Rental yields outperform

Yields from property units are tracking ahead of other asset classes.

Summary: Property rental yields have been trending down for several years, but surprisingly they’re still holding their own against other asset classes. The rental yields from residential units are ahead of the stockmarket, housing yields, 10-year bonds and term deposits.
Key take-out: Expect more rental yield compression over time, but that is likely to correspond with further increases in residential property prices. While yields have fallen since 2009, the national average house price is up 11% over that period and units are 14% higher.
Key beneficiaries: General investors. Category: Property.

The demand for yield is still a very strong force in the market.

Yields on term deposits are already very low and falling, and returns on cash-like products are even worse. The issue, as always, is where to go to find yield.

Property is a key contender, but there are rising concerns that yields here aren’t as attractive as they once were.

That may be the case but, as chart 1 above suggests, they’re not that bad either. Indeed, there isn’t too much between the main investable classes and rental yields on units are still top the list. As at March 31, 2014, the rental yield on a unit (national average) was 4.6%, according to RP Data. Rental yields on housing were a little lower at 3.8%, but this is only just below the market dividend yield (All Ordinaries) of 4.2% and the 10-year bond yield of 4.2%. That’s actually a pretty good yield though. Consider that property carries significantly less capital risk than, say, a government bond. At record prices, and coming into a rate tightening cycle, bonds carry very high capital risk (it’s a similar story with equities). That’s not to say property always goes up. But neither (since 1935) have prices ever fallen significantly in Australia.

Noting this, we’re actually still seeing very attractive yields at the moment. By capital city the best yields can actually be found in Brisbane for both houses and units, offering a return of 4.6% and 5.4% respectively. The other major cities don’t fare too badly either, although housing rental yields in Melbourne and Sydney are below 4%.

It’s fair to say that rental yields have declined recently, which you can see in chart 3 below. The chart shows that yields on houses and units have dropped over the last few years. In 2009, for instance, the national average yield on a unit was 5.4% (4.6% now), while for a house it was 4.6% (3.8% now).

Notice something though? Yields are down, sure, but not by much – we are only talking a 0.8% fall in yield in five years. When you consider that the national average house price is up 11% over that period and units are 14% higher, that’s a pretty good outcome. You are getting yield and capital growth.

One key reason for this modest decline in rental yield is inflation. Not for houses, but for rents. Rents rise, and they can do so by quite a lot. Take a look at chart 4, which shows rental increases of more than 8% per annum at the peak (on average) in 2008. Currently rents are increasing at a rate of about 3%. The thing is, and while the chart shows inflation pressure easing, rent inflation is likely to pick up over the next year or two.

Mainly, and as I discussed in my piece last week Housing glut doesn’t stack up, this is because housing construction is well below what we need for Australia’s strong population growth. You’ll note that at the time rent inflation peaked, the ratio of population growth to dwelling construction also peaked. It has come down and so has inflation as a result. Yet the ratio is still well above the averages we were seeing through the 90s and early 2000s and rent inflation now is only a little higher than then. That suggests to me there is more upside now confidence is coming back to the country.

Further compression ahead

Having said all that, I suspect rental yields will continue to compress further. But there are a few things investors need to consider as yields come down.

Firstly, and as I discussed in my note last week, yields won’t be coming down because of a housing glut. Secondly, yields won’t be coming down because of a surplus of available rentals. Chart 5 below shows vacancy rates are still very low: the market is tight. Now, it has to be said that this is up over the year in many cases, but the fact is, with population growth still in excess of the number of dwellings we need, it’s unlikely vacancy rates will rise much on average. I appreciate that some inner-city areas, like Melbourne, may eventually have an oversupply, but this isn’t the national trend.

This is an important point, because it doesn’t appear that there will be any malign influence driving yields lower. To the extent that yield compression continues, this will most likely be due to one factor only. Strong capital appreciation – and, for an investor, that’s not a bad thing.

In any case, plugging in some plausible capital appreciation numbers, we’re not really talking about a material decline in rental yields. For instance, if you assume capital growth of about 10% and rent inflation of 3.5%, which is the historical average , the average rental yield only declines from 4.2% now to 4% by the end of the year (average of houses and units). If prices go up 20% the rental yield falls to 3.6%. But then again, investors aren’t going to complain about that.

I’m not putting these numbers down as a forecast, I’m just using rough back-of-the-envelope calculations to make a point. Yields will compress, but not by much, unless house prices explode. In that case, I doubt anyone already in the market is going to complain, because the forces driving it up are positive for investors.

That brings me to my final point. When the time comes for capital price appreciation to taper, and I think we are some way from that, rent inflation actually means your rental yield will start to rise again. And, until we deal with this dwelling shortage the country has, rent inflation is not going away. The truth is, neither governments or developers are prepared to put in the infrastructure to accommodate a growing population – other than trying to cram people into high-density inner-city dwellings. That’s not a solution though.

So, extending the above example, if we assume no capital price growth over the next five years, and using average rent inflation, this implies your rental yield rises to 5% over a five-year period, from 4.2% now. A nice little sweetener for investors when price growth starts to moderate.

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