Property investment offers us many ways to create wealth such as the profits from development, renovation and passive price growth when we sell a property, and cash flow while we own it. But even though we all believe that property values grow over time, there are also many traps for the unwary in relying on the power of passive price rises to create profit.
Remember those mining towns in Western Australia and Queensland, where real estate values fell by over ninety percent from 2102 to 2017? What about capital cities such as Adelaide or Brisbane, where housing prices have stubbornly refused to rise during the last ten years, despite the confident predictions of so-called experts that they were about to boom? Even worse, in cities such as Darwin and Perth property prices have actually gone backwards over the same period of time.
This uncertainty about future price performance leads many investors to the view that while prices may rise over long periods of time, the immediate benefit of owning real estate is cash flow from rent, because it is immediate and measurable. If the rent we obtain each week is more than the costs of holding the property, we have achieved the holy grail of property investment – a property which is paying for itself and providing us with positive cash flow.
For example, if you followed my predictions and bought an investment property in Hobart’s Bridgewater for $180,000 in 2017, your current weekly rent would be $300, which is a rental yield of nine percent. Of course, you have to fork out for repairs and maintenance, property management fees, rates and insurance, which typically amount to around two percent of the property value each year. In addition, there’s the interest cost of the loan on your property, which can be around three to four percent of its total value, depending on how much of the purchase price was borrowed from a housing finance provider.
Your Bridgwater property could therefore cost you up to $200 per week to hold, depending on how much you borrowed to buy it, but the weekly rent is $300, so you end up with at least $100 per week in your hand – not only is the property paying for itself, it has generated around $10,000 net cash flow since you bought it, and the median house price in Bridgewater has risen by $40,000 over the same time – not a bad result.
Far more common are investments where the income from rent is not enough to cover the costs of holding the property and their owners are losing real money. For example, if you purchased an investment property in outer Sydney for $1,000,000 in 2017 you would be able to charge around $600 per week in rent, giving you a gross rental yield of three percent.
Just like in Bridgewater, you must pay holding costs amounting to two percent of the property value, plus the cost of the loan interest, which in total amounts to around $1,100 per week, so you are losing $500 each week. This property would have cost you around $50,000 to hold since you bought it, and median house prices in Sydney have fallen by around $70,000 over the same time – so why would you even contemplate such an investment?
The answer lies in the belief that housing prices will rise over time and in the lure of negative gearing, which allows you to offset your holding cost losses against other income, reducing your income tax liability. But while gearing reduces your tax, it does not generate income and you still have to pay the cost of holding the property.
This is the hidden reason why buying demand from investors, especially in our mainland capital cities, has slumped. It’s not so much about prices as it is about gross rental yield, or the return on investment we receive from rent. There’s no doubt that tougher lending regulations, lighter loan limits and termination of interest only loans had their effect, but even though the restrictions have been eased, investors have not returned.
Rental yields in our mainland capital cities are too low, and the gap between income and expenses is too high to make property investment attractive. The tipping point at which investor interest currently wanes is when the gross rental yield drops below five percent, which is when the cost of holding a property starts to outweigh the benefits of owning it as in our Sydney example. Conversely, when rental yields rise above five percent investors sit up and take notice, because properties in such areas can deliver positive cash flow from day one, such as the Bridgewater example.
The reason that rental yields are so low in Sydney and Melbourne is that housing prices have nearly doubled in the last six or years, but asking rents lag behind, and have only risen by twenty percent over the same time. The gross rental yield is now at its lowest level since 2012 – at around three percent. Virtually every Sydney and Melbourne property investment made since the booms began generates much less income from rent than it costs to hold and the owners have to make up the difference out of their own pockets each week. So, while all the focus is on rising prices, the real issue for investors is low yields.
Other mainland capital cities have also suffered from falling rental yields since 2012, but these have been caused by oversupplies of new housing, particularly in Brisbane and Perth. New home surpluses have been keeping a lid on housing prices. They encourage aspiring first home buyers to move out of rental accommodation and into their own home, with the repayments often being lower than the rents they were paying.
The drop in rental demand has seen rental yields in these cities fall by over one percent in the last few years as rental vacancy rates blow out and landlords compete for tenants. With rental yields in Adelaide. Brisbane and Perth at only four percent and prices going nowhere, investors are not excited.
The proof of the “five percent tipping point” lies just across Bass Strait, in the one property market that has been booming while others have languished – Tasmania. Rental yields in Hobart were over five percent in 2017; much higher than any other State capital city and they were even higher in other parts of Tasmania. Mainland property buyers have been surging into the Tasmanian market since then, buying properties in suburbs such as Bridgewater and yet both prices and rents have continued to rise due to an underlying shortage of housing stock for rentals as well for purchase.