Investment property: handle with care

This article first appeared June 23, 2009.

Investors are gingerly re-entering the residential property market, lured by the best investment yields in two decades, low interest rates, sharply rising rents, and growing prices in the $500,000-and-below sector – the most favoured as investments.

An overall shortage of rental properties along with weak construction levels, with many developers simply unable to obtain finance, are driving up rents and yields. Meanwhile, demand for rental property continues to escalate with the strongest population growth since the baby boom of the 50s and 60s.

Further, the impact of the savage bear market on share portfolios is also encouraging more investors to look again at directly-held residential properties.

On the surface at least, there are plenty of signs that seem to augur well for would-be property investors. But wait. Investors shouldn’t rush back into this market without considering the risks and less attractive aspects overhanging residential property, particularly at the lower end.

Some property professionals are at odds about whether or not the under-$500,000-$600,000 sector – which has experienced significant price gains – has been artificially propped up by government grants, particularly the Federal Government’s first home owners boost. An opinion is being expressed by some professionals, and rejected by others, that prices in this cheaper sector will fall once the extended federal grant ends on December 31.

And a number of leading economists expect housing prices to markedly turn downwards over the next 12 months as unemployment increases.

In short, this is a time for anyone considering investing in residential property to move with extreme caution. Even some of the most optimistic property commentators project “benign” price growth over the next year for properties costing up to $500,000 or $600,000.

Here are 12 points for would-be investors in residential real estate to consider, in addition to the possible impact of rising unemployment:

1. Recognise that investors are definitely stirring again.

Latest ABS housing finance figures show the value of fixed residential housing loans for April rising by 8.9% over the previous month – almost five times the percentage for owner-occupier loans. Clearly at least, some investors are returning.

“Investors will keep dipping their toes back into the water as this year continues,” says Angie Zigomanis, industry analyst and economic forecaster for BIS Shrapnel. “And the baton will change hands to investors for the next leg of demand.” He expects more investor activity late this year, increasing next year.

Cameron Kusher, research analyst with property researcher RP Data adds: “The only thing keeping investors inactive is the surge in first home buyer demand.” Both were competing for the same lower end of the market.

“[However] the most recent finance commitments data [from the ABS] has shown that the number of first home buyers has actually dropped in recent months in all states, except Victoria.”

Kusher says that many market specialists believe that first home buyer activity has peaked. “As first home buyers slow, we anticipate investor volumes will begin to creep upwards.”

Louis Christopher, head of property research for investment researcher Adviser Edge, accepts that investor activity in residential real estate has improved since December 2008, when he says it was almost non-existent.

2. Know that many astute investors may be waiting on the sidelines at this stage.

Sydney buyers’ agent Patrick Bright, chief executive of EPS Property Search, has noticed more investors looking to re-enter the market. “However, this might be a ‘false dawn’ at this stage,” he warns, “due to inflated prices in the first homebuyer market.”

“I believe, however, that a lot of investors are waiting on the sidelines and are poised to buy property,” says Bright. “They are just waiting for prices to return to more realistic levels; so we could see a quick influx of investors in the real estate market shortly.”

“At the end of the day, the smart investors purchase property based on value for money while home buyers buy with their heart, which is why they are often prepared to pay more.”

3. Don’t ignore somewhat contentious views that prices in the bottom end of the market have been pushed up excessively by first home buyer grants.

“There is legitimate concern that the first home buyer sector is [subject to] an artificial bubble caused by the government grants,” says Bright. He expects the bubble will deflate when the federal grants end in December.

“I would be cautious when investing in property under, or around, the $500,000 mark until the heat has gone out of the market late this year,” he says.

4. Understand that developers are not going to solve the shortage of properties any time soon.

There are simply not enough properties to rent; driving up rents and yields, says Angie Zigomanis of BIS Shrapnel.

“There is a deficiency of stock in most capital cities,” he says, “with Sydney most of all.”

Developers have not been able to construct to reduce demand pressures. “Construction of apartments has fallen back in 2008/09 – lots of developers can’t get finance,” Zigomanis adds. And he expects construction levels to remain weak for the next two financial years, locking in the shortage of supply for rental property for at least a year.

5. Consider a case for anti-cyclical investment.

As Zigomanis explains, this involves property investors buying in a downturn while yields are more attractive and holding on until a satisfactory upturn in capital growth occurs. He projects price growth for the investor-end of the market to be “benign” over the next 12 months.

Zigomanis believes the time might be right for anti-cyclical investors to re-enter the market. “The lower-end of the market [meaning mostly up to around $500,000] is still the most attractive – with Sydney, Melbourne and Adelaide having the most potential.”

6. Think about possible interest rate movements.

One of the attractions for property buyers is that interest rates are at long-time lows.

And Zigomanis does not expect a marked increase in rates any time soon. “The Reserve Bank and the Federal Government will want interest rates to remain as low as possible to drive the economic growth,” he says. “The strength of the housing market is important to lead the economy out of the doldrums.”

However, Christopher ominously adds: “We have just seen the Commonwealth Bank lift variable and fixed interest rates – this could signal an upward movement in rates.”

7. Check relative yields.

While yields on rental properties are at their highest for 20 years, Christopher suggests would-be investors compare the higher yields on such alternative investments such as fully franked shares.

8. Realise that not all vacancy levels are low.

There are significant areas where vacancies are rising,” warns Christopher. In such areas, it is next to impossible for landlords to obtain higher rents.

9. Consider impact of banks requiring higher loan-to-valuation ratios.

“By default, this will reduce the number of borrowers [in the lower-end of the market],” Christopher says. In turn, this could be detrimental for prices.

While Bright believes higher loan-to-valuation ratios will prevent a large percentage of first homebuyers entering the market, it would strengthen the property market because there would be fewer forced sales.

10. Don’t overlook the effect of the cutting of concessional super contribution caps.

The reduction of the caps on these contributions, which include salary-sacrificed, SG and tax-deductible contributions by the self-employed, is expected by some financial planners to encourage more investors to gear non-superannuation investments including residential property.

11. Carefully identify best investment buys.

Bright is convinced that the best buys for investors are currently above the first homebuyer points. In Sydney, for instance, this means properties from $750,000 upwards, and in particular in the $1 million-$2 million bracket (which, of course, is much higher than the traditional sector favoured by small investors.)

12. Before buying, think about what will most appeal to prospective tenants.

In general terms, Bright says this means quality properties near transport, shopping centres, restaurants, entertainment centres – and employment centres, particularly in busier cities.

“Other factors such as a secure building, pleasant outlook and a balcony are highly desirable,” he says, “while off-street parking can be a deal-maker or breaker, particularly in the very busy suburbs close to the city centres.”

And stay away from areas where there is an over-supply of rental properties – unless buying something really special like a penthouse with knockout views.