JUNO INVESTING ©

BOOM OR BUST?

JUNO INVESTING ©
BOOM OR BUST?

 

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WINTER 2015

By MARTIN HAWES, Financial Writer / AFA

Rental properties have in the past provided investors with very good returns. But in the current property market, is it a suitable time to invest in residential property for rental income? Martin Hawes encourages potential investors to think twice before joining in on the boom.

I am a property guy from way back – I have always thought that buying real estate and holding it for the rental income makes for an excellent investment. It is true that I have usually been more orientated towards commercial property than residential, but I do know that rental property of all types can give investors very good returns.

However, in the last few years I have become increasingly negative on residential property for investment purposes. Even though I stayed away from residential property in the past because of the costly management required by residential property and its role as a political football, for years I recognised that it gave good returns with generally moderate risk. For those who got stuck in, put in the effort and ran their residential investment portfolios like a business, real wealth was possible and I used to encourage people to do just that (in fact, I was a cheerleader!)

Now I am worried: wealth from property (especially in Auckland) is only still possible through speculating that values will keep rising – things have changed as the investment proposition of good income yields from rents has disappeared and a hysterical market bids itself up far in excess of fundamental value. 

For me, with good income yield gone and the market getting ever higher, the risks of residential property are now on the downside. And that is why I am a residential property bear.

You see, I am a value investor and I do not see any investment value in residential property at the moment – prices are too high and income yields too low. Over the last decade or so, values have climbed sharply but rents have not. The fundamental investment metric is always the amount of income you can achieve for a dollar of investment, and this is clearly way out of line with residential property.

When you look at the property boom from an investment point of view, residential property rental income is so small that people buy pretty much solely for the change in price (capital growth). The yields that I have seen on some Auckland house prices bought recently by investors have been around two per cent per annum net, which means that people are not really investing for the income (a yield of two per cent is pathetic) but are instead speculating on future capital growth.

Investors are people who look first at the income that they can achieve from rents, dividends or interest; speculators, on the other hand care little for the income and buy on the basis of their view of market direction regardless of the fundamental investment metrics of income yield. As an investor, I buy for income yield and let the capital gain look after itself.

In fact, rental yields are now so low in some New Zealand markets that those buying rental property cannot be called investors – buying residential property is really speculation. The higher that prices go the more that a fair rental yield becomes impossible. Prices are rising (which will probably continue for a bit yet) but I will not speculate on an out-of-control market becoming even more out of control. 

Several commentators, myself included, have worried that the housing market in Auckland, and some other areas in New Zealand, is an inflating bubble. It is always very difficult to say whether a market is a bubble – we only know that it was a bubble after it bursts. As house prices continue higher, the chances that it will end in a crash increase. Although prices may continue to increase for a while yet, the things that are pushing them up (low interest rates, immigration and a housing shortage) will not last forever.

Speculating on a market that is in the irrational exuberance phase is fraught. We can be fairly certain that one day interest rates will rise, immigration slow and the housing shortage turn to a surplus. We do not know when, but we can be absolutely certain that one day the mass hysteria of the market will change. At that point, as in a game of musical chairs when the music stops, there will be a mad rush for safe seats.

Property is already very highly valued by any measure you care to use. We may not be at the top of the cycle, but we are not far from it. No one rings a bell at the top of a market – sentiment can shift very quickly and booms can end quickly for no obvious reason. I hope this boom will end nicely; but there is no guarantee that it will. A major fall (like in Ireland where house prices plunged more than 50 per cent) would be very bad for this country. There is political consensus in New Zealand that house prices should be curbed. There is disagreement on the best method of doing this, but all political parties (along with the Reserve Bank) want to see an end to spiralling house prices. Eventually the politicians will have their way.

Those thinking about joining the boom and speculating on increasing house prices should take a deep breath:

1. Property is already very highly valued by any measure you care to use. We may not be at the top of the cycle, but we are not far from it.

2. No one rings a bell at the top of a market – sentiment can shift very quickly and booms can end quickly for no obvious reason.

3. I hope this boom will end nicely; but there is no guarantee that it will. A major fall (like in Ireland where house prices plunged more than 50 per cent) would be very bad for this country.

4. There is political consensus in New Zealand that house prices should be curbed. There is disagreement on the best method of doing this, but all political parties (along with the Reserve Bank) want to see an end to spiralling house prices. Eventually the politicians will have their way.

As someone who always invests rather than speculates and who is a lover of genuine property investment, I hate to see house prices divorced from the income that can be derived from them.  You may be able to speculate on a continuing boom for a while but such markets are very, very dangerous and are to be avoided by serious investors. Remember: the wilder the party, the worse the hangover.

 

DEFINITIONS

Commercial Property: real estate used for business activities. 

Residential Property: real estate available for personal occupancy, not for business activities.

Yield: the income one receives from an investment.

 

Martin Hawes is an Authorised Financial Adviser and a disclosure statement is available on request and free of charge, or can be found at www.martinhawes.com. This article is of a general nature and is not personalised financial advice.