A very narrow gap between gross rental yields and mortgage interest rates is a buy signal for investors.
The contrarian buy signal for property
Residential property investors are in long-term retreat. Using ABS monthly loan commitments statistics as a proxy for buying activity, the cohort is only striking one in four property deals. That is a shadow of the 46 per cent market share seen back in April 2015, when investors borrowed $10bn of the $22bn new housing finance total. That month was the high-water mark of a post-GFC 2012-to-2017 investor boom. But it turned out to be an exceptional period. Most of the 21st century has seen investor borrowings trend within a much lower $5-to-6bn-a-month window, which of course has seen investor influence progressively wane given total lending and property prices have risen substantially over that time.
This weakness belies the often-held assumption that investors dominate the property market to the detriment of all others. In reality, investors have been increasingly crowded out by owner occupiers, with resurgent first home buyers especially active in the last 12 months.
Now that outcome has undoubtedly been a social policy objective that has been delivered through various levers – e.g. tightening of borrowing criteria for investors and increasingly generous first home buyer supports from the Commonwealth and state governments – and will be a welcome result for many observers.
From an investor perspective, does this mean investing is doomed to whither or are there opportunities to make a sufficient financial return in the future?
There is a statistical trend that keeps me optimistic, even in these curious pandemic times.
Gross rental yields – income from rent divided by the property value expressed as a percentage – have been drifting downwards. They currently sit at a skinny 3.3 per cent for houses across our capital cities, according to CoreLogic. 12 months ago the corresponding number was 3.6 per cent, a drop of 30 basis points. The mathematical reason is of course due to property price growth outpacing rent increases. On its own, without further context, this would seem a disincentive to invest in property.
However, look at borrowing costs over the same 12 months. New borrowers – according to the Reserve Bank – are paying just over three per cent mortgage interest on average today. 12 months ago, it was just over 4 per cent – so a drop of 100 basis points. There has been a similar drop for investor interest rates.
With interest payments the most significant cost of property investment, more of the holding costs are covered today compared to last year despite weak rental growth.
Looking forward over the next few months, it is likely that there will be little growth in rents and possibly even rent decreases due to several coronavirus impacts: a lack of population growth, young adults returning to their parents homes, and higher unemployment. But on the flip side, the worst of the virus and therefore rent challenge may well be behind us in most parts of Australia (Victoria and NSW being an exception in the next few weeks). Yet we know mortgage rates are likely to remain low for months and even years (based on RBA public statements).
If these expectations are right, then this very narrow gap between gross rental yields and mortgage interest rates is a buy signal for investors. That’s because investors require less cashflow from their disposable income to finance an investment which means greater borrowing capacity and, in time, higher prices. Now few people are attuned to the signal. Those investors with better antennas could profit now.
That doesn’t mean investment success is assured. Prospective investors must overcome the comparatively tougher borrowing criteria set for them as well as the broader issue of banks struggling with mortgage application backlogs.
More fundamentally, as the exercise above illustrates, low rental yields are a reality of property investment. So investors should focus on finding those quality property assets that will deliver them an acceptable long-term return through capital growth rather than through rental dollars. Richard Wakelin