By Rodney Dickens*
Property Investors Federation executive officer Andrew King has been advising landlords to put up rents to try and offset the negative impact of mortgage interest rate increases on cashflows and profitability.
Andrew's warning is timely because the upside risk to interest rates is real, as I outlined in the January Raving.
Unfortunately for landlords, this isn't likely to happen to any great extend because low rental inflation appears to be a by-product of low general price or CPI inflation.
This Raving identifies what appears to be a major change in how rents increase as a result of the move from high general inflation in the 1970s and 1980s to low general inflation that started in the early-1990s.
This could be seen as a legacy Dr Brash has left landlords. This legacy has implications for house sales and house prices, as covered in our Housing Prospects reports.
The breaking of the link between house prices and rents
One of the great puzzles over the last decade has been the yawning gap that has opened up between the national average house price and the national average annual gross rental income (left chart).
This can be shown equally by annual rental inflation remaining low despite periods of high house price inflation since 2000, while in earlier periods of higher house price inflation rental inflation was much higher (right chart).
The result has been a large fall in the national average gross rental yield (black line, left chart below).
Most of the fall in the rental yield occurred between 2002 and 2007. This was a period during which annual house price inflation averaged 13.6% based on the QV House Price Index and rental inflation averaged 2.7% based on the rental component of the CPI.
Over this period the average mortgage interest rate increased and the 10-year government bond yield - a measure of low risk fixed interest returns for investors - changed little (left chart below).
So over the 2002 to 2007 period there wasn't a case for investors accepting lower rental yields because interest rates were lower, although the subsequent fall in interest rates has retrospectively justified some of the fall in the rental yield.
The reason rent increases didn’t vaguely keep up with increases in house prices between 2002 and 2007 and again over the last couple of years appears to be because rental inflation has become a hostage of low general price or CPI inflation.
In the 1970s and 1980s when house price and CPI inflation were high, it made sense that rental inflation was also high, although all three experienced significant cycles. The top right chart above compares house price inflation and rental inflation, while the right chart directly above compares rental price inflation and CPI inflation.
CPI inflation has been consistently lower since the early-1990s. In the first house price boom after 1990 - between 1994 and 1996 - rental price inflation increased much as had been the case earlier.
But it would seem that by the time of the 2002 pickup in house price inflation the low inflation environment had taken over.
It would appear that landlords began to struggle to justify or achieve higher rental inflation in an environment of sustained low general inflation.
This new, inflation-constrained behaviour is reflected in CPI and rental inflation living in similar ballparks since after the government interventions resulted in rental inflation turning temporarily negative in 2001 (right chart above).
The result was that the relationship between house price and rental inflation largely broke down (top right chart on page 2).
This doesn't mean that rental inflation can't increase somewhat when house price inflation increases, but rental inflation should have started to increase already if it wasn't constrained by the low general inflation environment and low inflation expectations.
Part of the story appears to be about the constraint of low inflation expectations, which can be seen as one of Dr Brash's legacies. The left chart below compares rental inflation with the ANZ survey of CPI inflation expectations that is only available back to 1988.
If landlords and tenants have reasonably low expectations about inflation in general, in line with the findings of the ANZ survey, it makes sense that this will put a limit of sorts on how much landlords can justify increasing rents.
This can also be viewed from the perspective of rents compared to incomes.
This is another means by which lower general inflation, including lower income growth, will put a ceiling on rental inflation. The right chart compares the ratio of the national average house price to the average annual gross income (black line) with the ratio of the average national annual gross rent to the average annual gross income (blue line).
Prior to 2000 the two ratios largely moved in synchrony while since then the rent/income ratio has fallen and the house price/income ratio has skyrocketed.
While being below the peak level, the current rent/income ratio is still a bit above the average level that existed between 1978 and 2000.
The fall in the rent/income ratio since 2000 may also reflect increases in government support for low income renters, with all categories of renters included in the CPI rent component.
But getting back to Andrew's recommendation, what about the behaviour of rents relative to mortgage interest rates?
The adjacent chart shows annual rental inflation compared to the average listed mortgage rate of the major banks.
In the mid- 1990s when rent inflation increased in response to higher house price inflation it also went someway to offsetting the negative impact of interest rate increases on cashflows/profitability for landlords.
However, when the average mortgage interest rate last increased significantly - between 2003 and 2007 - between 2003 and 2007 - rental inflation didn't change much.
The 2003 to 2007 experience suggests low CPI inflation is such a large constraint landlords aren't able to achieve larger rent increases even if interest costs increase significantly.
Maybe this time will be different, but I can't see why.
If landlords aren't able to achieve significantly larger increases in rent in the face of large increases in interest costs it will impact on how many investors will buy and sell properties over the next couple of years (i.e. fewer investor buying and more selling).
It will also impact significantly on the choice between renting and buying, as it did last decade.
This means it will impact on the number of dwelling sales, the demand-supply balance in the existing housing market and house prices, as discussed in the July Housing Prospects report.
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*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.
28 Comments
Individual investors manage yields by buying in higher yielding cities outside of auck as ocr starts rising.
That's why during 2005-2007 p.n was seeing 20% p.a capital gains while auck had slowed to 5% p.a.
And I agree. Don't see any reason for things to be different this time
There seems to be a general problem of coginsance of what happens when you have interest on a money supply, interest rates have to do down. Sure we have had a couple or rises, but they still fit well within the 30 year downward trend line. The trend also explains why rents won't rise appreciably and why yields will continue to decline.
There have been regular calls from the property investment sector for rents to increase. Calls? No. Maybe more like forlorn pleadings.....Achieving concerted action like in a cartel is just not possible. It is a very competitive business given the huge consequences of having a long break between tennants. Which would blow away any benefit from having a slightly higher rental income.
Excellent point. I have often said this is one reason why rents don't track house price increases during a speculative bubble.
The other important reason, is that you can't make people pay more rent than they can stand, like you can make them "pay" higher and higher house prices via more and more foolish credit terms.
The only way the landlord class finally does win from the housing supply distortions that force prices up in the first instance, is by getting people to endure less and less space for their rental dollar. This is a disgrace in the UK, and NZ is tracking them a couple of decades behind. All this is and has been foreseeable and avoidable.
Rodney, great article, well done. (take note Mr Ninness)
Finally someone has the balls to state the truth : property prices are completely divorced from rental incomes - especially in Auckland.
I wouldn't be holding my breath expecting hefty rental increases anytime soon, unless people also expect household incomes to rise significantly. The latter seems unlikely to me.
I can only point to anecdotal evidence but I am seeing and hearing of healthy rises in incomes of late in the construction/development sectors. Based on the shortage of skilled personnelI I would expect these increases to gain momentum over the next 6-12 months and beyond.
Rodney, Good of you to acknowledge Dr Brash as the great inflation fighter that he was. Another factor constraining rent increases in this country is the law: 21 days written notice and tenants can vote with their feet (and they do - the average tenancy persists for less than one year), The courts will not enforce "Fixed Term" tenancies to the letter either, so tenants can escape them too and reconfigure their households to mitigate housing costs, when they come under financial pressure. Landlords will probably turn their sights onto pollies to increase their cosy accomodation subsidies.
Ergophobia
No, that's the urban planners. If the country had listened to Don Brash about housing supply, we would have less adjustment pain being transmitted through the workers and producers, which is really all about rentiers successfully gouging the workers and producers.
This article is a pathetic beat up of a well worn story.
Rents have always lagged behind property prices and interest rates, and this time is no different.
Indeed higher interest rates play right into investors hands as fewer people can buy, and more remain in rental accommodation.
I have seen it all before. As rental accommoation slowly tightens, people start crowding in the available space and soon enough we will hear "horror" stories about 5 families with 15 kids crammed into a one bedroom flat and the leaky garage.
Rents will rise steadily ( as they have been doing) and eventually property prices will ease and the two will allign more realistically.
But it will always be far cheaper to rent than to own, and that is a fact.
What is needed is a complete overhaul of the rental market rules, doing away with the adversorial Tenancy Tribunal for starters, and encouraging investors to grant very long (99 year) leases to renters so they have a life interest and place that can really be called Home.
Come on Olly you have to be kidding right?
Can i point you at the first graph in this article. Now tell me what part of that looks like "this time is no different". Where other than the last 10 years do you see rent and ownership prices massively diverge?
Agree we could do with longer term rental rights like in Germany so that renting is an agreeable state to be in and more of a financial decision rather than last resort of the poor.
I am intrigued by you comments about 99 year leases Big Daddy and would like to see you explore them in greater depth. You have been slammed here but I am reluctant to do that as I would like to see more from you. By my reckoning 99 year leases would suppress prices, and thus capital gains, which is why I don't think you will ever get your wish as rising prices are too important to the banking system.
Btw how can it be a fault to call a top to the property market when ownership is, in your opinion here, more expersive than renting?
Further still, you may have seen investors buying in auckland in 2009-2011, and so the relevant yield for them will be based on a purchase price 30-40% lower than today. Would be great to see some data on % of sales going to owner occupiers Vs. investors over different regions. Unfortunately, rarely seen.
They are now forced to buy outside of auckland to get a decent return, look for price appreciation starting to ramp up at end of this year in secondary cities that have been flat for the last 8 or so years allowing increasing rents to over time lead to decent yields (welly, ham, p.n, dun). And once the investors are in, the locals will get worried about 'missing out' and 'getting onto the property ladder' so will pile in and and blow the price up past what investors will be willing to pay, and once again reset yields to a low level that is unattractive to investors, who will then sit and wait until the numbers start working again.
"....in the current market....." means where urban planners are enabling a racket in land on which housing is permitted to be built.
http://www.nzherald.co.nz/anne-gibson/news/article.cfm?a_id=39&objectid…
Land bought in 1995 for $890,000 - owner will sell for $112mAnd:
http://www.nzherald.co.nz/nz/news/article.cfm?c_id=1&objectid=11138332
“A Buddhist trust wants to build a Tibetan temple on a South Auckland rural lifestyle block - with 28 affordable homes for followers.
But objectors say the project will break planning rules and is inappropriate for the location.
A senior Auckland Council planner has also warned the council that allowing the Alfriston subdivision could start a run of religious groups trying to provide affordable housing for their members on cheaper urban-fringe land…..”
The racket is pretty explicit and shamelessly out in the open for all to see there, is it not?
ROFL, way to over think it guys, just more academic attempts to justify the sense of entitlement inherent in the rentier class.
Reality is a bitch, you cant spend more than you earn. When renting, you buy your shelter along with the other necessities in your life with your take home pay and when it is gone you buy no more.
The rent/income, house price/income chart says it all. The peak tolerance at a bit over 40% of gross (yes, gross) income would mean that more than half your take home income went to keeping a roof over your head. No surprise it tailed off as people moved out or increased the size of the household to cover the rent.
You can wax lyrical about ROI as much as you like but, as usual, absent is any mention that those who have paid too much might have to face reality and accept a value as represented by the actual consumer market rather than the speculative gamblers.
Good luck talking it up.
Two points: Rents dont follow House prices as most property investors are hacks (like me) and they dont have the courage to put up rents with existing tenants. But guess what, tenants dont even blink when you show them the rent increase. The second point is about cash flow, i think we fall into a trap that we dont want to lose a week or two of rent so we dont aim for higher rent, but in the long run you are better off losing 2 weeks rent now and making up a better 5% rental cash flow improvement for the following 50 weeks.
the rents do follow the house prices, it's just not very quickly.
It's easy to say "lose 2 weeks now", but when you've had a place empty for 6 months it gets hard to rent out, requires maintenance and cleaning, and if tenants think it's hard covering the rent on their paypackets, it's worse covering that rent loss as landlord.
I follow the principle of reviewing the rent everytime the council puts up it's rates.
fair enough, but if you have a place empty for 6 months then you have chosen the wrong investment property, after 10 years of investment houses i have never had an hour of my properties not being rented, all of them are antique houses (over 100 years old) in auckland CBD (ponsonby, grey lynn & kingsland)
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