Investing in Property in a Low Interest Rate Environment

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There are perhaps no markets more affected by interest rates than the property market, and the current cycle of interest rate cuts has coincided with healthy increases in many of Australia’s capital cities. For some analysts, this has stoked fears of a housing bubble, particularly in Sydney and Melbourne. Is this a legitimate fear for property investors? And how can you take advantage of cheaper money to make strategic property investments? Here are some simple tips to help you avoid making a bad investment while interest rates are low.

WHY PEOPLE BUY PROPERTY

To understand what low interest rates mean for investing in property, we need to understand why people buy property in the first place. There really are only two groups of people who buy properties: owner-occupiers and investors. Why does each group buy property?

-        Owner occupiers buy property for both economic and emotional reasons. People will generally rationally compare the costs of owning to those of renting, and if owning becomes much more expensive than renting then people will logically choose to rent. Potential buyers are also likely to weigh up the chances of capital growth (or decline) in an area, which will also affect their purchasing decision. It’s not all economic considerations though, and there are many emotional reasons why home ownership is considered preferable, such as security and prestige, which means that it is not a completely economic decision.

-        Investors buy for return on investment. This comes from two areas – rental return and capital growth.

In both cases, property buyers are considering the rental return of a property (owner occupiers are comparing rental costs to mortgage repayments, while investors want to know what income a property generates), and its potential capital growth (both want to see the value go up). Rational buyers in both camps will assess these two areas to determine a property’s intrinsic value.

BUYING WELL AND REDUCING YOUR RISK

The greatest concern for a property buyer during a period of low interest rates, is that the availability of cheaper money has inflated an asset beyond its intrinsic value. This fear is based on the assumption that interest rates will inevitably rise back to higher levels. This isn’t an unreasonable fear, so we need to be careful to avoid investments that pose higher risks

Avoid investing in properties with low and declining yields

Rental yields are the best immediate gauge of a property’s economic worth, as they strip out all emotion and indirect economic factors, and simply focus on what a tenant is willing and able to pay to live in a property. Renters don’t pay more because the property might go up in value, or because interest rates are low, they pay what the market determines purely based on supply and demand.

As we discussed above, rental returns matter to both owner-occupier and investor buyers. If rental yields keep falling, then it becomes increasingly irrational for either buyer to purchase in the area. There are some areas that will always have lower rental yields because owner-occupiers will pay a premium to live there. So it’s important to look at the historical rental yields to get a true picture.

Australian Rental Yields - August 2016. Source: Corelogic

This chart provides us with gross rental yields across Australia’s major capital cities. At 3.0% in Sydney and 2.9% in Melbourne, renting is already much cheaper than buying for potential owner-occupiers. There’s also not a lot of rental income being received by those investing in property in Sydney and Melbourne. For rental yields to improve, rents need to increase relative to asset prices, or asset prices need to drop. In either case, I don’t see a lot of room for further sustainable price growth. Should interest rates eventually start rising, then owning will become even less attractive relative to renting in these cities.

Avoid investing in property markets with too many investors

We know that investors are drawn into markets during good times, and flee the market during bad times. They’re also frequently not long-term buyers; in fact, only half of investors keep a property for over 5 years. For owner occupiers, moving house is a much bigger deal than an investor selling an investment property, so owner-occupiers won’t sell their property simply because the market changes. Indeed, they are more likely to hang on to it. This will keep supply in check and won’t mean a glut of properties for sale, should interest rates rise or prices drop.

Keep an eye on Price to Income Ratios

At the end of the day, there’s only so much income a person can set aside to housing. There has to be a natural price cap at which people can no longer afford to buy a home, unless their income rises or interest rates fall even further. Looking at the price of housing relative to the average household income is a great way to determine how sustainable property prices really are.  

Be aware of Price to Income Ratios

Sydney and to a lesser extent Melbourne, are again the most expensive, while our best placed capital cities in this respect are Brisbane, Hobart and Perth. Each of these markets needs to be assessed on its merits, but it’s fair to say that property markets that are less expensive relative to incomes are less likely to be inflated by low interest rates.

So is there a housing bubble in Australia?

Speaking nationally, there isn’t. Over the past decade, according to the Reserve Bank, dwelling prices have stabilized at around 5 times income, after large gains following the financial deregulation of the 1990s. In most capital cities we are looking at levels slightly elevated above 5 times income, but not dramatically so, and this isn’t surprising given we are in a low interest rate environment, where property is more affordable to buy and hold. The exceptions to this are Sydney and to a lesser extent Melbourne, where incomes and rents need to catch up to property prices before I see sustainable growth commencing again.

Of course, the idea of a ‘national’ market is not particularly valid – you need to dig deeper to work out exactly what is happening in smaller markets within our cities across the country. There are plenty of markets that offer strong rental returns, are largely owner-occupied and are affordable for the average family. That’s where I’d be looking for my next investment.

If you’d like to know more, then book a free consultation with Andrew at a time of your choosing.