Investing in residential property when prices are flat

Shahrukh-Abdali-CFA

Investing in residential property when prices are flat

This article is part 3 of a series aimed to address some of the common topics our clients ask us to
comment on. I hope the information provided will be useful to readers when contemplating financial
decisions. Note that the information provided is not personalised financial advice and does not
consider your personal circumstances. I encourage you to take advice from an Authorised Financial
Adviser before taking investment decisions.

To provide context to this article, in the first article, I discussed some of the key factors contributing
to the rapid increase of property prices in New Zealand over recent years. These include record-high
net migration combined with easily obtainable and cheap credit (mortgages) fuelling high demand
for residential houses. Simultaneously, a lower supply of residential housing than required to meet
the high demand, creating a housing shortage which has driven up the property prices. The first
article can be read at: http://saturnportfolio.co.nz/whats-driving-capital-gains-residential-property/

In the second article, I discussed five policies of the current government aimed at housing and what
these policies potentially mean for current and prospective property owners, particularly property
investors. The policies discussed include a ban on foreign buyers, extension of the bright line test,
ring-fencing of rental losses, favourable policies for tenants and the KiwiBuild programme. This
article can be read at:
http://saturnportfolio.co.nz/implications-of-government-policy-changes-for-investing-in-residential-property/

In summary, I concluded that the drivers of higher property prices are starting to wane and that the
current government policies are expected to decrease the overall demand for properties while
potentially boosting the supply of properties. Accordingly, I expect New Zealand property prices to
at best experience low growth for the foreseeable future, with the more likely scenario of flat prices
or even declining prices in some parts of the market.

Getting back to this article, the return on an investment in property comes from two sources; capital
gains and rental income. Assuming property prices are flat for the foreseeable future (i.e. no
material capital gains), the remainder of this article focuses on the investment returns achievable
from rental income for a “typical” residential investment property.

It is a challenge to define the “typical” residential investment property, so I have made a number of
assumptions based on a 3-bedroom property in Auckland. Although regional data will differ from
Auckland, I have focussed on Auckland as it is the largest property market in New Zealand.

 

Property values – In order to remove the bias from unusually high-priced or unusually low-priced
property transactions, I have used the median price for Auckland, which was $850,000 as at 30
September 2018 (source: www.reinz.co.nz).

Rent per week – To be representative of a common Auckland property, I have chosen the median
weekly rent for a three-bedroom house, which was $620 as at 30 September 2018 (source:
www.interest.co.nz).

Vacancy per annum – The number of weeks an investment property might be vacant each year depends
on a number of factors such as proximity to schools and public transport, condition of the property,
level of rent etc. That said, from my discussions with a number of real estate industry professionals,
2 weeks’ vacancy per year seems to be a reasonable assumption.

Mortgage rates – While there is some variation among the mortgage rates offered by lenders, the
registered banks’ offerings currently fall within a narrow range for floating and respective fixed
terms. An investor might choose any allocation between floating and different fixed terms. For the
purpose of this analysis, I have chosen the 2-year fixed term rate on offer at the time of writing by
the four largest banks in New Zealand. This was 4.29%pa (source: www.interest.co.nz).

Property management fees – A survey of the largest property management companies in New
Zealand showed the property management fee to be between 6%-9% + GST of all money collected
plus any repairs and maintenance carried out on behalf of the landlord. For simplicity, I have used
7.5% of the weekly rent as the cost of property management.

Council rates – The Auckland Council rates calculated for a property with a CV of $850,000 (the
assumed purchase price for this analysis) will be approximately $2,100 per year.

Maintenance – This depends on the age and condition of the property as well as the tenants
occupying the property. A press release by Barfoot and Thompson found property maintenance
costs varied from an average of $60 per month for apartments to an average of $90 per month for
houses. For this analysis I have chosen $90 per month as the average maintenance cost for a house
(source: http://www.scoop.co.nz/stories/BU1703/S00953/property-maintenance-costs-
surprising.htm
).

Insurance premiums – After surveying some of the prominent insurance providers, I have assumed
the annual premium to insure a 3-bedroom rental house to be $1,200 per year. This does not include
cover for contents.

Based on the above assumptions, the table below shows the expected rental return net of all
expenses based on two scenarios: 1. with a debt of 65% (i.e. the investor provides the lowest level of
equity required under the current LVR rules); and 2. with no debt.

 

Investment in residential property With a debt of 65% With no debt
Property value $850,000 $850,000
Rent per week $620 $620
Gross rental income per annum $32,240 $32,240
Vacancy per annum – 2 weeks $1,240 $1,240
Interest payment per annum – 4.29% $23,702 $0
Property management per annum – 7.5% $2,325 $2,325
Council rates per annum $2,100 $2,100
Maintenance per annum $1,080 $1,080
Insurance $1,200 $1,200
Net rental income per year $593 $24,295
Net rental return on equity 0.20%[1] 2.86%[2]

 

[1] The net rental return where there is 65% debt is [ $593 / (850,000 x 0.35) ] x 100 = 0.20%

[2] The net rental return where there is no debt is [ $24,295/ 850,000 ] x 100 = 2.86%

As can be seen from the last row of the table above, the rental return on equity net of all expenses is quite modest, between 0.20% and 2.86% per annum depending on the level of debt. These returns are before the deduction of any tax payable on the rental income. Furthermore, the investment property with 65% debt is very sensitive to changes in mortgage rates. An increase in mortgage rates of just 0.1% would turn the net rental return on equity to negative because outgoings would be greater than the rent being received.

To provide some perspective, despite interest rates being at historically low levels, bank term deposit rates for the four largest banks in New Zealand are currently higher than the net rental returns calculated above and range between 3.25% and 4.1% per annum for terms between 6 months and 5 years respectively. This is not to suggest that you should transfer all your capital invested in residential property to bank term-deposits. Term deposits are just one of the many investment options, which could be utilised to achieve diversification.

However, what the above exercise highlights is the “ballpark” returns an investor in residential property is likely to be getting in the absence of material capital gains.  This raises the question as to whether residential property should be the “go to” investment for so many kiwis.

In my next article I will discuss the alternatives to investing in residential property and the benefits of having a diversified investment portfolio.

Shahrukh Abdali is an Authorised Financial Adviser and an employee of Saturn Portfolio, an impartial financial advisory firm based in Auckland. Shahrukh holds the Chartered Financial Analyst (CFA) designation and can be contacted on +64 21 024 36542 or shahrukh@saturnportfolio.co.nz

Shahrukh would be happy to answer your questions.

The views expressed in this article are the views of the author. The information provided is of a general nature and is not intended to be personalised financial advice. You may seek appropriate personalised financial advice from a qualified Authorised Financial Adviser to suit your individual circumstances.

 

 

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