RBC Capital Markets has initiated coverage of buy-to-let mortgage specialist Paragon Banking Group PLC (LON:PAG) with a sector perform rating.
The broker noted that the buy-to-let (BTL) market continues to grow despite a number of tax and regulatory changes.
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Around 86% of Paragon’s business is for the BTL market, which means that of the lenders in RBC’s coverage universe, it is the one most exposed to this sometimes controversial market.
With more people in the UK choosing property investment as a primary means of supporting themselves, RBC says Paragon is well positioned to benefit from this trend.
“We like the UK BTL lenders which are benefiting from high growth in high margin products with little signs of any credit risk. PAG, in particular, offers an attractive yield and increasing profitability,” RBC declared.
The group is slowly running down its lower margin legacy BTL book, which means it will be the only speciality lender likely to see an expanding margin over the new few years.
RBC’s back-of-the-envelope figures suggest the net interest margin will increase by 0.27 of a percentage point – or 27 basis points (BPs) in the jargon – by 2020 from its current level.
“Paragon has been through the financial crisis with a BTL book and saw peak cost of risk of only 35bps and that was with a portfolio with significantly higher LTV [loan-to-value] than currently. There are no signs of credit stress in UK BTL lending,” RBC asserts.
In December 2017, the Basel Committee on Banking Supervision published its final proposals regarding amendments to the assessment of institutions' capital adequacy, in its document 'Basel III: Finalising post-crisis reforms'. This addresses both the Standardised Approach (SA) for credit risk, presently used by Paragon, and the Internal Ratings Basis (IRB), which is based on firms' own internal calculations and subject to supervisory approval.
Paragon plans to apply for IRB approval and RBC estimates it could benefit its capital ratios by some four to six percentage points.
“However, we also estimate that the new Basel framework in its current form will erode this benefit, more so for Paragon due to the legacy book's high LTV at origination. We expect regulation is more a risk to the large banks than it is a benefit to the small banks but it should level the playing field,” RBC said.
The 16.5% return on tangible equity is attractive, RBC believes, and Paragon continues to grow, improve profitability and payout 70-80% of earnings through dividends and buybacks.
It trades on a multiple of 8.6 times projected earning for 2019. “Through the EU referendum, the lenders traded down to 4-5x and therefore the downside risk of a no deal Brexit is higher for PAG,” RBC noted.