Buying a property for investment purposes is about two things: capital growth and rental yield. If you can achieve and maintain both then you are on to a winner.
Naturally, you will consider the type of property you are buying, what it looks like and its position before you buy. But you should also take a wider view and try to understand how different aspects of national and local economies can affect your success.
Interest rates and inflation
Interest rates are an important indicator of house prices because they tell you, on a national level, how much it costs to get a variable rate mortgage.
The Reserve Bank of Australia (RBA) sets a cash rate which all lenders use as a basis for their standard variable rate. The rate is designed to control inflation and keep a balanced economy. The RBA likes to keep inflation at 2–3%. This means that the Consumer Price Index (CPI), which takes an average of prices for a basket of goods and services including housing, is increasing at a rate of 2–3% per year.
If inflation moves above that level, it means that the economy is overheating and people are spending too freely, which causes prices to increase too quickly.
The RBA then moves in to make the cost of borrowing more expensive by raising interest rates. This has the effect of making it more expensive for people
to get access to credit and limits spending, thus cooling the economy, slowing price increases and preserving the value of money.
If the level of inflation is too low, it means the economy is moving towards a period of recession where spending is low, prices stagnate and the economy slows. The RBA will then reduce interest rates, making credit (debt) cheaper, to encourage the supply of money increasing inflation and allowing the economy to grow.
The implications of this for the investor are seen on several different levels. If interest rates increase markedly, then the loan used to purchase the property will become more expensive. This means the investor must find more money to service his loan. Rental increases are an option, but they can only be in line with the market, or there will be no tenants. The other option is negative gearing (offsetting losses against tax), which can mitigate losses from increased loan costs, but is only worthwhile if there is capital growth in the property.
In a period of interest rate rises, capital growth is likely to suffer, for investors and home owners alike. Rate rises affect affordability, which in turn reduces demand for property. If the supply of property begins to outstrip demand then prices slow, stagnate or even fall.
This rule is true for cheaper property, but not always in more expensive areas. During a period of strong economic growth and healthy share market performance, spending is equally strong, which is one reason why inflation and then interest rates rise. Those strong economic conditions have helped people at the top end of the employment market, so price growth for the inner suburbs of Sydney and Melbourne (where these people live) is strong during an economic boom. Prices in the outer suburbs, or the mortgage belt, aren’t doing nearly as well because people have big mortgages and are more affected by interest rates.
One plus for the investor is that rising property prices mean that more people choose to rent rather than buy, because the cost of getting a home loan is too high. If the demand for rental property increases, the investor has more people to rent their property to. They can even consider increasing the rent, because demand for rental property begins to outstrip supply as more people switch from being potential buyers to being potential renters.
So in a period of interest rate rises an average investor may see their capital growth suffer, but will be likely to get a healthier yield from rent.
In a period of interest rate cuts, generally the opposite will happen. Loans become more affordable so buying a house becomes more realistic for people, renters become potential buyers and the pool of potential clients for the investor becomes smaller. Those buyers are competing over a finite number of properties because building new properties takes time. This competition pushes house prices up; therefore, an investor will see better capital growth but may not be able to command as much rent for the property.
Demographics is the study of population characteristics, including socio-economic status, income, home ownership and employment status and immigration.
These characteristics can be very useful to the potential investor when working out where, when and how to invest in property.
Mark Armstrong, director, Property Planning Australia, believes a study of the demographics in the area you are looking to buy in can be invaluable.
“You should find out how many are homebuyers and how many are investors, then go a little bit further and find out how many homebuyers still owe money on their properties. If you have a high percentage of people in an area that are homebuyers and a small percentage of investors, then out of those homebuyers a high percentage owe money on their properties. These areas will be more affected by an interest rate increase. If half the homeowners have no debt, then there is insulation from interest rates.”
Armstrong gives two examples of suburbs in Sydney that fit the opposing criteria, Baulkham Hills and Paddington.
He believes that investors should be aware of this economic indicator because it could affect property prices in the area if owners get into trouble because of adverse factors such as interest rate rises.
“In Paddington, half [the number of property owners] are investors and half are owner-occupiers. Of the owner-occupiers, around 50% or more don’t have any debt. In Baulkham Hills, 90% of property is owner-occupied with 70% of those still owing money. That’s why Baulkham Hills has shown a volatile growth pattern and a high percentage of forced mortgagee sales. Places like Paddington are insulated from that effect,” says Armstrong.
Population growth in an area should be monitored closely by investors and broken down further to ascertain the makeup of that population.
Armstrong believes that high population growth in an area isn’t always
an oversupply of housing, which may negatively affect house prices. He again uses the example of Paddington versus Baulkham Hills to illustrate his point.
“There might be 2–4% per annum population growth in Paddington, while the national average is 2–3%. You may find that population growth in Baulkham Hills is 8–10% per annum. It doesn’t mean people don’t want to live in Paddington – they are falling over themselves to live there. It’s an issue of affordability – there’s no more real estate for them to buy, while there is in Baulkham Hills,” says Armstrong.
Another factor in population growth that the investor should look for is where the new residents are coming from.
Peter Koulizos, property investor and author of The Property Professor’s Top Australian Suburbs, believes the high level of immigration into Australia is good for investors in terms of rental yield because those individuals possibly won’t be in a position to buy property for several years after their arrival, regardless of price or supply.
It may also indicate that cheaper rental properties will be in greater demand in that area than more expensive ones.
Employment and industry are also very important to an investor for understanding whether the property will have good capital growth and rental yield. An investment in an area that has seen a lot of private or public money go into industry will have strong employment, meaning potential renters with money to spend on rent.
Armstrong says employment trends should definitely be considered and points out some examples of when investors should be wary of industry and employment factors.
“Mining towns are a prime example of a one-industry environment. If that industry dried up, why are people going to stay? When the mine opens property prices soar, then they level off and when it closes they plummet. The same is true for somewhere like Geelong, near Melbourne. When the Ford factory closes for a couple of years, it will have a significant impact on the wider community,” says Armstrong.
Koulizos says low unemployment levels give consumers confidence, which feeds into the housing market, helping to increase property prices.
“When we have very low unemployment levels, people are pretty confident and more willing to borrow money. High migration to an area means there are lots of job opportunities and vacancies, and this creates more money for property,” says Koulizos.
Gavin Hegney, executive chairman of the Hegney Property Group, suggests higher levels of unemployment can lead to a lack of confidence in the housing market.
“If people don’t have a job, or the confidence they will keep their job, then that will affect the housing market. Confidence to borrow money is distinct from the ability to borrow money when interest rates rise.”
Investors should therefore study unemployment data in the area they wish to invest in to understand if prices are rising or not.
Hegney adds that investors should also pay close attention to the number of people per job vacancy, since the fewer there are, the more people will move
into the area for the jobs. Consequently, there’ll be a greater demand for rental accommodation.
Land versus property prices
Since the two major attractions of property investment are rental yield and capital growth, it’s a good idea to decide which one you will target primarily. In an
ideal world you get both, but that isn’t always possible.
One way of working out which you are likely to get from your investment property is to study economic statistics on land values. Hegney says that buying a property where most of the value is in the land will give your investment better capital growth, while a property where most of the value is in the actual bricks and mortar will be better for rental yield.
“Consider the underlying value of the land in the purchase price. The higher the land value, the higher the capital growth; the lower the land value, the better the rental return, but lower capital growth. Apartments usually have a higher rental return.”
Armstrong agrees, saying it’s easier for investors to understand the likely depreciation of their property if they know the percentage of its value in the land.
“Work out before you buy how much you’ll be paying for the land and how much for the building on it. When you know what the land value is, you know what percentage of the property is going to appreciate or depreciate in value.” YM