It has certainly been a wild ride for property investors over the past 6 years.
In 2017 and 2018, the banking regulator demanded banks reduce the volume of interest only loans, particularly to investors. The media called this the “interest only cliff” and predicted that many borrowers would face financial stress when loan repayments switched to principal and interest resulting is higher arrears and default rates. It didn’t.
Then in 2018-2019, Bill Shorten (you will recall that everyone was expecting him to win the 2019 federal election) promised to ban negative gearing and increase capital gains tax which unsettled property investors. Of course, he didn’t win, and the ALP abandoned this policy.
Of course, the Covid years (2020 and 2021) were very kind to property owners. But aggressive interest rate hikes over the second half of 2022 have ruined the party and property prices have retreated to pre-Covid levels in many locations.
Despite a relatively volatile period, it is important to note that property fundamentals remain very robust. In fact, it is vital that investors remain solely focused on these long-term fundamentals and not get distracted by these temporary volatility events.
Rental crisis will only get worse
There is a shortage of rental properties in Australia and as a result, rents are rising quickly. According to Domain, the national vacancy rate was a mere 0.8% with Perth, Adelaide and Hobart essentially reporting close to zero vacancy. Melbourne and Sydney’s vacancy rate has fallen from 2.7% and 1.9% respective to only 1.0% over the year to January 2023.
Over the 2022 calendar year, rents have risen by almost 20% nationally. Of course, these rises are coming off a lower base, due to rental reductions during Covid, but the trend is strong and doesn’t look like it will abate anytime soon. The chronic shortage of rental properties will continue to put upward pressure on rents. You should expect to see a lot of media coverage this year about the growing rental crisis.
Tighter rental laws could be to blame…
Tighter rental laws certainly do dissuade people from investing in property. One of the most attractive advantages of being a property investor is control – you have full control over how you use and improve the asset. Tighter rental laws (that favour tenants) reduces the amount of control investors have over their property (like the ones Victoria rolled out in 2021). They also increase the cost to run a rental property thereby reducing investment returns.
Whilst tighter rental laws have reduced investor demand (and therefore the number of rental properties available), I think it’s only been at the margin. That said, any further regulation would most likely have a material impact on rental supply. Tenants must be protected, but a healthy rental market is equally if not more important.
But I think the main cause of the undersupply is…
There are fewer rental properties in Australia today because there are fewer investors buying property (owner-occupiers have dominated the market) and more investors have sold existing investment properties.
According to data by PropTrack, approximately 15% of vendors are investors (i.e., people selling their investment properties). The proportion of investors selling property increased to between 20% and 25% over the past few years during the Covid property boom. Obviously, many investors took the opportunity to cash out whilst property prices were booming during 2020 and 2021.
For the 6 years between 2017 and 2022, 31% of all new loans were made for investment purposes compared to 38% for the previous 14-year period between 2002 and 2016. This suggests that over the past 6 years there have been 20% fewer investors, probably due to the government/regulator intervention (e.g., interest only, tax policies, etc.), as mentioned at the beginning of this blog.
In summary, this main cause of today’s rental crisis is that (1) the number of property investments made over the past 6 years has been below average and (2) an above average number of investors exited the market during the recent boom between 2020 and 2022. In short, supply has fallen, a lot.
How to solve the rental crisis
Commentators and special interest groups have offered several solutions to solve the rental crisis.
Increasing social housing is a politically attractive proposal, but the truth is that most renters don’t qualify for social housing, so it won’t solve the crisis for most renters.
Introducing regulation to stop landlords from increasing rents (e.g., rental caps) have been proposed. But that will only result in a mass exoduses of investors, as experienced in Ireland. Hopefully, our state governments won’t repeat the same mistakes.
It has been suggested that build-to-rent could be a used to increase rental property supply. Build-to-rent are typically new high-density buildings owned by institutions for the sole purpose of renting, not sale. Firstly, there’s not enough build-to-rent construction in Australia to have a meaningful impact. And secondly, recent research by Charter Keck Cramer suggests that rents are 19% to 27% higher in build-to-rent properties compared to privately owned apartments.
The truth is that there is no easy fix to this rental crisis, unfortunately. The only way to increase the supply of rental properties is to encourage more private investors into the market. There are two things that governments can do to achieve that.
Firstly, make sure rental laws are balanced by providing enough protection for renters whilst still giving landlords enough control over their valuable asset.
Secondly, the chart below (published by CBA) shows how restrictive borrowing capacity is currently. Lenders test a borrower’s ability to service a loan at 3% above current rates, which means interest only investment loans are being tested at a rate of 8.70% p.a., principal and interest, over 25 years e.g., loan repayments on a $1m investment loan would be $94k p.a. – almost double actual repayments ($56k p.a.). The benchmark interest rate must be reduced, because a 3% buffer is no longer necessary if we are close to the top of the interest rate cycle.
Property fundamentals are sound
Higher rental yields will eventually attract more investors into the market (markets always find equilibrium), but in the meantime, renters will be the ones that stuffer.
In addition to rising rental yields, the housing market fundamentals are quite robust.
Australia is facing an undersupply of housing. The HIA predicts that new home starts will fall below 100k for the first time in a decade. Higher interest rates have a big negative impact on the construction industry.
Australia’s population growth will be driven by an increase in immigration with annual net immigration. Westpac estimates net immigration reached a record of 400,000 in 2022 with an additional 350,000+ expected this year. In addition, circa 50,000 Chinese international students are expected to land in Australia over the next few months.
Finally, Australia’s economy appears to be in good shape. The federal budget is expected to be in surplus this year thanks to strong iron ore, gas, and coal exports. The unemployment rate is at historic lows, although the labour market does appear to be cooling. And should we face an economic slowdown, the RBA and federal government have plenty of options to provide fiscal and monetary stimulus, if required.
Despite the volatility over the past 6 years, long term fundamentals for investment-grade property are very strong.
Fixed rate mortgage cliff won’t be a problem
There has been a lot of talk about the impact of lots of fixed rate mortgages expiring and rolling over onto much higher variable rates this and next year. Whilst default and arrears rates may rise a little, overall, I don’t expect any major issues. Even the RBA cited in its February board meeting minutes that Australian’s excess pool of savings was estimated to be higher than almost anywhere else in the world. All fixed rate borrowers know higher rates are coming and have had plenty of time to prepare for it.
There was a lot of commentary last week about the fact that Westpac disclosed that 45% of its mortgage portfolio was tested at a benchmark rate equal to current interest rates. Commentators suggested that these borrowers may not be able to afford their mortgage repayments should rates rise further. However, what is forgotten is that more than 75% of customers borrow less than the maximum allowed by the banks, which means they have more of a buffer to weather higher rates.
Australia’s mortgage market has weathered several tests over the past 20 years including the cash rate getting as high as 7.25% in 2008, navigating through the GFC credit crunch, and dealing with the supposed interest only mortgage “cliff” which never eventuated. Over this time, our mortgage arrears and default rates have remained persistently low. I doubt this time will be any different.
Has the property market already turned?
Feedback from clients and anecdotal evidence suggests that market sentiment has improved over the past couple of weeks. Interestingly, property prices in Melbourne or Sydney stopped falling in late January, per CoreLogic’s daily home value index, although February usually benefits from pent-up demand from buyers, as very few new properties are listed in the last half of December and all of January. I wrote in late November 2022 that I suspected that the market was very close to the bottom, and recent data seems to support that view.
Regardless of what happens to property prices this year, long term fundamentals for property investing are very attractive. It is far easier to buy property when prices are falling then when prices are rising.
