The commentary below relates to the purchase by an individual of one or more residential properties for the purpose of generating a regular income by renting out the properties.
Most individuals would leverage such an investment by taking a first mortgage to part fund the purchase price. As I have not covered leveraging the other investments, I have not contemplated a mortgage or any other type of loan in this case. I should however point out that while leveraging an investment generally increases the investor’s expected return on investment it also increases his/her risk. If the property concerned drops in value, the investor faces a much higher prospect of losing the capital he/she invested.
For example: If the property is leveraged to 80% of the total purchase cost and the property suffers a 20% loss in value, the investor would lose all his/her capital. If the loss is greater than 20% the investor will have ‘negative equity” in his/her property – the amount owing to the lender will exceed the value of the property. If the property drops by 10% from the total purchase cost, the investor will lose more than 50% of his / her capital.
This risk is compounded by the rights of the mortgagee (the lender). If the property drops in value, the lender may call a ‘default’ (due to the loan amount outstanding exceeding the maximum loan-to-value ratio). In this case the lender may require the investor to make an immediate repayment to bring it within the maximum loan-to-value ratio. If the investor is unable to do so the lender may exercise its rights to repossess and sell the property. As lenders are not renowned for achieving the ‘top’ sale price the investor is likely to suffer a larger loss.
The Expected Return
The investor’s return is generally expected to come from a combination of net rental income and a capital gain – a positive change in the value of the residential property.
Residential areas with higher than average expected capital growth generally have lower than average rental yields and vice versa. For example: As per Residex’s June (2016) Statistical Summary: Sydney and Melbourne had the lowest rental yields (of 3.20% and 3.17%) and the highest capital growth over the past 10 years of 7.19% and 6.99% respectively. Darwin and Hobart had the highest rental yields (at 5.32% and 4.90%) and average capital growth of 4.37% and 2.4% respectively. The average of the average growth rates enjoyed over the past 10 years by the seven State and Territory capitals (Adelaide, Brisbane, Darwin, Hobart, Melbourne, Perth and Sydney) was 4.26% pa and the rental yield was 4.31% pa. The average property value was almost $600,000.
For the purpose of this exercise (to give an indication of the expected return) I have made numerous assumptions. These include the following: A rental of 4.31% pa, capital growth of 4.26% pa, a property price of $600,000, a 10-year investment period and 1% pa for meeting the cost of repairs and maintenance. I also made a provision of 2.5% pa for the cost of replacing the building (i.e. after 40 years). Buildings as well as kitchen and bathroom fittings don’t last forever – so one needs to provide for their replacement. Even solid buildings designed to last ‘forever’ are likely to need substantial renovation to cater for changing lifestyles. The cost of such renovations could be as much as and often even more than the cost of demolishing the structure and building a new one. In other words, it is prudent to make a provision for replacing (or a major renovation) the building.
My calculation produced an expected return on investment of 4.1% pa. The returns I have experienced on a residential property are a bit different. The capital growth I have enjoyed over the past 17 years is about 7.0% pa. A local real estate has recently informed me that the rental yield I could expect would be around 2.5% pa. Assuming this rental yield is achieved and increases in line with the increase in the value of the property, I could expect a return of 6.35% pa if the property increases in value over the next 10 years at the same rate as it increased over the past 17 years. That surprised me – I was expecting the return to be much higher.
The Expected Risk
Like most other assets, the value of residential properties can go up or down. While the Australian market has generally enjoyed fabulous growth over the past decade or so property values may not continue to enjoy similar increases. Some are arguing that they are likely to drop substantially in value.
One of the crucial questions for someone contemplating the purchase of a residential property is whether and if so to what extent the property will increase in value over the expected term of his/her investment.
Various micro and macro factors have an impact on the values of residential properties. The micro factors are specific to the property concerned and include factors such as the zoning status of the property and neighbouring properties, the zoning for local schools, transport and other infrastructure, and access to shopping precincts. Any changes to micro factors could have a positive or negative impact on the future price of the property. Various macro factors could also have an impact (positive or negative) on the value of residential properties. These include the following:
- Negative gearing – There is increasing political pressure calling for the abolition of ‘negative gearing’ (where net tax deductions can be offset against personal income). Such a change will probably have a negative impact on (reduce) property values. Since the abolition of negative gearing of residential properties will also enable government to increase its tax revenue there would be a reasonable expectation that negative gearing will be abolished or at least restricted.
- Population growth -While many (if not most) Australians would probably prefer the population size not to increase, politicians and ‘big-business’ want the Australia’s population to continue growing (through organic growth and net immigration) as it adds to GDP growth. Population growth, which one could argue is reasonably likely, would probably have a positive impact on (increase) property values.
- Foreign buyers – Residents of other countries are currently buying Australian residential properties. This additional demand has increased property prices. The question for a prospective investor is whether and if so to what extent foreign buyers will continue to be permitted to buy residential properties. Many (if not most) Australians are not in favour of foreign buyers purchasing residential properties – so there is pressure on Australian politicians to curtail the practice. Their governments may also curtail the practice – as it amounts to a drain on their balance of payments and has little if any direct benefit to the foreign country. If the practice is curtailed by either government, property values in Australia are likely to experience downward pressure.
- Interest rates – Movements in interest rates impact property values. Higher interest rates generally place downward pressure on property values and vice versa. Market talk is that the RBA considers the cash rate to be at or near ‘the bottom’ and is reluctant to cut rates further and that the RBA has been advocating the raising of interest rates on residential investment properties. Adding further upward pressure on rates are the increasing yields in the USA, which will increase the cost of borrowing for Australian banks who would be expected to pass on the increase to borrowers. As a result the general expectation is that interest rates for residential property investment in Australia are likely to rise over the foreseeable future, leading to downward pressure on residential property values.
- Taxation / incl. GST – An increase in personal tax rates will lead to people having less disposable income which in turn will have a negative impact on property prices. The opposite also applies – a reduction in personal tax rates will have a positive impact on property prices. Prospective investors should consider which scenario is likely and the extent of any change. On the one hand Australian politicians are generally more likely to support spending increases (as that seems to be what gets them elected) than cuts in expenditure, and so are less inclined to argue for reductions in personal tax rates. On the other hand, they need to keep Australia competitive with the other major economies which have lower tax rates.
- Strength of the economy / level of employment – As a general rule a growing economy with higher levels of (fulltime or fulltime equivalent) employment and increasing wages leads to increases in property prices and vice versa. I am not expecting a boom or a bust over the next few years. I am however not an economist and have not applied my mind to any data – so don’t rely on my view on where the economy is heading.
- Housing stock – If the supply of houses outstrips the demand for houses there will be downward pressure on property prices and vice versa. In other words, the more residential construction activity there is the more downward pressure there will be on property prices. It is however important to compare ‘like-for-like’. An over-supply of student accommodation or small inner city apartments would probably have little effect on the price of 3 to 4 bedroom ‘family’ homes in the suburbs. These are very different markets. The supply of family homes depends on the level of subdivisions, industrial areas being rezoned for residential development and new land areas being opened up for residential development. As it is becoming increasingly difficult for governments to rezone agricultural land for residential development (as they are facing increasing pressures to curb urban sprawl and cater for the cost of infrastructure such as roads, rail and schools and hospitals) any growth in the number of family homes in the suburbs will be slow. This puts upward pressure on prices.
Given the state of the various macro factors (where some factors are likely to exert upward pressure on prices while others are likely to exert downward pressure on prices) I would be inclined to argue that property prices will be higher after ten years but that any such increase is likely to be at a lower rate than the rate at which property prices increased over the past 5 to 10 years.
The Expected Return-for-Risk
The return experienced over the past 10 years on the east coast of Australia is probably ‘as good as it gets’. I would be inclined to argue that the expected return from an investment in residential property over the next 5 or so years will be considerably lower than the average return (of 4.1% pa) enjoyed in the major cities over the past 10 years. It would be brave to forecast similar returns over the next 5 years.
Although an investment in residential properties is generally considered to be ‘safe’ it is important to recognize that residential property can drop in price and that drop can be dramatic. There are many instances where the price of a property has dropped dramatically due to changes in micro factors. There are also numerous instances where property prices in Australia and around the world have dropped due to macro factors. Recent examples are mid-market ($1.0 million to $2.0 million) properties in Perth (which I understand have dropped by about 30% over the past few years) and inner city apartments in Melbourne (where I gather there is a large oversupply).
Some are arguing that the Australian property market, in general, will also suffer a material drop in price. While I do not share this view (as outlined above) I accept that some markets could suffer a material drop in price. Others should hold their value, over the medium to long term. It is the short to medium term (up to 5 years) that concerns me the most. Unless one is buying in a market that has already suffered a material drop in prices it would be ‘brave’ to buy a residential investment property in the current market (December 2016) with the intention of selling within the next 5 years.
In conclusion, an expected return of less than 4% pa over 5 to 10 years is well below the return needed to justify taking on the risk losing a portion, perhaps even a substantial portion, of one’s capital. If one leverages one’s investment this loss of capital could significantly greater. For example, if the property was leveraged to 80% and the property sale price dropped by only 10%, one would lose a lot more than 50% of one’s capital (due to transaction costs in and out).
Prepared by: Mark Morris (December 2016)