Developers Switch to Buy to Let

The problem with build-to-let is that your development company can end up being re-classified as an investment company, which brings a number of tax disadvantages, for example the company's shares are not eligible for entrepreneurs' relief or holdover relief for CGT purposes. However it is possible to run a "mixed" business, part investment (a.k.a renting out your new-builds) and part-trading (selling on completion), without losing the advantages of being an active trader. HMRC apparently recommend a 20:80 split, but the de-minimus rules for VAT reclaims allow a 50:50 split for smaller developers, i.e. you can reclaim VAT on rental costs provided they don't exceed your 0% VAT reclaim on new-builds over a given period (quarterly, sometimes annually).

Historically builder-developers have avoided the rental market because the management costs are high and it's a pain dealing with the never-ending stream of issues thrown up by tenants' messy lives. Also, when you want to sell, the new-build sheen has gone from the property, and the developers' capital has been tied up in the rental property for year, where it's effectively dead money that is subsidising tenants: rents are usually less cheaper than the cost of ownership once you factor in maintenance, and even more so for developers who also suffer steady depreciation on the achievable price of the property when it was new. The returns offered by rents are invariably much poorer than the returns from investing your capital actively and keeping your levels of debt down. A 5-7% gross return is simply not good value for most profitable companies, even if it does work for small private landlords who don't charge for their time looking after tenants, and for retirees for whom a 5-7% gross return, linked to earnings, is dramatically better than the index-linked income they can get from a pension annuity (approx 3.1% at the moment)

However, the new-build premium has been slashed dramatically since the crash, as the CML now requires surveyors to value new houses and flats as if they were already second-hand, plus buyers are skittish, many sales take forever, and development lenders seem increasingly to value a higher cash flow from income as well as capital sales. Small developers are increasingly saying that if they build or renovate five houses, they'll keep one - usually the one that is proving hardest to sell - for rental investment, even though this acts as a drag on their future growth prospects because they've less capital to work with. Judging from the above news story, it sounds like larger developers like Rushbond are making a similar calculation: they're still a developer-renovator, but with a larger income component to the business (plus the hassles of being a landlord).

I concur with most of the points you are making Tony. However, as you will appreciate, with the benefit of leveraging the 5 - 7% yield can become a 15% plus net return on capital. Obviously the higher the gearing the higher the risk unless balanced with a liquidity strategy. Presumably you've read my strategy, if not there's a link to it in the author profiles of all articles I've posted in Landlords Log. I use the Number Cruncher in our Due Diligence section to calculate optimal gearing in line with my long term hold strategies. Also, if the developer is working on the typical one third land cost, one third build cost one third profit model there may be a possibility to finance out all costs then some. This makes any net cashflow infinite if there is no risk capital other than profit tied into a property. I also appreciate that you might say that one third profit is unrealistic in the current market and I would have to agree but I think we will get the point I'm making which is that 5 - 7% gross yield can be leveraged to improve net yields.