Rental yields, where do they indicate we are in the cycle and where should you buy? Ed Chan

The property market ebbs and flows over the middle to long term and different forces come into play to cause this.

For example economic growth with low unemployment, low interest rates create the demand for housing which attracts developers to build to meet this demand.

Eventually demand is met and the market reaches saturation as developers may have built too many properties and this causes developers to cease building until the oversupply dries up and demand is there again.  

This may take many years before the tide turns again however it creates the ebbs and flows that are associated with prices moving up and down.  

That was a very simplistic over view of the market. There are many complex dynamics that affects the market as well, the overseas confidence and the Australian dollar.  

One particular area that has not had much coverage but could be a great indicator of the potential movement of property prices is the difference between yields and property prices.  

As demand from investors make up a significant part of property price movements and investors are focussed on returns on investments such as rent yields, we should look at the correlation between rent yields and capital value.  

Let’s see how rental yields dictate where we are in the property cycle 

As rents increase it attracts investors into the property market, especially since the return from fixed interest instruments such as term deposits and other cash investments are considerably low at the moment.  

There is much talk from many economists about the end of the mining boom and predictions of a slowing economy due to China’s slowdown and running into potential head winds with unemployment growing to over 6.5% and economic growth slowing to below 2% per annum over the next five years causing a possible recession on the horizon.  

Whenever economists predict the worst, share investors react first, by cashing in their stocks for safer investments but cash returns are so low that property is the next best group to invest in. So as people hop out of the share market and into the property market, it generates demand for property.  

The other group that drives property prices are owner occupiers.  

Since interest rates on home loans are at its lowest, many people who are renting find it cheaper to purchase, causing a second group of people who drive demand in property.  

The last group that drives property is the supply line. Developers have not been building, where by there is also a shortage of properties.  

Our net immigration of around 250,000 into Australia also drives demand for property.  

Most rental yields are now over 4.2% to 5.2%. Interest rates on home loans are as cheap as 4.85% fixed for three years.  

Research from last month’s RP Data shows, rents have outpaced growth in values since the GFC and created a gap which indicates the conditions are there for the property market to move upwards.  

According to RP Data since the end of 2007, house prices have grown 13.4%percent. For five and a half years, combined capital house prices have been below inflation.  

However over the same period rents have grown 32.1%, almost twice the rate of house prices.  

Refer graph below:

You can see the gap is largest right now which means yields are increasing.  

When yields are so high (namely it’s very expensive to rent) it opens the door for people to buy.  

When people start buying (owner occupiers) it pushes prices up faster than rental increases, thus reducing yields down to normal levels.  

As you know, to calculate yield, one must divide the yearly rent by the value of the property, e.g. rents per week of $500 is $26,000 for the year, divided by the value of the property $450,000 gives a rental yield of 5.78%.

So if property values drop, the yield would increase and should property values increase, the yields would drop, without the rental moving at all.  

The last property boom started when yields were around 6% to 7% and as the property market boomed and the values increased, the yields dropped to around 4% per annum making it more difficult to buy into the property market.

When the yields eventually drop to around 3% due to property growth it will hit a ceiling where the market will no longer tolerate and people will go back to renting and put pressure on rents to rise to a level where it becomes cheaper to buy again and thus the cycle repeats itself.  

Let’s look at city by city  

In Sydney, home values have increased by around 20% since the end of 2007, while rents have increased 35%. The gap between rental and value indicates potential for capital growth.

In Melbourne both rents and capital growth have increased around 20%. This indicates that there is still a way to go before Melbourne is in a position for capital growth.

In Brisbane, house prices have fallen by 3%, and rents have grown 27%. The huge gap between values and rental growth say’s that the high rentals will drag up the values so Brisbane shows a lot of potential.

In Adelaide as well, house prices have grown just 7%, while rents have increased 21% and shows great potential

In Perth, the gap is quite large where home values have only grown 2% since the end of 2007. Rents on the other hand have increased 48%. Perth appears to have the greatest potential for capital growth.

Please be aware that there are many indicators that drive property prices and this analysis is based only on one indicator, but a useful indicator.

He has co-authored three best-selling books as a seasoned property investor who understands the relationship between property investment and tax.