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.

Peter Fray

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Peter Fray
Editor-in-chief of Crikey