RLA News Service

As you may have seen, there have been press reports of proposed European Union (EU) legislation which could have an adverse impact on interest rate hedging arrangements which could in turn affect residential landlords’ borrowings. In conjunction with the British Property Federation (to whom we express our thanks) we have been investigating the possible effect of the EU proposals. Whether we like it or not, as a result of the “credit crunch” banks and other lenders are increasing the cost of borrowing; raising margins even as official interest rates have been kept at record lows.

Like all borrowers landlords want to know that they will be able to cover their debt service costs and many landlords therefore take out fixed rate loans. Alternatively, landlords may take a floating rate loan but enter into hedging arrangements such as caps, collars and interest rate swaps to achieve effectively fixed rate borrowing. Indeed, sometimes they are urged to do so by lenders.

The EU’s ‘European Market Infrastructure Regulation’ (EMIR) will require banks and other financial institutions to trade derivatives (such as interest rate hedging arrangements) through collective clearing houses known as ‘central counterparties’, or CCPs. These entities will be counterparties to every derivative trade and will bear the full risk that either the seller or purchaser of a derivative such as a banks default on their obligations under such contracts. In order to protect themselves against that risk, CCPs will require buyers and sellers of derivatives to deposit security equivalent to a proportion of the value of the derivative.

It is not yet entirely clear whether residential landlords will be directly affected by the new rules. Individuals are definitely outside the scope, but structures in which there are a number of investors may be caught – depending both on where the rules end up and on the structure in place in any particular case.

Even if the hedging arrangements which banks offer to residential landlords are not directly subject to these regulations, any derivatives which banks have entered into in connection with loans to landlords (e.g. a swap to hedge the bank’s own interest rate risk) will fall within EMIR’s remit. Due to the requirement to deposit security on these derivatives banks will incur additional costs in securing that funding and as always they will seek to pass these on to their customers.

The proposals also change the rules for derivatives that are not required to go through a CCP, imposing tighter requirements for capital and collateral. Borrowing does therefore seem set to get more expensive in any event.

Unfortunately at the moment we do not know exactly how much additional cost banks will incur as a result of EMIR and it is therefore impossible to say by how much residential mortgage margins will increase. However we do know that EMIR is likely to come into force around the end of 2012.

To make matters worse for residential landlords, increased capital requirements under Basel III will force banks to find additional capital to strengthen their balance sheets, which is expected to further raise the cost of borrowing. Unfortunately, the private rented sector is particularly dependent on bank debt as a source of finance (especially owners of larger portfolios) and is therefore extremely vulnerable to changes in the cost of borrowing. Landlords with limited reliance on debt finance may benefit compared to more highly leveraged peers as borrowing costs rise.

As a result of the above we are likely to see upward pressure on residential rents as the cost of borrowing increases. This will compound the increase in rents arising as a result of supply shortages and increasing demand for rented property as prospective homeowners are prevented from getting on the property ladder due to constrained mortgage supply.

Separately, there is the EU’s Alternative Investment Fund Manager’s Directive (AIFMD); sometimes referred to as the hedge fund directive. This is intended to make hedge funds more transparent. The problem with this directive is that the definition of “alternative investment fund” in the AIFMD is very broad. Only individuals (i.e. sole traders) are clearly exempted. It can be interpreted to potentially catch any investment arrangement where more than one person is involved. However, there are various exemptions which will probably mean that most if not all residential landlords would be excluded. Precise details as to who would be affected by this directive are not yet available. In practice, it is unlikely that members of the RLA be affected by this. Certainly AIFMD should not result in any increase in the cost of borrowing for residential landlords as it does not apply to banks and other credit institutions.

NOTE: We are grateful to Ion Fletcher of British Property Federation for his considerable assistance in the preparation of this note.