Experienced property investors are acutely aware of the significant increase in holding costs over the past four years. With the cash rate climbing from 0.10% to 4.35% alongside persistent inflation, it’s been a perfect storm for investors.
While inflation might eventually ease, expenses such as insurance, council rates, and maintenance are unlikely to ever revert to pre-2020 levels. These elevated costs are here to stay, inviting me to question their impact on the viability of property investing.
Review of cost increases
The chart below illustrates how property holding costs have changed since the start of 2020. It’s easy to gauge the increase in interest rates since most investors are charged similar interest rates. However, expenses like council rates, insurance, and land tax can differ greatly among properties and investors alike, making it more difficult to ascertain the average increase over the past few years. Whilst I have made some generalisations, the purpose of the chart is to highlight that despite rent increases, many costs have increased at a faster rate.
Long-term investing assumptions
Over the last couple of decades, all property holding costs, excluding mortgage interest, typically equated to 25% to 30% of the gross annual rental income for most properties. The exceptions to this general rule of thumb are apartments with hefty owner’s corporation fees and properties with expensive amenities such as pools and lifts. However, over the past four years, expenses (excluding mortgage interest) have now increased between 30% and 35% of the gross annual rental income, on average.
According to RBA data, the average discounted investment interest rate over the past 20 years was 6.04% p.a. Presently, most investors are paying variable interest rates ranging from 6.60% to 7.00% p.a., being up to 1% p.a. higher than the historical average. Therefore, while some relief in interest rates may be anticipated in the coming months, long-term investors should plan for rates around 6% to 7% p.a.
In terms of rental income, I believe it’s quite reasonable to expect an above-average increase in rental income for the next few years, due to the shortage of rental properties. If rental yields return to the long-term average since 2000, there’s a real possibility that rental income could increase by an additional 20% to 25% over the next few years. However, it’s important to note that rental growth will eventually stabilise, reverting to the long-term growth rate of 3.8% p.a.
How much capital growth is needed to justify your investment?
Based on the following assumptions, I’ve calculated that a property investment would yield an after-tax investment return of 13.5% p.a. if the property is sold after 20 years:
- Starting gross rental yield of 2.7%, which grows at 10% per annum for the next 2 years and then stabilises at 3.8% p.a. thereafter.
- Long-term average capital growth rate of 7.0% p.a.
- Borrowing the full cost of the property at an interest rate of 6.5% p.a.
- All property expenses amount to 25% of the gross rental income.
If we adjust the assumption that expenses now represent 35% of gross rental income (up from 25%), the property investment would need to appreciate by an additional 0.35% p.a. to maintain the overall investment return of 13.5% p.a.
In a situation where property holding costs eventually escalate to 45% of gross rental income in the future, the property would need to generate an additional 0.30% p.a. of growth (totalling a growth rate of 7.65% p.a.) to maintain the after-tax investment return at 13.5% p.a.
This analysis highlights that investment property returns are not that sensitive to changes in property holding costs.
Investment returns are a lot more sensitive to interest rates
It is important for me to highlight that property investment returns are significantly more sensitive to interest rates, as depicted in the table below.
Apart from ensuring that your bank offers you the best deal, investors have no control over long-term interest rates.
Again, this analysis proves growth is the most important
The key to successful property investment lies in investing in the right property – one with attributes that can drive substantial and perpetual capital growth over the next few decades. To achieve this, it’s crucial to (1) target a property possessing three specific attributes and (2) focus on undervalued geographical markets. Seeking advice from a reputable buyer’s agent will significantly mitigate the costly mistake of investing in the wrong property.
Of course, it’s also prudent to actively minimise property holding costs. This involves actions such as engaging an insurance broker, overseeing property maintenance requests, ensuring regular review of mortgage interest rates by your mortgage broker, and optimising taxation benefits.
That said, the bulk of your future investment returns will depend on your property’s future capital growth.
If you anticipate that your property’s future capital growth rate will fall below 5.5% p.a., your overall return is likely to be below 9.6% per annum. In such a scenario, you might find it more economical, simpler, and less risky to invest in a moderately geared diversified share fund such as GHHF. Higher holding costs can render average-quality investment properties less economically viable to retain.
Loved the simple table showing the relationship between interest rates and the IRR. IRR is the key to any investment not just in property, but in any event an IRR of 11.1% is still an excellent IRR over the long term. Can I ask what approximate gearing ratios were used and if the full suite of tax benefits from negative gearing to mortgage interest, to depreciation and expenses formed part of the IRR calculations?
Thank you. I assumed the investor borrowed 100% plus purchase costs. Only cash contribution is the ongoing negative cash flow. Tax benefits based on 47% tax rate. Allowed for expenses @ 35% of gross rental. No depreciation included.