In the residential rental market there is two forms of return with property- the rental return (often quoted as a capitisation rate or rate of return –a percentage) and the difference between the buying price and the selling price (often called capital gain)
They tend to work against each other as shown on the graph below.
Over the last three to four years we have been in the boom phase of the property cycle-when property has been selling at less than the interest rate. This is because the buyers have been factoring capital gain and tax advantages into the equation. We are about 8 on the graph. They have seen and heard other investors buy and sell property in this time and make a handsome profit. The greed factor comes in and they jump on the bandwagon. Because of buyer demand, auction sales are rife with high clearance rates at auctions. The average number of days that the property is on the market is low.
But as the market goes into the next phase most of the buyers will disappear out of the investment market (lead by the out of town investors). At this point if rental demand is strong then there is normally a round of rental increases as the owners who have bought negative cash flow properties try and make them positive. If rental demand is not strong properties will be sold with higher capitalization rates. If rents have not raised that means that the selling price will be lower than the previous boom. In this phase the number of auctions and their clearance rate drops with more properties being advertised for “sale by tender “or by negotiation. You start to see properties advertised with price cuts. The buyers who are still buying are only looking for cash flow positive or properties with a ‘twist’ or angle to improve the rental return. We are about 5-6 on the graph and heading left. As the slump continues you see more ‘mortgagee auctions’ and other property labeled ‘offers wanted ‘or ’name your price’. Rental returns are king with no expectations of capital gain. Other forms of investment are in favor. Vacancy rates go up with tenants sharing accommodation, living with relations etc to save costs.
This is the time to buy –but only the right property at the right price. If you are a new investor look at least fifty properties before you buy-this will give you an insight into what type of investment and property that you are comfortable with and over this period what is happening in the market.
As the slump continues the number of rental units remains static with the number of tenants slowly increasing putting pressure on rents. We enter a recovery phase with slowly increasing rents and roughly equal buyers and sellers. Property starts to find favor as an investment vehicle as it is perceived as giving good returns to other forms of investment.
As interest rates move up or down the arms of the graph moves up and down with it. An example of that is in the 1980’s when interest rates were 22-24% property was selling at 24-26% capitalization rates. When interest rates dropped the rents stayed the same but the capitalization rates dropped in line with the interest rates. So by the time interest rates reached 10-11% the value of the properties had doubled.
If you start plotting individual sales on this graph you will find that the rental return and capital gain arms tend to have bulges in them as no two properties are the same location, condition, type, etc. If you look at places with no or negative capital gain you will find rental returns of 15 – 18% are possible
This is based on over 30 years of observations of the rental market by now a full time residential property investor and is a guide only.
Cliff Seque is the President of the Otago Property Investors’ Association and has been a member of the Executive of the New Property Investors’ Federation since 2005. He has been investing in property for over 30 years and is a full time Property Investor and Landlord.