Written by Leading Australian Property Market Analyst, John Lindeman.
Nothing could be worse for an investor’s fortunes than to invest in areas without understanding its future rent demand. Rent returns can vary widely for different types and locations of investment properties. So let’s first look at what rent means to various types of investors.
The high demand for rental properties around Australia from emerging households and overseas arrivals seem to assure property investors of income security. Average weekly housing rents have doubled in the last ten years, easily outperforming the national housing price growth of 10.9%. That’s the highest on record since 2009.
Rent allows start-up investors to enter the property investment market with a relatively small initial deposit and reducing ongoing net outlays. That’s because it offsets their interest costs and other expenses. They can continue to develop their portfolio in high growth areas by leveraging their investments, using negative gearing to minimise outgoings.
This buy, sell, buy strategy is an effective way to continuously increase capital. But while rent demand and low vacancy rates are important, growth is essential. Without capital growth, leveraging is futile.
Figure 1 shows an example of the benefit of negative gearing and leveraging on an investment house purchased 7 years ago for $250,000 in Queanbeyan, NSW. With a $25,000 deposit, the income from rent covered all the expenses. At that time, capital growth was projected to provide a total net return of around $180,000 to the purchasers.
At the same time, the graph shows the importance of buying in the right area at the right time. But the stakes are sometimes higher than investors realise: if interest rates rise suddenly or if housing prices fall, negative gearing and leveraging can be disastrous, even though rents continue to rise.
RENT PROVIDES CONSOLIDATING INVESTORS WITH CASH FLOW
Because of the risks associated with leveraging, investors who are consolidating their investments with an eye to security and income should shift to high rent-generating properties as they sell and rebuy. Even though all investment properties turn cashflow positive over time, consolidating investors can make a smart decision by buying and holding low maintenance properties in areas with good rental growth prospects and low vacancy rates.
In Figure 2, a unit purchased in Darwin 7 years ago for $250,000 has provided total rental income of nearly $180,000. The rising rental yield is caused by higher rents, delivering over $28,000 per year in rental income to the owners. Their aim of minimising cost and maximising the security of good income from rent has been achieved.
RENT AND GROWTH HAVE DIFFERENT DYNAMICS
Start-up investors need capital growth, while consolidating investors rely on rent. But the dynamics of rental markets are very different to those of capital growth markets.
Our housing market history demonstrates how the relationship between population growth and rent growth is dependent on the type of population growth. Figure 3 shows that from 1947 to 1960, our population’s annual growth rate was well over 2% per year, its highest consistent rate of growth ever. But as the nature of population growth changed, so did its impact on the housing market.
During the early baby boom years from 1945 – 1950, our population growth was caused by new families our soldiers started when they came home after the war. Banks provided housing finance freely to these returning heroes. This was combined with generous War Service Home Loan schemes. So while home ownership and housing prices climbed quickly, there was no increase in the demand for rentals. The population boom created new families who had the means to purchase their first homes.
Over the next 10 years from 1951 to 1960, our population continued to grow at record rates. But while babies were now increasing the size of existing families, the flood of new ready-made families arrived as Australia opened its doors to post-war immigration.
These new families would have waited years before they could build or buy homes so they were forced to rent. Housing prices stopped growing as the demand slackened, but as Figure 3 shows, rents rose from $5 per week in 1951 to $25 per week in 1959 – a staggering 500% increase caused by new families who had no option but to rent.
This pattern has been, more or less, repeated throughout our history and in our various housing markets. This shows that although population growth always generates demand for housing, it may flow into either demand for rentals or owner occupation. That depends on the prevailing economic conditions and the type of households being created.
Apart from mining boom towns back then, prices and rents tend to see-saw, and seldom rise at the same time. This means that rental yields, one of the most commonly used methods of establishing the relationship between prices and rents, can easily lead unwary investors astray.
THE RENTAL YIELD TRAP
Capital growth is to start-up investors what rent is to consolidating investors, yet both are important. This is why analysts measure the performance of properties, suburbs or cities by using rental yield.
Rental yield is used in the way that we might express interest on a loan, or deposit as % per annum. In association with terms such as positive cash flow and positive gearing, we hear high rental yield spoken of in whispers as some sort of Holy Grail – but is it really?
Housing prices and rents continuously shift rental yield as they rise or fall. This means that the rental yield trend is far more important than the yield itself. But even more important than the trend is what is causing it.
We tend to think of high or rising rental yield in terms of rising rents. However, as the table shows, there are many situations where falls in prices or rents or even both can cause rental yields to rise. But this doesn’t mean that rises in rent don’t automatically lead to higher rental yields. If you’re attracted by the promise of high rental yields, your essential research should be to find out the cause. High rental yield caused by prices falling faster than rents is a disaster for any investor.
High rental yield traps can appear anywhere at any time. Be especially wary of high rental yields on offer in dead or dying mining, timber, railway and fishing towns. Many of which litter our rural areas and where high rental yields are the result of savage fall in prices.
Avoid high rental yield guarantees for new developments, unless you’re sure that the future demand for rental is genuine, and that the price you’re paying doesn’t have the rent guarantee loaded in as a hidden cost. Taking into account rent potential, capital growth forecasts, potential risk and rental yield trends, this is how the best of Australia’s rental housing markets scrub up.
LOW RISK AND GROWTH, HIGH RENT: PERPETUAL RENTER LOCALITIES
The lower socio-economic localities of Australia are home to large proportions of permanent renters and households that will never buy a property. Many also rely on some form of temporary or permanent government assistance. They reside in ex-housing commission suburbs on the outskirts of suburbia, in ex-holiday homes along coastal fringes, and in rural towns which have affordable rentals. They constitute a pool of permanent renters, many of whom are long-term residents unwilling or unable to relocate. Because of government rental assistance, rental yields in these rental markets tend to be higher than in urban rental markets.
Vacancy rates are very low and defaults are rare. Typical house prices will vary from $150,000 to $300,000 providing rental yields around 6% or 7%. They generate a reliable and secure source of income to investors even though the only buyers, apart from investors in the current economic environment, are renovators and only then in areas with potential.
MODERATE RISK, HIGH RENT: OVERSEAS MIGRANT RENTER DESTINATIONS
The middle distance, older well-established suburbs of our major cities have always been an initial destination for overseas arrivals. They look for ethnically friendly localities, close to shops, transport, and employment. In such suburbs, they can form most of the households and because their mobility is limited, send rents shooting upwards, generating rental yields of over 8%.
Extremely reliable renters, their aim is to save enough money to buy a dwelling, which will usually be elsewhere. If the number of overseas arrivals who prefer a particular area starts to drop, then rental demand will slow. The key to this market is to watch the trend in number and country of origin of overseas migrants and their propensity to rent in ethnically friendly areas.
HIGH RISK, HIGH TOTAL RETURNS: MINING TOWNS AND PORTS
Mining towns are the stuff of housing investor legend, producing the highest rental yields in Australia and good capital growth as a bonus. As usual, if it seems to be too good to be true, it probably is. Investors should be increasingly wary of throwing their lot into such towns because rental demand in some mining locations is problematic.
Residents of Queensland’s coal mining towns in the Surat and Bowen Basins gain little benefit from the profits that mines produce yet they suffer all the downsides of increased pollution, traffic, noise and high rents. Mining companies dislike subsidising the housing rents of their employees, or paying high wages to compensate for the astronomical rents.
Increasingly, mine owners and operators are using FIFO (fly-in fly-out) and DIDO (drive-in drive-out) contracted labour. They’re housed in camps near the mines and are completely un-reliant on local housing, necessities or supplies. Everything needed is trucked or flown in, so the miners don’t even spend their money in town. This has led to demonstrations by locals in towns such as Moranbah against FIFO and DIDO practices.
The demand for iron ore from the Pilbara in WA is rising and while uranium mining is under somewhat of a cloud. Purpose-built mining dormitory towns such as Roxby Downs in SA don’t suffer from FIFO AND DIDO issues. In these areas, further mine development or expansion is the only key to housing market rental demand.
LOW RISK, HIGH RENT GROWTH AND YIELD: GEN Y RENTER PRECINCTS
Although the assumed key to Gen Y renter markets is natural growth, this is misleading. That’s because their numbers in the large eastern capital cities are boosted by a large and continual interstate movement of younger people from the smaller states and the territories and also by well-educated younger overseas arrivals with a cosmopolitan outlook on housing who prefer urban living.
The demand for inner suburban modern units in Sydney, Melbourne and Brisbane near recreational and entertainment facilities is, therefore, higher than the numbers might suggest, and it’s growing. Many live in rent sharing groups and so investors are looking at purchase prices from $500,000 upwards with rents that are forecast to rise rapidly in the medium term.
The unwillingness of younger people to buy properties increasingly turns to inability, as high rents make deposit saving difficult and banks remain reluctant to lend to first home buyers. This increasing pressure on the demand for such rental accommodation offers investors excellent long term rent opportunities which are relatively low risk in the current economic environment.