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When rental rivers run dry, investors will be left stranded

The morning after the Abbott government’s ‘horror’ first budget, a crowd of journalists stood in the chilly Senate courtyard to hear welfare organisations explain what government cuts would mean to Australia’s poor.

The human cost would be high, but there were also knock-on effects for the economy. As I wrote at the time, the cuts would mean “billions of dollars in reduced spending power for tenants renting at the cheaper end of the property market … Property investors in the less glamorous suburbs of metropolitan or regional centres may feel the sting of welfare cuts as much as their tenants”.

A year later, that sting, and several others, are being felt.

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Figures released earlier this month by CoreLogic RP Data show rents growing at their slowest rate on record, at 1.5 per cent per year, with gross rental yields in hot-spot capitals Melbourne and Sydney falling to 3.3 and 3.6 per cent respectively.

It would be unfair to blame this all on the Abbott government, however, given that many of its spending cuts were blocked in the Senate.

Auction

Getting into an already overheated property market may cause some pain for investors, first home-buyers. Photo: Getty

Nor does the government have much control over the end of the investment phase of the mining boom, which has hit Perth (rents down 4.5 per cent year-on-year) and Darwin (down 5.5 per cent year-on-year).

It is likely, though, that its public service cuts are helping to drive Canberra rents down – they fell 0.6 per cent year-on-year.

And there the government influence ends.

The desultory yields for Melbourne and Sydney have very little to do with the budget, and a lot to do with the RBA’s attempts to stimulate the economy through record low interest rates.

Those low rates have failed to boost genuinely productive investment, but have helped pump up the Melbourne and Sydney property bubbles. And as dwelling prices rise, rental yields, by definition, fall.

It’s important to remember too that gross yields are not directly comparable to investment returns in other asset classes.

For instance, fixed-term deposit rates are currently available from several banks at between 3.0 and 3.5 per cent for six months. Given those investments are virtually risk free, they might look attractive in pure dollar terms compared with the Melbourne gross rental yield of 3.3 per cent – which comes with higher risks.

It’s a lot more complex than that, however. Gross yields are simply the rental income earned, divided by the value of the property and expressed as a percentage.

They do not take account of a range of expenses: agent fees, council rates, maintenance and repairs, money lost during periods the property is vacant, and in some cases strata title levies.

It is relatively easy to estimate those kinds of costs, and they produce net rental yields for Sydney and Melbourne below the current risk-free return on a bank deposit.

But property investors are not just throwing money away. Each individual will have their own set of circumstances in three key areas: tax, gearing and the interest rate they pay on their loans.

Australian tax law allows negative gearing on a range of investments – in essence, if you borrow money to invest, the cost of servicing that debt is deducted from the profit you make.

In property investment, many investors pay out more in interest on their investment property loan, and the other costs listed above, than they earn in rental income. And the ATO currently allows that loss to reduce their taxable income from other sources, and so cut their tax bill.

There are currently 1.2 million negatively geared investment properties in Australia – a giant cottage industry in which mum-and-dad investors run their businesses at a loss.

What makes it all add up is that when their reduced tax bill is taken into account, and when the property’s capital gain is calculated, those investors are making much more than they could make in a low-risk investment such as a term deposit.

Housing market

Renters and investors are in it together, and the pendulum may be swinging in favour of renters. Photo: Shutterstock

But will this continue to be the case? As explained previously, each year in which house prices outstrip wage and prices inflation is a year in which the private debt-to-GDP ratio grows larger.

And given that interest rates have very little room to move down, and plenty of longer-term potential to move up, that means each year’s first homebuyers will have to put an increasing proportion of their pay-packets into their mortgages – and that is already putting many off getting into the market at all.

So we’re gradually becoming a nation of renters – no bad thing in itself, particularly if more attractive leasing arrangements can be developed. Victoria, for instance, is now talking about legislating to make 10-year leases easier to obtain.

But that does not alter the outlook for housing investors. My fear, as a former negative-gearer myself, is that many of the cottage industry mum-and-dads investors now holding housing stock got into the game after years of uninterrupted high returns made it look as it would last forever.

Some may be thinking that if rates rise they will simply pass on the cost as higher rents.

However in Melbourne in particular, but in other capitals too, it is fast becoming a renter’s market.

Vacancy rates are edging up and credit-squeezed investors who try to raise rents quickly – and remember the US Federal Reserve is likely to set debt markets alight this coming September – will be competing with other worried investors who might even be dropping rents.

The greatest misconception about housing demand at present is that there is plenty of extra money in renter’s pay packets if times get tough. There isn’t.

Patterns of demand, including more house sharing or moving back in with parents, will change when renters just don’t have the money to pay.

That’s not the kind of return mum-and-dad investors were expecting.

See all of Rob Burgess’s columns here

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