There is a set of conventional wisdom around the rules of buying property. The worst house on the best street. Buy in a blue-chip school district. High risk equals high return.
In an overheated Melbourne property market can buyers ensure the safety of their investment? Our recent analysis of property sales and rental returns arms investors with information about the potential differences in investment returns based on location, property size and structure type – a house or a unit.
Housing, as an investment market, has specific risks and returns. Rental and housing costs influence these returns and risk, and, therefore, act a key indicator for property bubbles. Banks are warning investors of a downturn in returns this year – will we see the bubble burst?
Many banks are increasing the down payment in risky postcodes and suburbs; however, as our analysis shows evaluation at a postcode level is too crude to evaluate risk or returns.
In the current market climate, buyers must still be driven by price and subsequent costs. With many first time homeowners renting out their property in full or partly, buyers need to skill-up in estimating rental income (and property yield).
We argue that rental yields of the property market need to be properly evaluated as they may be a leading indicator of bubble creation. The first step towards prevention is identifying the problem. This work can be used to identify areas and market segments at risk and can lead to the design of policies preventing a sudden collapse.
The lending industry can only estimate the risk if residential rental yields, property type and location are taken into account. Having a higher rental return reduces this risk exposure of mortgages in case of a total default by the owner.
In a postcode-driven market, improved knowledge of the differences in yields by location, type and size can indicate supply and demand mismatch, signalling profitable investment possibilities.
Melbourne’s property market – the data
Using a dataset of nearly one million unique home sales and rentals, we investigated the spatial and temporal changes in residential rental yields across the Melbourne metropolitan region from June 2010 to June 2015. We first presented this work in March 2016 at the American Real Estate Society Annual Meeting in Denver.
Our results show a steady decline in rental yields (rent-to-sale price ratio) for both single-family homes and apartment units. Declines averaged around 15% (0.6 percentage points) for houses and about 4% (.02 percentage points) for units when compared to the 2013 highs.
Our detailed analysis showed that apartments offer higher yields than detached houses. This difference has widened over time, with yields from houses falling off considerably in the past 24 months while yields on apartments have held relatively steady since 2013.
Yield levels and changes in yields over time, however, have varied widely over the metropolitan region (levels ranging from 1.7% to 7.5%). Many areas of the region offer better returns from an investment standpoint as well as less lending risk in the instance of foreclosure.
Thinking beyond postcodes
Across property types, we see considerable variation in returns, with highs around 7.0% for apartments in Carlton, its surrounds and the far north; and lows of around 1.5% for houses in the expensive inner eastern suburbs.
Our evaluation shows a spread of 4.5 times between and within suburbs. In other words, yields can be highly variable even within a given suburb or postcode, so investors need to consider the exact home location, size and structure type, and not just the postcode.
This evidence can help investors to make a much more refined decision when purchasing a property. We found that changes within and between localities have a more significant impact on returns that changes over time.
Predicting the Melbourne market
That the overall market has encountered a decline in rental yields of 10% within 3 years has to be understood in the context of declining interest rates and a declining stock market.
The Reserve Bank of Australia has reduced the interest rates for cash from 4.75% in 2010 to 1.75% today. Since the market will take time to catch up to this reduction, we can estimate a further decline in the rental returns of the property market.
Nevertheless, investors must check, for their desired locations, whether the rental yield is below the existing interest rate for cash. These locations are overheated markets – they pose a higher risk for a total default and require more underwriting for security.
Banner image: Melbourne suburbs like Carlton have experienced a rapid change in the mix of properties available. Picture: James Rafferty.