The new mortgage prisoners – the unintended consequences of improving the world

In the constantly evolving UK mortgage and housing market, two new developments that are increasingly relevant for both property owners and lenders have recently become worthy of closer attention. Firstly, the eco-driven Minimum Energy Efficiency Standards (MEES) proposes increasing the minimum EPC ratings for new tenancies starting in 2025. Secondly, industry standards around cladding inspections have been strengthened by regulation. Both issues resonate due to their relationship with ESG considerations, an integral part of our investment processes.

All housing stock in the UK currently receives an Energy Performance Certificate (EPC) when either built, sold, or rented out. A rating is produced via a specialist survey that considers all the property features, from the thickness and construction of its walls and windows to the type and age of the boiler and even the kind of lightbulbs installed. The result places the property on a scale from A for the most efficient to G for the least so.

Since 2018 for new tenancies, and  April 2020 for all, the minimum required EPC rating for properties in England and Wales is E, essentially compelling landlords of class F and G properties to either sell or invest in property improvements. A consultation exercise was recently issued for the minimum EPC rating to become C for new tenancies from 2025 and all tenancies from 2028. Currently, c.30% of UK properties have an EPC rating of C or higher. Similar regulation is being rolled out across Europe as various countries strive to meet carbon emission targets. However, not all countries are moving simultaneously or consistently; for example, France targets a minimum EPC of E from 2025, corresponding to a UK G in the European Babel of EPC ratings.

It is expected that landlords will soon start investing in home improvements, partially aided by government funding. However, there are fundamental reasons that won't allow many E rated properties to move up the EPC ladder: for certain properties, their structural features make poor insulation hard to tackle, the advertised grants are often hard to obtain and only partially cover the cost of an upgrade, while there is essentially no private offer of credit for such improvements. Finally, there is minimal intervention allowed on listed properties or conservation areas. This restrictiveness contrasts with countries like Holland, where, perhaps because their housing stock is easier to adapt, government subsidies have been more forthcoming and utilised.

It is worth noting that lenders are also adjusting to the new MEES rules. They are now obliged to verify the EPC rating and, other than a small number of exceptions, won't be able to extend new mortgages, whether for a new purchase or a refinance, to landlords that can't comply with the new requirements.

Another relatively recent change that has made headlines is the enhanced safety regulation following the Grenfell fire tragedy. Accordingly, sales of properties in large buildings with external cladding now require an External Wall Fire Review form (EWS1) to certify the safety of the cladding material. This strengthening of regulation follows a RICS (Royal Institute of Chartered Surveyors) initiative to facilitate sales in high rise buildings at a time when demand had slumped due to uncertainty and fear. However, it soon became apparent that the number of experts available to issue this form was limited and insufficient for the demand, thus creating a backlog and bottleneck for the sale of properties with cladding.

In both instances, the good intentions of the regulator and the authorities are clear, as these types of measures are essential to fighting climate change and also to eliminate public safety risks.

But at the same time both changes have the potential to cause an increasingly undesired side effect; a new generation of mortgage prisoners, or rather “regulation prisoners”, where it’s not a poor credit profile or an inactive lender that prevents them from obtaining a new mortgage, but a feature of their property that wasn’t under consideration when they purchased it and is potentially out of their control. The result is however the same: the property becomes illiquid, the borrower can neither sell nor refinance and will have to suffer an often higher reversion rate on the existing mortgage.

Whether we invest in the underlying loans or the bonds backed by such loans, at TwentyFour, we like to follow regulatory developments up close to anticipate change by designing and following processes that allow us to assess and price the risk of the assets in which we invest. Accordingly, both of these regulatory developments are covered in the due diligence processes that govern our transaction analysis, allowing us to make the most informed investment decision.