Australian residential real estate market has had a great run in the last few years. The strong price and rental growth in major capital cities (see our interest rate chart Australia) were driven by strong income growth, stable employment markets and RBA relentlessness in cutting interest rates.
QBE (QBE ASX) issued their annual housing sector report. QBE keeps a close tab to the residential housing market given it is one of Australia’s largest property & casualty and lenders mortgage insurer.
We saw a few charts in the report which highlights some key points on how rental yield can be used in the investment analysis process on a macro and micro level. On the macro level, it can provide a indication of where we are in the cycle and on micro level, it shows what are the key drivers that leads into the number and how it can be calculated.
Property Market Yields
Chart above shows the Australia capital city rental yield today as well the last 15 year historical high and low range. What is clear from the chart is Sydney and Melbourne property yields has always been yielding lower than other capital cities. But even today’s low rent yield is low by historical standards.
The only major city where the current yield is in the middle of the historic 15 year range is Perth. However this is a high level market snapshot. The Perth property market under closer examination is trading at a discount to its east coast peers due to its exposure to commodity prices. In the near term it has to find a way to address the end of the commodity boom.
An inverse of the yield is the asset price multiple which can be seen as a proxy for the price. Record low yields is another indicator that Sydney house price trend is nearing peak. This is not surprising when the median house price is above $1 million in Sydney and $770k in Melbourne.
Residential investment property buyers today should note that you are buying in a market where the median price is at its highest with a decent return driven either by continual rental growth in keeping the multiple constant or someone else coming along in paying an even higher price.
We see the upcoming supply in Sydney, Melbourne and Brisbane will continue to put pressure on future rental growth.
Year on Year Property Rent Growth
The first chart examined the current absolute level of rental yields across Australia. This chart shows the year on year changes in the rents in each city.
The year on year change is an important indicator because it shows the directional trend of the market. A steady uptrend or downtrend market means that the year on year increase or decrease is steady.
The chart shows that Perth saw a dramatic decline from 2.9% growth last year to negative 0.4%. It could be worse, as Canberra saw a negative 2.7% in rents from previous year. However we have to stress that the Canberra due to its small size is more volatile and can be very dependent on current government fiscal stance.
What is Rental Yield
The rental yield represent the income that the owner receives for the investment over a specified time frame. From valuation perspective, it can also be used as a relative valuation tool in comparing it with other similar properties.
On a micro level, the rental yield can be broken down in to a number of factors as proportion of income. It can also be useful to use comparable cost in managing the property for similar assets to determine if the cost of running the property is inline with its peers and if its higher without good reason, income can be increased by cutting unnecessary costs.
Commonly, if the yield of property is higher than cost of debt, it is known as positively geared and vice versa when the yield of the property is lower than the cost of borrowing, it is called negative gearing.
Rental Yield Calculator
Below is a key steps on how to work yield on investments.
Revenue – Cost – Interest = Net Rental Yield
Gross Revenue – total rent plus parking income from the lease
Operating Cost – this include regular local council taxes, property management fees and if its an apartment there will also be strata fees. Investors should also take into account some irregular cost that may occur such as routine repairs and maintenance to repair items around the property which is outside the tenants responsibility. Also the fees relating to leasing the investment property.
Interest cost – It is useful to separate cost interest cost from operating expenses in calculate rental yield as it shows how much portion of the rent is actually absorbed by the interest. The value of the property should not change based on how much borrowing you use. This is because interest is a financing cost while assets should only be valued based on its future cashflows. For example the value of the house does not change if you use more or less equity or debt, the cash flow is split between equity and debt service costs.
Using the above factors we reach the net rental yield. Also note that we have excluded major capital expenditures. Investors should create a regular sinking fund to carry out major repairs that would not be covered by insurance. After all, a property cannot be rented if it is not safe to live in.
Beware of high yields investments
Real estate is one of few asset classes where buyers can be driven by non economic factors such as cultural affinity for particular areas, a premium to pay for close proximity to key transport hubs or good school zones. While these points should be a factor in setting the price. Some people see housing as a necessity and not as an investment and will make the final decision based on emotions. This means that prices in an area could be set by factors other than the underlying income of the asset. Other sellers will take note and will not sell less than comparable transactions which means buyers either have to meet the market or move on.
A positive cash flow residential property after debt cost can be considered rare in the best areas. We are always biased towards cash flow positive investments. A negative cash flow investment means that we have a cost just in holding the investment where our returns is dependent on the price someone else is willing to pay at the time of sale. This means that for us negative yield assets have a higher hurdle rate before considering investing.
Investors from recent experience in the search for yield have gravitated to weaker socio economic areas or mining towns in buying investment properties that provides a high yield. These areas provides a high yield for a reason and that is because they are higher risk. This initial cash upfront provides a nice mental boost could be wiped out by the potential capital losses in commodity downturns or a bad area that turns worse.
As with anything in investment, there is no such thing as a free lunch. Assets prices are where they are for a reason, either a rational or a irrational reason. While there might be bargains to be had, we encourage everyone to do detailed research and see what is primary factor that leads to the yield to be higher than other areas. Examine how the property value in the area performed in the last downturn is crucial to get an understanding of the potential future volatility in residential real estate investing.