Defence houses on the march

PORTFOLIO POINT: The conservative, low-risk option of buying a defence house is proving irresistible to buyers.
The stockmarket is down 50% and house prices are flat or softer than they’ve been in a decade, but one sector of the property market is flying. Defence houses sales are up almost 30% this year on 2007, as investors warm to a conservative, low-risk option that offers certainty in a dangerously volatile equity market.

Investors own about 65% of the 17,500 army houses, worth $7.6 billion, that are managed by DHA (Defence Housing Australia). DHA has houses in every city and typically leases its properties to defence personnel for six, nine or 12-year terms, with an option that allows DHA to extend it by three years after giving one year’s notice.

DHA sales and leasing manager Tony Winterbottom says defence housing is a growth sector because both the Howard and Rudd governments have budgeted to expand the defence forces. He says interest in the sector has jumped following the interest rate cuts and the sizeable amount of equity people have lost in their own homes and investments. The government-owned DHA sold 592 properties this year to the end of November, compared with 460 in the same period last year.

“The profile of defence homes has changed since the economic problems began; it’s as safe as the viability of the Australian government and the Australian Defence Force,” Winterbottom says. “But if you are looking for high liquidity during the term of investment, then it may not be the investment for you.

“We are not for everyone, but we don’t need everyone to be interested either; we only need to sell 500 to 1000 homes each year.” Repeat investors make up more than 40% of sales and the investor profile is typical of people involved with trust or super investments.

Certainly, investors enjoy the stability of long leases, but DHA has been criticised for its high 16.5% management fee. In turn, DHA argues that the all-inclusive fee, coupled with the advantages of defence housing such as no vacancy risk, guaranteed rental income and “no maintenance hassles” for the term of the lease make it an attractive investment option that leads to cost savings. For example, a two-week vacancy each year effectively increases a traditional agent’s management fee by about 4%.

A study by Access Economics, commissioned by DHA, found the DHA management fee model a cheaper alternative to the traditional real estate agent model (8%), when all other costs were factored in: vacancy costs, leasing fees, advertising fees, statement fees, repairs, painting, carpeting and the “hassle costs” for time spent dealing with a traditional agent.

On a weekly rent of $450, DHA’s fee is about $2500 a year cheaper than with a private agent (and $4600 cheaper than some). Property management through a private agent cost $6375 annually, or 27.2% of net annual rent, while the DHA model cost $3847.

DHA senior consultant Ian Hughes says the high management fee is necessary to ensure the houses remain in top condition and that at the end of the lease, new carpets, timber re-flooring and an “inside and out” paint job are thrown in if needed. “We are not dealing with normal people here; we are dealing with defence personnel, and they don’t want a knocked-about rental,” Hughes says.

As an investor, what represents good value for property management depends on your personal situation, Winterbottom says. “If you are the type of investor that wants to maximise your capital returns, who wants do your own renovations, manage it yourself and keep your costs low then you can do really well that way, but very few people in the market want to do that,” he says.

Most defence properties sell for $400,000–500,000; the average national price this year is $420,000. The most expensive house at the time of writing was in Epping, Sydney, which sold for $790,000; while the cheapest was $330,000, in the Northern Territory town of Katherine. Winterbottom is quick to correct the misconception that the homes, which are typically new, four-bedroom, brick veneer, double-garage houses, have worse capital gains potential and are in poorer markets than other investment properties.

“We are now building 40 townhouses in the northern Sydney beach suburb of Dee Why, we’re developing houses in Upper Kedron in Brisbane on $300,000 blocks of land, and we’re developing a new suburb in Darwin called Lyons, and it is very difficult to get any new land in Darwin,” he says.

“Gone are the days of enclave defence housing – using our buying power we are often able to buy in nicer areas than the general market can,” Winterbottom says. Although he concedes popular suburbs are characterised by low vacancy rates and investors don’t need rental guarantees as an incentive to purchase in these areas, he says investors in the private market are facing increasing uncertainty about their tenant’s stability. “Rents are very high, a lot of people are being pushed into the rental market but you can’t be assured of who your tenant will be and that they aren’t faced with the increased prospect of unemployment,” he says.

Defence house prices are standardised, so they are never going to be cheap, but DHA has been criticised for selling at non-negotiable prices that are higher than market. Although DHA used to charge a premium that was scrapped when the economy got tighter, and houses are now priced on third-party valuations and DHA’s recent sales history.

Eureka Report property correspondent Monique Wakelin has long been sceptical about the value of defence housing. She says sought-after investment property does not need rental guarantees because underlying demand underpins consistency of rental demand. It is asset selection, Wakelin notes, that returns steady long-term rental income, capital gains and equity build-up. She cautions investors not to be tempted by the comfort of assured rental income and low-risk tenancy, and writes them off as incentives factored into the very high purchase price and exorbitant management costs.

Winterbottom believes that much of what Wakelin said (see Defence housing: danger zone) about high buy-in prices is redundant today. “In past years, we were able to attract a small premium of $10,000–20,000 per property due to the quality of the attached lease, but since January this year, we have been selling at market valuation price,” he says.

Wakelin says that if the defence forces move base you’ll be left high and dry and the locations are rarely prime real estate. But Winterbottom can’t think of a time when defence wholesale moved out of an area in Australia. “They don’t just shut down major bases and if they do, it takes 20 years to do it,” he says. “And if the government or the defence forces folded, then it’s my view we’d all have bigger things to worry about.”

The risks that come with buying DHA housing are the same as those inherent in buying any property: if the market falls, so does the value of your investment. Hughes warns that the lease comes with a variation clause that allows DHA to extend or shorten the term by one year. So, considered with the three-year extension, a 12-year lease would run for 11 years at minimum and 16 years at most.

Currently DHA is offering most investors a second lease because it is short on homes and the capital needed to build is becoming more expensive and harder to get. However, when the lease is up, investors are no longer tied to DHA, they are free to move in or sell to whoever they like.

If you get into trouble and want to sell before term, the leaseback arrangement can present problems and Wakelin says the resale situation is precarious at best as it excludes the vast majority of buyers and forces you to take your chances on an open market. Resale before term comes with strict conditions designed to protect defence personnel; you can still offer inspections but advertising the address and erecting a For Sale sign are banned. “It shrinks your buying pool to include 30% of the property buying market who are investors, but that’s 30% of six million odd and it’s probably the only market that is starting to gain any momentum,” Winterbottom says, adding that resale is rare. You can resell your investment through DHA for a 2% commission.

DHA also fields large numbers of calls from home owners keen to sell, but it can be difficult to meet the strict defence housing criteria. DHA bought less than 10%, or about 250, of the homes offered, which it terms “direct-lease” investments.

Rent is reviewed annually and adjusted in line with the market, but if market rent falls, the investor’s rent won’t ever drop below the starting rent. However, Wakelin is critical of the investor’s inability to influence the rent, occupy the property themselves or rent to a tenant of their choice.

Hughes says you could reasonably expect your returns to go up over three to five years. “Some of these houses are showing 5% gross returns, with a couple of [interest rate] falls in the next few years they’re going to be paying themselves off, even if you’ve borrowed the lot,” he says.