Description

“There is a myth that buy-to-let is higher risk. If I said that for the last 25 years, arrears in buy-to-let are lower than in owner-occupier mortgages in all but one year, people would be quite surprised” Nigel Terrington, Paragon CEO

Buy-To-Let (BTL) in the UK:

As successive UK governments reduced direct support for social housing, professional buy-to-let (BTL) private residential landlords took up the slack. BTL investors have been responsible for the largest additions to UK dwelling stock over the past two decades.

The BTL interest-only mortgage was a key feature of the UK’s housing market in the late 1990s and 2000s. However, since 2015 it has been much tougher for BTL investors and their lenders. Almost every net new home added to England’s housing stock between 2005 and 2015 ended up in the private BTL rented sector. However, that situation reversed since 2016 with most net new homes being owner occupiers due the UK government’s policy to significantly reduce the attractiveness of a BTL investment via four key policy changes:

1. Restriction of personal tax relief on mortgage finance costs

2. Introduction of an additional 3% Stamp duty surcharge.

3. Removal of 10% 'wear and tear' allowance.

4. Accelerated payment schedule for Capital Gains Tax.

BTL was no longer the dominant force it once was. The financial crisis in 2008 appeared to signal the end of the BTL boom as house prices crashed and mortgage lending dried up. However, as the economy and housing market began to recover in the early 2010s, it was the BTL sector that benefited most. However, a renewed political focus on owner occupiers from this change in government policy brought these plans to a grinding halt. It is clear to view the introduction of these policies in 2016 as marking the high point of the BTL mortgage market (see fig 2 above). There are now regular reports suggesting large numbers of landlords are ready to sell up thanks to rising rates, higher taxation, and tougher regulations. If these reports turn out to be true, this suggests the death knell of the BTL mortgage. However, while the heady days of the 2000s are long gone, the BTL mortgage still plays a significant role in Britain’s residential housing market.

While the overall growth of the BTL private rented sector has stagnated in recent years, it does not appear to have shrunk meaningfully. Other data even shows the BTL mortgage market has continued to grow. The value of outstanding BTL balances has risen since 2016, albeit at a much slower pace than in previous years. This result isn’t just due to rising house prices. UK Finance reported in their latest Arrears and Possessions release that the actual number of outstanding BTL mortgages had risen into 2022. While the data is not yet updated for the substantial increase in interest rates in the UK during 2022-2023, my expectation is that the BTL market will now start to shrink.

Since 2016, BTL mortgage activity has shifted towards larger, more professional landlords including those using corporate company vehicles (SPVs). Borrowing via a limited liability company is now more tax efficient than as a high-rate taxpayer. It is possible this explains the large disconnect between constant press articles about “mom and pop” landlords selling up due to reduced profit levels and the continued growth in professional BTL lending. Survey data tells us the private rented sector contains a vast spread of casual landlords owning only one or two properties. Many of them might be intending to sell up due to the tough current situation (due to shrinking profit levels from rising rates) but professionals could be looking to use this challenging time as a buying opportunity.

Even with the massive interest rate shock, the BTL mortgage market has been stable thanks to the continued interest of larger scale landlords with multiple properties who have benefitted from strong demand, decades of rising prices and higher starting gross yields. Many are not as leveraged and are better able to increase rents and cope with rising interest rates and costs. In fact, press reports and data about the mortgage crunch are very selective and do not depict the full picture of the UK’s housing market tenure.

Forced by stronger regulations since the financial crisis, many BTL landlords in the UK are not too over-levered with modest 60%-68 LTVs (Loan to Value) and decent 200% ICR (Interest Coverage Ratios). A reason there has been no mass dumping of property is primarily because the industry overall is not too leveraged and there is still strong UK wage growth and a massive housing supply shortage.

A Shrinking BTL Market... yet housing demand in UK is rising?

While the BTL market is starting to shrink, demand for residential housing in the UK has never been higher. The UK government has recognised that there is an under-building issue and a shortage of housing supply. This lack of supply is brought about by “BANANAS” ("Build Absolutely Nothing Anywhere Near Anything") who advocate strong opposition towards any land development. Furthermore, the UK is also seeing record net migration which exacerbates the supply shortage. The Office for National Statistics said the 2022 immigration total of 606,000 was up 24% from 2021 net immigration figure of 488,000. This was driven by people coming to the UK from outside the EU, including from Ukraine and Hong Kong. Students accounted for about a third of net immigration (UK universities still attract many foreign students), and work-related routes for a quarter, while humanitarian visa schemes and refugee resettlement made up roughly a fifth. Put simply, rising housing demand in an inflationary environment with undersupplied housing is now contributing to outsized rental growth. Recent Hometrack, ONS data shows the rise in asking rents across London alongside a large -40% drop in 1-4 bed properties available for rent in both inner and outer London Vs the 2017-2019 average according to Rightmove data.

Even with rents moving up considerably due to the rental shortage, higher interest rates now make it cheaper to rent than to own which has not happened in the UK for 14 years. Most variable mortgages have also gravitated to fixed 5-year periods from floating rates since 2016. The deepest liquidity in the UK mortgage market is the 5-year swap spread. This differs from the U.S. 30-year duration mortgage primarily due the absence of Government-Sponsored Enterprises (GSEs) in the UK. Freddie Mac and Fannie Mae are uniquely U.S. institutions with no direct British equivalent. These GSEs buy mortgages from lenders, package them up and sell them on to financial institutions and lend directly to homeowners. As a result, there is deep liquidity in longer-term U.S. swap tenors. For cultural, liquidity and regulatory reasons this is unlikely to happen in the UK. This has further been accentuated by the short-term re-mortgaging commission incentives of mortgage intermediaries and brokers.

A Value stock in a shrinking BTL market?

This primer on the BTL industry brings me to OSB Group. OSB (formerly OneSavingsBank) is a niche (market cap £1.36bn) retail deposit-funded monoline provider of mortgages to professional (Buy-to-Let) residential landlords in the UK which is priced for distress (0.6x tangible book for sustainable 20%+ ROE) even while continually delivering very strong credit metrics and compounding EPS by 19% p.a. for the 8 years since its listing in 2014. I do acknowledge the level of EPS growth will fall in 2023, primarily due to rational customer behaviour from a one-off reversionary accounting adjustment on its Precise mortgage back book. A boring, one-dimensional UK bank specialising in the fretful BTL sector is certainly not the flavour of the day in the current climate. Nor is it nearly as enthralling as an AI or chip investment. My point is, going into 2024, and after the 2023 EIR "kitchen-sinking", if things turn out even slightly less bad than the dire predictions, you should make a decent return from this low price.

Banks in 2023:

Banks are highly geared businesses leaving little margin for error. Already this year, four major banks have hit the rocks - Credit Suisse in Europe and three major regional banks in the USA, including SVB. The crash in the bond market has been a massive headache for banks which are sitting on large unrealised losses on their bond and loan portfolios. Banks are hoping to dig themselves out of this hole by paying nearly nothing to their depositors, even though depositors are their single biggest source of funding. But the problem banks have is deposit flight. Depositors are now moving their money out of the banks into short term Government bonds where they can now earn a nominal 5%. Indeed, since the Federal Reserve started raising rates, over $1 trillion of deposits have left the U.S. banking system and flowed into money market funds which mostly invest in Government bonds.

In the UK, there has also been a move into higher yielding Gilts as banks have continued to pay low rates on current accounts. Although deposits have been a lot stickier than in the USA, this is starting to change. Political pressure is now rising with Jeremy Hunt demanding action from the banks to reward savers. The FCA has also weighed in with new consumer duty rules to try and stop “bank profiteering” by passing on rate rises to depositors way too slowly. When I study a bank, I am concerned with both Liabilities (deposits) and Assets (lending) and their relative strengths and how they match. On the liability side for OSB, it is a very big advantage that they are retail deposit funded.

Liabilities (Deposits) at OSB (Kent Reliance Brand):

Many smaller and mid-size non-bank wholesale funded lenders have now left the industry (e.g.: Kensington, Fleet Mortgages) as their funding costs have sky-rocketed with the rise in rates and as the securitisation market has evaporated. This has helped to reduce the competitive intensity and created more share for specialist challenger banks like OSB and Paragon (OSB’s closest listed peer). Currently OSB has about 7% of the BTL mortgage market and is taking share in a shrinking market from bigger banks and smaller non-bank lenders. While OSB still faces competitive challenges from the larger banks who are active in the BTL mortgage market, they will likely not face rapid deposit repricing as many of the larger banks. This is because they have already been satisfying customers by offering the highest fixed rate term deposits in the market via Charter Court as well as Kent Reliance. In other words, OSB has the highest implied deposit beta at over 70% whereas the average cumulative deposit beta across the entire UK banking sector is around 35%.

On the Liability-side, OSB has a quality retail deposit franchise which is mostly funded by fixed-rate liabilities and is not too reliant on wholesale funding markets or a changing deposit mix. Because OSB have been passing on the highest rates in fixed term deposits, they have minimal future impact from deposit mix changes that high street banks will face moving from current accounts. OSB had a huge year in 2022 in terms of deposits. The group opened two times more savings accounts than usual and as a result its NPS scores suffered slightly from the operational challenges of savers chasing higher fixed term deposits. Net Promotor Scores (NPS) for Kent Reliance Savings dropped to 64 (2022) from 70 (2021) and for Charter Savings dropped from 71 (2021) to 61 (2022). OSB now has around £20bn of retail deposits at its Kent Reliance/Charter Savings Bank brands spread across 200,000 customers with an 88-94% retention rate rolling into new fixed term deals. The average tenor is around 15 months with more 1-year deposits than 2-year deposits. These customers are a different contingent to their BTL mortgage customers. That is, there is minimal cross-sell between OSB’s liability and asset side. The savers are usually older people who are less-tech native and more income oriented, with a large portion of repeat business being generated by mail rather than online.

Assets (Lending) at OSB:

On the Asset side, UK tax law changes in 2016 made it much more efficient for clients to own BTL properties through a limited company structure (SPVs) if they own multiple properties. On top of that, regulations required that lenders to owners of 4 or more properties must underwrite the full portfolio and essentially sign off on a landlord’s business plan. As a result, traditional banks mostly stepped away from this lending market as it is a lot more specialised and labour intensive (e.g.: student lets, HMOs - Houses in Multiple Occupancy, social housing etc) than dealing with simple cookie cutter mortgage loans.

Therefore, while OSB still faces competition from the larger banks and building societies in BTL mortgages, it is well positioned because it remains one of the largest specialist lenders, exposed mostly to strong employment markets in London and the UK Southeast. Additionally, while it often takes months to get a loan approved at a large high street bank with many of the functions automated, it can take OSB’s core risk team less time to make a quick decision. While the process is manual and people driven at OSB, growth comes secondary to returns on equity and risk management which is vital for a lending business in any environment. Overall, the competitive intensity in the market at least for the next few years will likely continue to decline as the BTL market is now a shrinking market. With any bank what you’re most concerned about is the Asset (Lending) side of the balance sheet. Are OSB’s credit and risk management team making sensible NPV positive lending decisions? OSB’s strong underwriting and trivial historic arrears stand out here as well.

The average loan-to-value (LTV) on its properties is around 60-65%, and the average coverage of rent income to interest expense (ICR) is 180-200% with minimum requirement levels. Accordingly, for OSB to see a default, three meaningful things must happen: 1.) The value of the property must fall below the value of the loan. Or 2.) Rent income must go lower than interest expense. Finally, and most importantly, 3.) because most of the loans have personal guarantees from the directors who own the limited companies, those owners would also have to declare personal bankruptcy. Given the rarity of these three points above and OSB’s underwriting discipline, defaults/arrears have been extremely low. In 2022, bad loans/impairments amounted to a mere 0.14% of assets.

Moreover, under UK law, the BTL mortgage provider can even have the rent diverted to them if their client (the landlord) goes 3 months into arrears.

Even in a very deep recession scenario and with inflation about to potentially roll over in the UK, it’s difficult to imagine material interest rate rises from the already raised higher level (5.25%). While noting I am taking a contrarian view and buying OSB during the doom and gloom, I believe we will eventually see some light at the end of the tunnel. It is hard to imagine everything will go wrong at a magnitude that would result in material loan losses for the business. As discussed, the rental housing market in the UK is currently quite hot, with very low available capacity, low persistent building, large net migration, significant bureaucratic red tape, and rents are still rising at a decent pace.

About 70-80% of new BTL lending for OSB is residential interest only (no capital repayment) lending based on the 5-year swap curve which overall has been the most stable tenor of a jittery UK yield curve. This was the case even throughout the Liz Truss mini budget debacle where business dried up for a short period but then came back quickly. Importantly, a lot of OSB’s business is from recurring re-mortgaging. The average maturity of over 80% of OSB’s lending book is around 5 years, with around 20-25% of the book maturing each year.

OSB’s major brands (Kent Reliance, Precise Mortgages, Charter Savings Bank, Interbay, Heritable) all operate independently as they have different market propositions but in general OSB are good at larger, more complex portfolios where the large banks (eg: Lloyds, Nationwide, Coventry) are less active or when there are more than 10 properties. OSB under-writers base their risk management decisions purely on rental cover and are not focused on income like many high street banks. Additionally, the secondary layer of personal guarantees of all the directors of the companies acts as another key risk buffer.

Lending Growth:

2022 was a record year for OSB with record NIMs (Net Interest Margin) of 300bps and NPAT (Net Profit After Tax) of £410m of which £133m was paid out in dividends and £101m used for a share buyback. Note the current fully diluted market capitalisation of OSB is a mere £1.36bn. As clients rushed to re-mortgage under the rising interest rate environment, this is unlikely to be repeated in 2023. Additionally, as many wholesale funded non-bank lenders dropped out of the market due to the volatile funding environment, OSB picked up business from non-deposit funded competitors. A negative consequence from this rising demand is that processing times became longer and their Lending NPS scores suffered due to the record demand. NPS scores from brokers/intermediaries on the Lending side fell from 55 to 37 at OSB and 42 to 39 at CCFS from 2021 to 2022.OSB’s lending business is a broker-based intermediary business and, therefore, mortgage brokers give NPS scores based on consistency, time of approval, and predictable credit decisions. As OSB’s culture appears highly customer centric (doing right by intermediaries) and not highly competitive and much more collaborative, these NPS scores will need to improve going forward.

BTL mortgage lending has a large element of counter-cyclicality. Rising rates and a house price correction is likely to even be a good thing for OSB as it will stimulate more mortgage volumes and better rental yields. The mortgage completion rate is still high and the big pull forward to lock in rising rates now without dropping out of the approval process has continued during 2023. Also, a small portion of OSB’s loans can go into default as the business is well provisioned and LTVs across the book are only 60-65%. Currently, provisions are waiting for reality to catch up. Usually, the impact of downturn is only felt after it is already over and OSB has predictably increased provisions on new business and its existing back book.

Valuation:

OSB trades at 0.6x tangible book with sustainable long-term ROEs above 20% from 2024 onwards and has had a cost-to-income ratio below 30% for the past five years which is low by any bank standards but significantly below 41% of the second-largest player, Paragon Banking Group [London: PAG]. Paragon is a very well-run and good listed comparable for OSB, however it has a slightly worse geographical exposure and a more expensive valuation (0.85 P/B). Paragon’s higher valuation is most likely from having a longer listed history having come out unscathed from the 2008 credit cycle. Paragon also has a larger asset-backed finance book (£800m) compared to OSB. Cost-to-income ratio is low at OSB because they only have 2,000 employees and high absolute Net Income. Of these employees, 600 are based at its lower cost wholly owned Indian subsidiary with functions such as back office, HR, and a call contact centre. As this subsidiary is fully owned rather than contracted, OSB’s Indian staff have incentives around call quality rather than time spent on phone for example.

There is a major disconnect between the quality of OSB’s recurring business and its current valuation. Net earnings and book value have grown at a 19% compound rate for 8 years since the company’s IPO in 2014. Return on equity (ROE) last year was 24% and is consistently above 20%. Earnings will fall materially in 2023 primarily due to lowering reversionary net interest income assumptions at their Precise brand (customers switching to fixed rates quicker than usual as variable reversionary rates went so high so quickly). However, this will likely be non-recurring at a similar magnitude as in 1H2023 so net income should bounce back strongly in 2024. Additionally, the 9% dividend yield and large ongoing buyback should continue, and I would expect on top of the dividend, about another 8-10% of the shares to be bought back this year (£150m buyback).

Risks:

Some risks to the investment thesis include: cost of capital (interest rates) materially rising even further; delayed impact of fixed rate interest-only deals coming to an end on low rates (5yr swap spread volatility); lower rental growth for its clients; significant sales/impacts on valuations; high street deposit-funded banks entering the BTL space in a bigger way; rising unemployment and its impact on rents; additional holdco debt capital requirements imposed by MREL bank regulations (loan books greater than £15bn will require additional capital at the senior holdco level over a phased period); limited capital release from IRB CET; requirement to payback BOE TFSME funding (UK banks will need to refinance close to £100bn of BOE TFSME balances in coming years through a combination of wholesale issuance primarily covered bonds, securitisation and potentially deposits. Based on OSB’s £4bn drawdown, this could hit their EPS by about 5-10%); staff heavy business with duplicate data centres across their separate brands; burdensome workflows; less advanced IT systems - not a true tech-embedded business; reliance on company-owned Indian subsidiary (600 employees); multiple brand teams/propositions; special dividends could be one-off; potential deposit flight from higher gilt rates and other competitive fixed rate deposit offers.

Conclusion:

OSB is a solid but unexciting recurring cash-generative business that trades with a significant margin of safety well below tangible book value. This discounts an incredibly pessimistic outlook for BTL lending, very far from the historic growth in EPS and book value over the past 8 years since its listing. Even if you model low single digit net loan book growth, with even a small re-rating to only 0.8x tangible book over the next three years, forecasted IRR on the stock is close to 30% p.a. when including cash generation including the dividend and buyback. In a scenario where inflation comes down, interest rates may be close to peaking, house prices fall moderately and volumes pickup due to the shortage of residential housing, it is likely to be an excellent entry price taking advantage of the reduced competitive intensity, a one-off 2023 kitchen-sink accounting adjustment and the pervasive BTL doom and gloom in the UK.

Catalyst

• 2024 Net Income improvement after the one-time 2023 EIR adjustment at Precise
• Dividends
• Buyback
• Cash-generation
• Clarity on IRB and MREL capital requirements