With lower rental yields and rising vacancy rates, analysts are warning investors to tread carefully, writes John Collett.

FOMO, or fear of missing out, is driving the property market.

Real estate demand in both Sydney and Melbourne is running hot. Net rental yields may be less than 3 per cent on many properties, but that is not dampening enthusiasm for bricks and mortar.

Real estate is tangible, so most people feel they need no special skills to be a successful property investor. And spurred on by apartment price rises of more than 10 per cent during the past year and record low interest rates, investors are leading the charge. They have elbowed aside first home buyers, who compete in the same part of the property market as investors.

First home buyers are taking out just more than 10 per cent of new home loans compared with the long-term average of about 20 per cent.
With the typical two-bedroom inner-city apartment on a ”net” rental yield (after costs) of between 2.5 and 3 per cent, even very low mortgage interest rates of about 5 per cent leave investors often losing money, at least in the short to medium term.

Supply of inner-city apartments is being added, especially in Melbourne. Higher dwelling approvals, low rental yields and rising vacancy rates mean would-be property investors need to tread carefully, analysts say.

Cameron Kusher, a senior research analyst at RP Data, says rental yields for units are very low across both cities.

”While apartment prices have risen, rents have not risen as much and rental yields across both cities have fallen,” he says.

With interest rates and mortgage interest rates likely to stay low and prices likely to continue to rise, ”it seems as if yields will continue to fall across both cities”, Kusher says.

Louis Christopher, the managing director of specialist property researcher SQM Research, urges caution for would-be investors in Melbourne’s inner city, in particular.

Vacancy rates in inner-city apartments in Melbourne are already ”elevated”, he says. ”Anyone thinking of investing in these markets needs to factor in the possibility that they may have to lower the rent to attract tenants.”

A vacancy rate of between 2 and 3 per cent is indicative of equilibrium between landlords and tenants. Vacancy rates in inner Sydney apartments are low, at about 2.5 per cent, however Christopher expects vacancy rates to start to rise in the second half of this year. Rising vacancies put pressure on rents to fall.

Melbourne oversupply

Robert Mellor, the managing director of BIS Shrapnel, estimates there could be 2000 apartments in excess of demand in Melbourne’s inner city. ”This is a classic cycle where everyone is overdoing it.”

Vacancy rates are high in Melbourne’s Docklands, Southbank and around the CBD. Vacancy rates are seasonal, usually peaking in January and falling in February. During the past two years, the trend vacancy rate in Docklands and Southbank has averaged about 7 per cent, data from SQM Research shows.

Mellor says the vacancy rates in Docklands and Southbank could even peak at close to 10 per cent in three years’ time – a ”worst-case scenario”.

Vacancy rates may not reach that high because landlords are likely to reduce rents to attract tenants. Mellor’s advice to would-be investors in Melbourne’s inner-city apartment market is to wait. ”There will likely be bargains for patient investors in two years’ time.”

Analysts say Sydney’s inner-city apartment market is not as over-supplied as Melbourne’s.

Sydney brighter prospect

But there is a lot of supply coming to the southern end of Sydney city, in areas such as Green Square, Chinatown and Broadway, Christopher says.

”We are aware of multi-storey dwellings that are going to be constructed and completed in the next few months,” he says. ”We are saying to investors who are buying in these markets to be aware that they will be unlikely to increase rents and may even have to lower rents a bit, to encourage renters to their properties.”

Mellor says apartment approvals for Sydney are significantly higher than they were. And the high number of apartment approvals for Sydney during the past six months has surprised him. However, Sydney has been under-supplied for the past five years.

He is expecting further ”solid growth in rents and values” for Sydney apartments as immigration and population growth remain strong.

Interest rates may start rising in 12 to 15 months’ time from their historic lows now, according to Mellor. But rates will only rise if the economy is stronger. And the mortgage interest rate is not expected to rise to more than the ”low 7 per cents” from just over 5 per cent now.

That would be about equal to the average long-term mortgage rate, Mellor says.

Regional focus

Pauline and Mark Klemm have built a property portfolio of three houses and one unit during the past two years.

The Melburnians buy lower-priced properties in regional centres. They have houses in Whyalla in South Australia, Townsville in Queensland and Orange in NSW and a unit in Toowoomba in Queensland.

Pauline, 50, and Mark, 52, both work in the health industry. Pauline is the driving force behind the couple’s property investment strategy. She bought the properties for between $100,000 and $290,000. The investment properties are “cash-flow positive”, meaning the rent coming in is higher than the outgoings after taking account of depreciation.

Pauline could have bought in outer Melbourne, but the competition from other investors is too great. And lower-priced properties produce higher rental yields, on average, than higher-priced ones, she says. She is looking at buying her first capital city property, in Adelaide. She has built-up a network of property contacts, such as the real estate agents who manage the properties.

Pauline and Mark are long-term investors. They will hold on to the properties and, over time, the income from them will increase. It will provide them with income in retirement in addition to their superannuation.

Pauline says running a property portfolio involves a fair amount of work and it is something that you have to be interested in doing. “I really love it,” Pauline says. “I have found something that I am passionate about,” she says.

Red brick is the new black

“Units are easier to manage,” Kevin Lee says. “If something goes wrong inside [the unit] it is your expense, but if it goes wrong outside, the expense is shared.”

Lee is referring to “sinking” funds, which are required under strata laws and to which all owners make a financial contribution. Lee says would-be property investors have to be prepared to invest for the long-term and to do their homework, not only on the location of the investment but on whether the numbers stack up.

He likes “red brick” units without lifts. Newer builds with their gyms and swimming pools have high strata fees, he says. And lifts break down constantly requiring expensive repairs. “For an investor the strata fees in these complexes can be a killer,” he says. In his opinion, the investor is subsidising the lifestyle of the tenant in these complexes.

He says too many investors place too much importance on the tax breaks. “You do not buy an investment for the tax breaks, you buy it so that you can make money from day one,” he says. Lee means “negative gearing”, where, if the rent does not cover the interest and other expenses, the shortfall reduces the investor’s income tax liability. Negative gearing reduces the landlord’s losses. But the only way to make money on a loss-making investment is to eventually sell it for capital gains that more than make up for the accumulated losses. But relying so much on capital gains increases the riskiness of the investment, Lee says. He prefers units in the lower price range as they pay the highest yields and can be become cash-flow positive in a short time.

He says units can be found for between $250,000 and $300,000 in Sydney and Melbourne’s outer suburbs that can be rented for up to $300 a week. On Lee’s calculations, with a mortgage that is 90 per cent of the purchase price, repayments over 30 years and 5 per cent interest rate, the property could be almost cash-flow neutral from day one and, as the rent rises and size of the mortgage reduces, the investment would turn cash-flow positive. Units in the $650,000 price range, with the same assumptions, would have a lower yield and be cash-flow negative for the investor for longer, Lee says.

Posted by John Collett – The Age on 2nd April, 2014