Is Australia’s rental property obsession misguided?

With rental prices rising very rapidly, it is tempting to fall into the trap of pitting landlords against renters, with the narrative being that landlords are simply being greedy.

With rents having risen an average of 8.3% last year and 9.5% and 9.6% in the previous year according to CoreLogic, there is little doubt that renters have been paying a high price – sometimes very much higher than these averages suggest.

However, it would be wrong to simply assume that all landlords have been making windfall profits, with the investment case for buying rental real estate seldom having been as weak as it is now.

Gross yields are very low, net yields often negative

Looking at the other side of the equation, even with the rising rents, average gross rental yield on residential property nationally was just 3.7% in December, again using CoreLogic numbers.

That figure is even lower in the big capitals such as Sydney and Melbourne and it is worth remembering that this is a gross figure – coming before big costs including interest, rates, insurance, owner’s corporation fees, real estate management fees and repairs.

At a time when an online deposit account is yielding something around the 4% to 5% mark, that is a really feeble rental return.

That is especially the case when you take into account some of the other disadvantages of investing in residential real estate rentals – the large and lumpy amount of capital tied up, the large loans, the perils of vacancies and the very high touch involvement required.

So why would you borrow money at more than 6% to achieve a gross return of around 3.7%?

Tax system encourages negative yields

The answer, of course, lies in the interplay between the tax system through negative gearing and capital gains tax and also the requirement for large capital gains.

In simple terms, without hefty capital gains over time, investing in residential rental real estate looks to be a real mugs game.

So, how likely is it that residential real estate will keep producing the sorts of capital gains required to top up the rental return and achieve a solid, after-tax profit?

History backs up investor hopes

If you look at history you would have to think the chances are good, with residential real estate performing very strongly over the long term.

CoreLogic figures show that Melbourne returned the best figures over the past 30 years with a 459% growth rate equal to 5.9% a year, with Perth the worst performing capital at 303% or 4.8% a year.

Those are excellent long-term capital returns, although a little behind the ASX 200 which averages around 9% a year including dividends and allows for more flexible but more volatile investment.

You would also assume that current indications are strong for residential real estate, with supply struggling to keep up with demand for both the investor and home owner markets as very strong immigration continues and home building is subdued.

The bigger question though is whether residential real estate should remain the “go to” investment for everybody.

Massive concentration of wealth in housing

If you include owner occupied and investor housing, Australians have a mammoth $10.3 trillion of their wealth tied up in housing.

That totally eclipses the $3.5 trillion held in superannuation accounts and is significantly more than the total $2.3 trillion value of the Australian share market.

At the very least that suggests a very concentrated investment asset class, given that most of this investment is in one or two properties rather than a diversified pool of properties.

Why not listed property?

It might be a slightly different animal but it is strange that diversified property trusts or Real Estate Investment Trusts (REIT’s) are not targeted much more by investors, given the ability to start much smaller and to sell off part of your investment without penalty rather than having all of your property eggs in a single, inflexible and highly concentrated basket.

Admittedly REIT’s usually target commercial property rather than residential and they also have the downside of being linked to fluctuating share market sentiment but with careful choice they produce consistent income and returns without the high personal input often required by direct property investment.

Portfolio approach better but less popular

Combined with a portfolio of local and offshore shares, the numbers suggest that this would be a more diversified investment than direct property that features higher returns and greater flexibility – although volatility will be greater and the attraction of bricks and mortar that can be touched and driven past remains strong.

It may be the investment equivalent of shouting into the wind but as admirable and historically impressive as Australia’s record with investment property is, the time is perhaps ripe to think a bit harder about potential investment opportunities.