Apr 16, 2012

Housing’s bull … what a load of, well, bull …

Housing, like every other asset, should be valued with respect to the cash flows it can generate.

Adam Schwab — Business director and commentator

Adam Schwab

Business director and commentator

There is one commonality between housing's bull -- that is, almost as a rule, they are ignorant (intentionally or otherwise) of the actual returns that can be obtained from owning residential housing. There’s a good reason for that -- it makes their arguments, for wont of a better phase, a load of bull. The latest rental data released by Australian Property Monitors emphasises the bubble (and contradicts fallacious claims of a housing shortage) with there being absolutely no rental growth in the March quarter -- in real terms, rentals actually dropped in the most recent quarter. Housing, like every other asset, should be valued with respect to the cash flows it can generate. The situation for residential property is a bit confused because the majority of property owners live in their own asset, so it doesn't generate income for them, however, that can be easily solved by using the market value of net rentals (less costs). In fact, property should be a lot easier to value than other assets like businesses as the income it generates (rent) is a lot more stable than business profits. Tenants, by and large, enter into one or more year leases on fixed rental amounts (the main variable is maintenance costs). By contrast, operating business face far more variable cash flows. In a rational market, property prices should, over the long term, follow rental increases. If rents rise by 5%, it follows that property prices should increase by a similar amount. (The main exception to that would be if rents are expected to increase or decline substantially in the years to come). Since the property bubble started inflating in 1997, property prices have substantially outperformed rental increases (and just about every single other metric, like wages and inflation). The reason is simple -- banks have been extraordinarily "generous" with lending, which has pushed up house prices (and also caused the mortgage debt to GDP ratio to rocket from about 25% to almost 90%). Instead of using the complicated metrics suggested by housing bulls, the simple calculation of the median rental return provides a stark example of how overpriced housing is. RP Data’s most recent survey indicated that the median capital city house price is $445,000. An APM survey released last week stated that the national median rental amount is $409 per week. That means the gross yield on the median property is 4.8%. The problem is gross yields are completely useless as property owners have a large number of costs to consider. When you factor in depreciation, maintenance, rates, sewage and property management fees, the net yield on the median property slumps to about 3%. To compare, most term deposits, which have minimal risks are almost double that level. Or course, a low rental yield is justifiable if there is a reasonable likelihood that rental levels will increase substantially in future years. Similar to a growth stock, if an investor believes that earnings will improve significantly, they will be willing to pay a premium for that growth. However, rental yields did not increase at all in the March quarter across Australia (in real teams, they actually dropped when inflation is considered). The Age reported yesterday that rentals in Melbourne, the epicentre of the property bubble actually fell by 1.4% in the past year (the only capital cities to record rental growth in the March quarter were Hobart and Darwin). The situation in Melbourne is made even more dire by the massive amount of housing stock currently flooding the market (upwards of 35,000 apartments are expected to be completed in the coming years) and Victoria’s increasing unemployment rate (which rose to 5.8% last month). Even with rental prices increasing, residential property appears expensive. With flat or falling rentals, purchasing investment property based on a yield of 3% or less (and dropping) appears to be a fool's errand.

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4 thoughts on “Housing’s bull … what a load of, well, bull …

  1. Phen

    If anyone had argued that prevailing rental yields alone made housing an attractive asset then this might’ve been a good rebuttal.

  2. drsmithy

    If anyone had argued that prevailing rental yields alone made housing an attractive asset then this might’ve been a good rebuttal.

    Well, there’s not going to be any real capital gains for at least a decade (and that’s a best case scenario), without which the tax-dodge of negative gearing is pointless, so what other factors are there to value housing as an investment asset ?

  3. Koshka

    Comparing median capital city prices to median national rent is comparing apples and oranges.

  4. Melanie Monico

    The question this article brings to light is; what options are available for first home buyers?
    One encouraging trend for first home buyers is to look at property investment as a means to getting onto the property ladder, as discussed alongside others in this article: http://bit.ly/I5GaJx
    There are two options then; continue saving and be patient until the market improves, or research into property investment before this option is dismissed. If there is a particular area you are interested in for example, find out the capital growth history or the area and the potential rental income of the property. Certain areas/suburbs may show more signs of investment opportunities that are worth looking into.

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