The link between capital growth and rental return

[Peter_Tersteeg]

Here's some observations of mine, gathered from the past 5 years. This is intended to apply to a buy and hold strategy.

It seems to me that investors have been motivated in part by what is an exceptable rental return for an investment property. As rental returns have decreased, investors are less and less willing to pay higher prices, to the point where they simply refuse to purchase the property. Those who are purchasing low yeilding properties at the moment seem to be new to the area or new to investing and thus are unaware of what's acceptable to the locals.

5 years ago it was possible to get an 8-10% return in Melbourne. Now you're doing very well to get 4%.

Take Hobart for example. 5 years ago, people were buying there for a 15% rental return. Capital growth had been very slow for a long time. 2 years ago, people were happy with a 10% return and there were a lot of interstate investors looking for cashflow. Rents have increased somewhat, but the gains have been huge.

Those who bought 2 years ago have done well, those who bought 5+ years ago have made a killing. The same thing has happened in country areas. People have chased cashflow, which has led to capital growth.

I've also seen a lot of people buy some 'growth properties' and then buy a 'cashflow property' to offset the rental losses of the growth properties. I know of cases where the cashflow properties have had a better percentage increase in value than the growth properties.

 

[always_learning]

In an opposite repect some potential buyers will say "why would I buy pay 7%+ interest" whereas I can find some sucker to rent the place to me for 2% yeild and pay all repairs. If market perception changed back to the mid 90's in melbourne which was "this place is going down the gurgler, only a fool would invest here" then I am sure we would see some change in the rental return equation.

Dare I sugges the market is held up by the continued expectional of low interest rates and the perception (real or not) of excellent capital growth!

 

[jrc]

Following from AL's comments the logical solution if one were in the market for a PPOR and borrowing to pay for it would be to purchase a property rent it out as an IP and rent a similar property for the residence.

There does seem to be a continual willingness to accept a lower yield. I had a property valued last year and the valuer worked on a net yield of 7.8% (a gross of about 9.4%) and said in that area the net yield for medium density properties ranged from 5.7% to 10.7%. Less than a year after the valuation I have been offered a price that works out at a gross yield of 6.6%.

Of course one possibility is the rents might be a bit below market. However, to get back to a net yield of 7.8% a rent increase of 50% would be required and the market would not bear that increase.

There have been a few reasons why a lower rent yield might occur eg the reduction in CGT in late 1998, the reduction in tax in 2000 or a belief in capital growth so that the total return of capital growth and rent makes investment sense. However, the reduction in yield caused by the first should also factor in a political risk of changes to CGT and the last needs to factor in the likelihood that capital growth will continue at its current levels. There certainly seems to be a perception that high rates of capital growth will continue. However, if PT's views are accepted that many investors invest because of acceptable income (and certainly that is my motive for investing) the current rental returns for many residential properties are not attractive. Indeed it would not be attractive for me to purchase my IP at current yields.

So if high CG is not guaranteed, and income yields remain low, should we look for other investments using some of the additional equity to lever some more value from our equity other than reinvesting in property?

 

[twodogs]

Following from AL's comments the logical solution if one were in the market for a PPOR and borrowing to pay for it would be to purchase a property rent it out as an IP and rent a similar property for the residence.

Interesting idea. I just have my own first PPOR (small flat) after 10 years of investing, always rented although that was not because of any investment plan! Now I want to move the family to a house, but I have great discomfort paying $700k+ for a Sydney house, that's money that could be making money. Perhaps a better plan, short term, is to buy a few more QLD IP's returning 7% plus basic CG and rent the home paying some "investor" his 2% gross. I think that is win-win for me, again in the short term. Long term, the investors CG of the $700k Syndey house should outstrip the return from poor yeilds.

I once saw a freeware program to calc the rent-v-buy options. If I find the link, I will post it. It should provide some interesting calc comparing GC and rental yield.

 

[Aceyducey]

So if high CG is not guaranteed, and income yields remain low, should we look for other investments using some of the additional equity to lever some more value from our equity other than reinvesting in property?

That's what some investors are doing

A good spread of investments is useful for 'bust-proofing' and maximising the ROI through the various asset cycles.

Just ensure you follow the same rules as for property:

1) Do your research (understand the investment)
2) Use independent advice
3) Keep a hand on the tiller

Cheers,

Aceyducey

 

[Sunfish]

3) Keep a hand on the tiller

I call it weeding the garden. When using investments other than RE, you do need to stay hands on and check daily. That may not appeal to RE investers who do not check prices and trade this way.

Thommo

 

[Peter_Tersteeg]

I'm not saying that people activly buy at a price to meet certain cashflow expectations (although that is probably part of their calculations), but it does seem that there is a correlation between the two.

A few years ago we were saying that Hobart had great returns, but no growth. We've now seen the growth and the returns are looking like negativly geared losses.

Country areas have experienced the same thing. A few years ago you'd only invest there for the cashflow. Those who did have had cashflow and now they've got lots of equity as well. Take a look at parts of Queensland. Once a cashflow only zone, late in the boom they're the hottest growth areas.

Perhaps a decent strategy would be to buy cashflow early in a boom and wait for the groth to ripple outwards from the capital cities. Some 'cashflow areas' have seen a higher percentage of growth than the 'growth areas'.

It also makes me wonder if now people are looking these places for its growth potential rather than cashflow. A few years ago you only bought there for cashflow.

If these areas stay true to form, that might be a mistake because they'll stop growing, with no cashflow either. Eventually inflation will generate cashflow again, but that might be a long wait.

If you look at Hobart over the really long term (40+ years), it's actaully showed quite good growth. It's just happened in short periods of time and is harder to predict.

 

[geoffw]

Country areas have experienced the same thing. A few years ago you'd only invest there for the cashflow. Those who did have had cashflow and now they've got lots of equity as well. Take a look at parts of Queensland. Once a cashflow only zone, late in the boom they're the hottest growth areas.

Perhaps a decent strategy would be to buy cashflow early in a boom and wait for the groth to ripple outwards from the capital cities. Some 'cashflow areas' have seen a higher percentage of growth than the 'growth areas'.

I suspect a reason for at least some of that capital growth is the growth of the number of investors looking for cash flow, therefore pushing up demand.

I have a cashflow +ve property in Canberra which was appraised 2 weeks ago. I expressed surprise at the high number he gave- he said the reason was the comparatively high return, which was not much of a concern to buyers 2 years ago (the seller had had difficulties in selling it).

 

[Freedom]

PT Bear - I would just caution that the ripple out effect that has been experienced in this boom, may not be experienced in the next.
eg, inner ciy land, let's say Kangaroo Point in Brisbane - if it is protected as a single dweliing zone and not able to be developed, we should not make assumptions about its desirability and rate of capital growth.
I have recently had friends prefer a unit to a house, both for about 500K in this area - because it can be very hard to modernise the layout of some old dwellings, if you are not able to demolish or substantially change.