Rush slowly at rent yields

As the ASX slumps into what is now technically a bear market, investor attention turns towards safe havens, particularly Australian residential property.

Historically, as sharemarkets fall, investors head towards bricks and mortar. This time around though, as stocks are falling, the latest property data indicates a further tightening of already chronically low rental stocks with the prospect of increases of between $50 and $100 a week in rents. If the projections are accurate, rental yields will continue to rise, particularly in outer suburbs.

Before you rush for the real estate sales guides, take a steady, deep breath and read on. The cardinal sin is to assume that all property is going to provide a short-term, safe haven of income and growth, and to buy quickly and indiscriminately!

The good news for investors is that record low rental vacancy rates and a growing housing shortage have pushed median rents up consistently throughout 2007 with the promise of more to come this year. Australian Bureau of Statistics figures show that in the year to September 2007, average dwelling rents showed their highest growth rate in 17 years. Separately, property group Residex’s measure of the growth in advertised annual rents shows a jump of 18% to 35%, depending on location, over the past 12 months.

Average weekly rent rose by $35, and Residex claims we could see increases of up to $100 a week this year. Further, ANZ’s annual property outlook indicates that the long lead times on lease renewals (which prevent investors from raising rents) mean we won’t see true market values emerging until later this year, but we can expect upward movements when lease renewals start to bring the rental increases into the data stream.

Moreover, the latest report from property research agency RP Data says that rents in the outer suburbs have surged ahead of increases in capital values, whereas the opposite is the case for inner urban and coastal locations.

It is true that accurate market rates of rent require relatively long lead times to emerge. Investors can’t raise rents on existing tenancies until leases expire. What’s more, there’s nothing uniform about when that occurs. Put simply, no two properties are ever created equal and rental properties are no different.

The tenant market, like the home buyer market, has only so much capacity to pay. Like the general housing market the tenant market has become multi-layered and multi-faceted and is being driven primarily by affordability issues. For instance, rent movements in the most sought-after inner-urban end of the rental market are less volatile because of perpetual demand. Already relatively high rents for the most sought-after properties tend to rise – over the longer term – in a slow and steady fashion, underpinned by higher demand for locations offering a particular lifestyle.

Even though it is owner-occupiers that drive price growth, the additional demand from tenants helps maintain values. Investors in these prime zones are focused (as they should be) on capital growth first and foremost and rental yields second.

Property investors need to understand where their “consumers” (tenants) come from. About 30% of the Australian population rents, both out of economic necessity and choice, in the short-to-medium term and most do not expect luxurious accommodation. Break this down and we find that outside of the largely lifestyle-driven inner urban areas, the rental “consumer” is in pursuit of comfortable, affordable accommodation. This core pool of renters includes first-home buyers excluded from the market for longer in the face of low housing affordability.

In the real world, irrespective of the data, to suggest that an average rental property that currently returns $320 a week is going to remain in hot demand if it is bumped up to closer to $370 or $420 a week in six months is to misunderstand the realities of market capacity.

The informed investor must instead strike a sensible balance between arriving at a reasonable and sustainable income level that will bridge the gap with loan repayments for an asset and avoid raising rents to a level that would effectively price them out of the market. Investors must look beyond the hype and the generalised data and assess their own assets very specifically.

When a lease is up for review, ask the managing agent what that particular property, in that specific location, with that tenant pool would realistically rent for if it was vacant and being offered to the market for the first time. It is critically important to weigh up the advantages of reliable, steady income from good tenants and moderate rental reviews against dramatic rent increases that lead to high tenant turnover, greatly increased wear and tear and potentially long and costly vacancy periods.

And, let’s not forget the bigger picture; greedy investors who adopt the “let’s raise the rent as far as we can, as quickly as we can” will add further to upward inflationary pressures. That can only bite them where it hurts the most – by way of increased interest rates.

This first appeared in The Eureka Report