the residential housing stock comprised over 22 million units, with an estimated 134,000 newly built homes.

An intriguing element was the unevenness of price growth. While London prices remained relatively stable, massive increases were observed in northern England and Scotland. In these regions, the majority of purchases were made by second-home buyers, often with rental purposes in mind. These buyers competed with locals, drove up prices, and created affordability problems. While it was generally agreed that the increase in prices was largely due to insufficient supply, arguments were also made that buy-to-let purchases had contributed to house price inflation (Property Mark).

The debate over the causes of the massive price increases observed mostly between 1996 and 2005 remains ongoing. On one side are the "property bulls," who argue that price increases were the natural result of higher employment, economic stability, and lower interest rates. On the other side are the "property bears," who claim that rising prices were not linked to genuine economic growth but rather to a "bubble mentality among speculators" (Property Mark).

Literature Review

Introduction to the Literature Review

The literature review is divided into four primary subsections. The first introduces the section, its importance, construction, and sources. The second details sources addressing the economic crisis and the ways in which the credit crunch has affected residential property in the United Kingdom. The third subsection focuses on credit rationing, a recurring phenomenon in the literature linked to the UK economic crisis. The final subsection focuses on more specific material detailing buy-to-let in the British real estate market and its potential given the economic crisis.

Both theoretical and practical sources are used, including books, journal articles, and websites. Books are generally reliable but may be outdated; journal articles are peer-reviewed but may also deal with past events; magazine and internet articles are not always peer-reviewed but offer contemporary relevance. The literature review serves a dual role: first, it centralizes and disseminates the most important findings in the field; second, it constitutes a starting point for the subsequent analysis and research.

Impact of the Financial Crisis on the UK

At a general level, it is accepted that the financial crisis of 2007–2008 commenced within the United States with the issuance of subprime mortgages. The conditions in the United States closely resembled those in Great Britain. Like the American economy, Britain was experiencing a booming housing market, relaxed crediting conditions, a myriad of opaque securities and derivatives, highly indebted financial institutions, and an unsuitable reliance on short-term financing (Wilkinson, Spong, and Christensson, 2010).

When the financial crisis reached the United Kingdom, all of these features contributed to the propagation of problems. The first issues emerged at the funding level, and an immediate shortage of crediting opportunities was observed. Under these circumstances, the first victim in the financial sector was Northern Rock, which was forced to seek support from the Bank of England and was nationalized by February 2008.

The year 2008 was broadly difficult for the entire British financial sector. Asset and equity prices fell significantly, and the liquidity shortage became generalized. Credit and interbank markets nearly froze, and several financial institutions faced severe difficulties. Jim Wilkinson, Kenneth Spong, and Jon Christensson (2010) describe the following changes in the lending market:

"In September 2008, Lloyds TSB acquired the failing HBOS, the largest UK mortgage lender. Bradford & Bingley, a building society, was partly nationalized and partly sold to Abbey Bank, a subsidiary of the Spanish bank Santander. The Royal Bank of Scotland was effectively nationalized in October 2008 as the UK Treasury took a majority stake in the company."

The three authors also note that the situation in the financial sector extrapolated to create a series of other social and economic problems. Banks became unable or unwilling to lend to the population, which translated into reduced purchasing power. Within the residential real estate sector, financial restrictions materialized in lower levels of demand for and access to residential buildings.

Financial institutions restricted their lending to both households and the corporate sector. For the real estate sector — both residential and commercial — this meant decreased demand, correlated with subsequent declines in property prices. At the socioeconomic level, the impacts of the crisis materialized in slower economic growth and higher levels of unemployment. Service industries were continually pressured, personal insolvencies became common, and these developments generated further pressures on the already unstable banking sector (Wilkinson, Spong, and Christensson, 2010).

Authors Simon Kirby, Ray Barrell, Tatiana Fic, and Ali Orazgani (2008) argue that the largest economic problem was a decrease in national output, and they expected it to continue contracting as a result of both lending restrictions and reduced investments in UK industries.

At the household level, consumer spending registered significant decreases and was expected to continue declining. This trend was relatively novel. As the crisis hit in 2007 and 2008, the population initially capitalized on assets through sales in order to subsidize lifestyles, making consumption levels appear unaffected in the short term. Gradually, however, the British population curtailed spending, and reductions in consumption became obvious. Another trend was that of prudential family financing, through both credit rationing and personal savings. Within the immediate period, consumerism was expected to contract by 2 to 3 per cent.

At the level of economic supply, the four authors noted a massive decrease in business investment. A predominant risk was the possibility of investment projects being abandoned outright rather than merely delayed, a risk that increased as recession became confirmed within the United Kingdom.

In the financial sector, the scarcity of capital became increasingly obvious in 2008, and the costs of borrowing capital rose significantly. The probability of business investment further decreased. These conditions were expected to lead to a sustained decline in investment — projected to be the worst since the recession of the early 1990s.

In terms of residential properties, Kirby et al. made sobering predictions. By 2008, housing investments had decreased by over 4 per cent in each of the first two quarters. They wrote:

"Housing investment is highly cyclical and still has some way to fall before dropping to 3 per cent of GDP as it last did in the first quarter of 1996. Housing investment declined by 4.8 and 4.2 per cent at a quarterly rate in the first and second quarters of this year, respectively. Data on the volume of orders for the construction of private sector housing continue to show a fall, suggesting housing investment volumes may have continued to contract in the second half of this year. The sharp deterioration of the housing market has contributed to the poor outlook for housing investment over the next couple of years. The increasing cost of raising capital, together with the scarcity of credit, will also push housing investment volumes further downwards. We expect housing investment to continue to contract, declining by 14 per cent this year and 17 per cent in 2009" (Kirby, Barrell, Fic, and Orazgani, 2008).

As for the overall crisis, Kirby et al. (2008) did not expect the first signs of economic revival until 2013. They argued that credit rationing would continue to put pressure on investment, and — like Wilkinson, Spong, and Christensson — they believed credit rationing was a central trend in UK society that played a significant role in the unfolding crisis.

Credit Rationing

Credit rationing is understood at a basic level as the situation in which a loan request from an individual or group of individuals is denied, even when the applicant or applicants are willing to pay the financial and non-financial costs associated with the loan (Freixas and Rochet, 1997).

At a deeper level, Jaffee and Modigliani (1969), quoted by Nunung Nuryartono (2005), stated that credit rationing occurs whenever the demand for commercial loans exceeds the supply of those same loans. From this perspective, the interest rate on commercial loans influences rationing and generates two forms: equilibrium rationing and dynamic rationing.

The underlying idea is that a loan is not rejected because the applicant finds it too expensive, but because the lender denies it on the basis of conditions the lender has imposed. Even when a borrower offers a higher interest rate than that requested by the lender, the loan may still be denied. The importance of credit rationing lies in its relationship with the broader economy: the absence of credit rationing indicates equilibrium between the supply and demand of money — or at least a sufficiency of borrowed capital — which in turn indicates high consumer spending and a healthy economy. Conversely, when credit rationing is imposed, the amount of money circulating in the economy decreases, as do economic operations generally (Greenbaum and Thakor, 2007).

Residential Real Estate in the UK

At an overall economic level, the United Kingdom is one of the most powerful nations in the world, recognized as a trading power and a major financial centre. Throughout recent decades, UK government efforts have focused on reducing public ownership and control while improving social programs. Great Britain had been one of the fastest-growing economies in Europe before being severely affected by the internationalized economic crisis.

The residential real estate sector witnessed the first impacts materialize as a decrease in demand resulting from restricted lending. Housing prices subsequently fell after more than a decade of sustained increases. The financial sector was in jeopardy, prompting the government to implement a wide array of measures to ensure financial stability and the revival of residential real estate and the broader British economy.

"Sharply declining home prices, high consumer debt, and the global economic slowdown compounded Britain's economic problems, pushing the economy into recession in the latter half of 2008 and prompting the Brown government to implement a number of measures to stimulate the economy and stabilize the financial markets; these include nationalizing parts of the banking system, cutting taxes, suspending public sector borrowing rules, and moving forward public spending on capital projects. Public finances, weak before the economic slowdown, deteriorated markedly during 2009, as did employment. The Bank of England periodically coordinates interest rate moves with the European Central Bank, but Britain remains outside the European Economic and Monetary Union (EMU)" (Central Intelligence Agency, 2010).

In 2008, the central and south-eastern British markets experienced losses of investment and employment. In London particularly, 2008 was expected to bring about a 10 per cent decrease in housing prices. As job losses mounted alongside rising interest rates, the British population became progressively less able to finance or refinance their mortgages. Situations in which mortgages were seized by banks, or in which people were forced to sell their properties, became increasingly common. Since London was the financial capital most closely connected to the international community, it was expected to be the worst-affected region of the United Kingdom (LEAP 2020, 2008).

A major concern among British economists in 2008 was the possibility that the housing crisis in the UK might prove more severe than that in the United States, given that the British economy was more reliant on real estate than its American counterpart (Foreclosure Connections, 2008).

The UK real estate crisis was also assessed in relation to the historically low interest rates maintained by the Bank of England. As of January 2011, the Bank had kept the interest rate at a record low of 0.50 per cent for 22 consecutive months (Straits Times, 2011). With interest rates so low, vendors of real estate properties were less inclined to sell, particularly since lower mortgage rates also reduce the overall value attributed to properties. This strategy was used to reduce the risk of repeating a housing bubble (Stammers, 2010).

Additional pressure on the residential real estate sector came from a social dimension: the housing crisis. This is understood as the situation in which the supply of housing is far outweighed by demand, driven by population growth through immigration, rising birth rates, more people living alone, and the purchase of second properties. The UK government stated that the country would need to construct 240,000 new residential properties per year to meet demand. In 2010, however, the actual rate was only 120,000 (Shackle, 2010). In terms of the population affected, 4.5 million British residents were on housing waiting lists and 2.5 million were living in overcrowded conditions (BBC News, 2010).

In 2008–2009, UK districts set individual targets for building new residential properties, but none managed to attain them. The largest shortfalls occurred in the North, where only 51 per cent of the initially established targets were met. By contrast, regions in the South of England achieved approximately 85 per cent of their targets (BBC News, 2010).

Given this context, concerns were raised about the UK's ability to build one million affordable homes by 2020. The National Housing Federation urged the government to reduce taxation on the residential real estate sector (Shackle, 2010). A report completed by the Office for National Statistics in January 2011 indicated that the volume of construction had fallen by 0.7 per cent, new work had fallen by 0.5 per cent, and repair and maintenance operations had fallen by 1.1 per cent.

Simon Rubinsohn (2009) found that as the crisis hit the real estate sector, more spaces became available while fewer people became interested in purchasing or renting them. He expected this situation to persist in the near term and noted it was common across Western Europe. According to Rubinsohn:

"As a result of the sinking occupier market, rental expectations are now negative across all world regions, with weaker occupier demand likely to lead to further rises in available space and looser market conditions across all emerging and developed markets. In Western Europe, rental pessimism is bleakest in Ireland, Portugal, Spain, Belgium and the UK. Germany remains a relative outperformer, with less negativity towards both rents and tenant demand as available space continues to decline."

In this context, the question of buy-to-let housing deals becomes pertinent. It is traditionally acknowledged that higher interest rates and intensifying socioeconomic conditions make real estate purchases more expensive. But for investors seeking returns from rentals, buy-to-let deals are becoming more appealing. According to the Council of Mortgage Lenders, buy-to-let purchases increased by 12 per cent in the third quarter of 2010, a trend "supported by ongoing demand for rental property against the backdrop of a dysfunctional owner-occupier market."

Their recent success is partly due to a lack of trust in stocks and other forms of investment. Buyers are willing to accept the risk of short-term real estate devaluation because the property retains value as a tangible asset, particularly if the investment meets 75 to 85 per cent of loan-to-value criteria and returns 125 per cent of the monthly mortgage payment (Lambert, 2011).

The buy-to-let deal is understood as a situation in which an individual purchases a residential property for the purpose of renting it. The rent collected would normally exceed the value of the mortgage and would create financial opportunities for building maintenance. As the Mortgages website noted:

"Over the past few years, more and more people have taken to investing in buy-to-let property as a long-term opportunity to make profitable returns, as well as a way of securing finance for their retirement plans" (Mortgages, 2010).

Overall, the growing interest in buy-to-let mortgages is driven by low property prices, increasing access to funding, and the promise of rising real estate values once the crisis ends. Access to second properties for rental purposes has also been facilitated by the fact that buy-to-let purchasers — historically forced to pay higher interest rates — can now purchase properties at rates comparable to those for owner-occupied purchases.

"In the current uncertain times this remains true if the correct research is carried out, and with capital values lower the rental income once again becomes more attractive, with the hope of capital growth in the future" (Association of Residential Letting Agents, 2011).

The Road to Recovery

The financial and economic sectors remain sensitive to the crisis. The United States strives to develop and implement strategies to support national recovery, while the United Kingdom collaborates with the European Union to improve the chances of economic revival. Important emphasis is placed on globalization and integration, particularly since these processes facilitated the international propagation of the crisis.

James K. Jackson (2010), in Financial Crisis: Impact and Responses by the European Union, stresses the role the crisis played in revealing the growing interdependence of the European states, as well as their ability to cooperate and develop an efficient, integrated response. Similar to the United States, most national governments in the EU addressed the crisis by implementing stimulus packages aimed at sustaining economic activity.

A particular challenge in Europe stems from the diversity of its member states. Western states are generally more advanced and thus better able to cope with the crisis. States in Eastern Europe are less developed, and some of their governments have implemented austerity programs rather than stimulus packages — restricting incomes and imposing new taxes on their populations (National Institute Economic Review, 2008).

Jackson argues that this divergence demonstrates an inability of the EU to develop a fully integrated solution. Additionally, he notes that the persistence of the crisis risks undermining the EU's ability to economically integrate the eastern states, which may become too severely impacted before integration can be achieved.

Emphasis is also being placed on developing more prudential financial policies and on better organizing and regulating both local markets and the overall European market. Given the intense levels of integration among economic actors in member states, problems in one region can easily affect other European states. Jackson writes:

"Another important factor that is affecting the EU's response to the economic recession is the need to develop new policies in a manner that meshes with the carefully crafted and highly negotiated Directives that already exist within the EU framework. These Directives act as guiding principles for EU members. In particular, the call for economic stimulus has created a conflict for some EU members who are politically and philosophically committed to the goals of the Growth and Stability Pact and with the development goals of the Lisbon Strategy. Arguably, these agreements have helped stabilize economic conditions in Europe by bringing down the overall rate of price inflation and by reducing government budget deficits. In addition to the Lisbon Strategy, EU members likely will consider proposals to examine financial supervision and regulation within the context of the EU's Directive on Financial Services and the Financial Services Action Plan (FASP) when it engages in negotiations with the United States and the G20" (Jackson, 2010).

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