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'FOMO' is driving residential property prices, not yields

There’s a confluence of events boosting Australian property prices, especially in Sydney, but none is more pervasive than the Fear Of Missing Out (FOMO). All investment markets are driven by sentiment, and when it’s impossible to pick up a newspaper without the latest story on 85% auction clearance rates and smashing of reserve prices, potential buyers change their mindset. They may have trudged from one open house to another in 2012, waiting for the no-compromise property, but now they are jumping in before prices rise further. According to RP Data-Rismark, prices in Sydney were up 5.2% in the September 2013 quarter and 10% since the start of the year, multiple times the rise in average weekly earnings.

A common technique used to promote properties is to quote the gross yield. Purchase price $700,000, rent $700 a week, that’s $36,400 a year or 5.2%. Even better, many inner-city apartments can become part of a short-term apartment letting scheme, like a long-stay hotel. Room rates might be as high as $300 a night during a major event, $200 at other times. That’s double the weekly rent of a lease. It’s a no-brainer.

It’s only when the off-the-plan property settles a year later, or time comes to select an agent and a decent tenant, that many investors face a harsh reality check. The costs are always greater than expected.

The confluence which is creating the competitive forces behind FOMO includes:

  • various first-home buyer schemes and stamp duty exemptions

  • investors moving money out of cash and term deposits into the growth asset class they believe they understand and is not volatile

  • Asian buyers, especially Chinese who are restricted in owning property in their own country. Asians love property and Australia is seen as more stable than Europe or the United States. They often have children studying here

  • SMSFs are the new players, and although the amounts are not high in absolute terms (only about 3% of SMSF assets are residential property and three-quarters of property assets are commercial), it’s a new competitive influence

  • other residential property investors (local non-super) who have regained confidence at a time when unemployment remains low and financing has never been cheaper.

But let’s take a look at the harsh reality check facing many of these exuberant buyers, considering the costs of purchase and owning an apartment with either short-term or long-term rents:

  1. Stamp duty. Stamp duty varies from state to state at about 3-4%. On a $700,000 property in New South Wales, stamp duty is about $27,000. Imagine transaction costs of that amount in the share market. The efficient allocation of equity capital and efficient trading would be compromised.
  2. Legal costs, loan establishment fees, valuations, building inspections, etc. Let’s call it $5,000.
  3. Mandatory furniture package for short-term rentals. Need to set a high standard for someone paying up to $300 a night, so full package for a 2 bedroom serviced apartment say $40,000.
  4. Apartment leasing agent. Between 6% and 15% of gross income depending on the type of leasing plan.
  5. Body corporate administration fees. These are often deliberately understated during the selling period, but there are four killers to watch for: 24 hour concierge, swimming pools, lifts and gymnasiums. Then there’s gardening, fire services, cleaning. A decent building and apartment will cost at least $2,000 a quarter to maintain all these services. No point paying a million for an apartment and not maintaining the building.
  6. Body corporate sinking fund. Again, depends on what is agreed by the body corporate but set for future major capital expenditures, such as repairs or repainting the entire building. Say another $1,000 per annum.
  7. Council rates. Although charged on the ‘unimproved capital value’ of an apartment rather than the land value of a house, it could easily be $2,000 a year on a $700,000 apartment.
  8. Water, electricity, gas. Usually paid by the tenant on a longer lease but by the owner in a short term apartment scheme, rising rapidly and maybe another $2,000 a year.
  9. Vacancy. Long-term leases allow 4 weeks a year, short-term depends on the success of the managing agent or apartment scheme operator. May need to discount rates to compete, especially in winter. Assume short-term occupancy is healthy at 75%.
  10. Apartment cleaning. A 2-bedroom apartment leased for a few days might cost $120 to clean, giving an annual cleaning bill of over $10,000 (assuming apartment rented for 270 nights a year for 3 nights each time, that’s 90 cleans). There’s no choice to clean it yourself, it’s all part of the apartment scheme.
  11. Travel agent's commission. Short terms pay online services such as wotif.com 10% of the rental, and similar for travel agents. Assume paid on half of rentals.
  12. Replacement of furniture and equipment. The short-term agent will say that the apartment looks tired and needs a complete refit. Not all tenants are neat, tidy and careful. Some will have raucous parties, kick a door, smash a vase. After a few years, the sofa will be disgusting, the carpet filthy and the mattress stuffed. Expect to replace the furniture at least every five years, and probably the entire kitchen and bathroom every 10 to 15 years. Everything in the apartment will need replacing regularly, plus painting and air conditioning. Cost per annum, say $10,000 (ignored in the table below to avoid double-counting with original cost).
  13. All the other stuff. Where do we stop! There’s a linen fee, pay TV, PABX, credit card fees, advertising, insurance and postage fee. The agent charges $20 to replace a light bulb, $15 to adjust the TV, $200 to fix the dishwasher, using tradesmen who have a far closer relationship with the agent or building manager than the owner. The apartment will be better maintained than the owner’s home. Call it $2,000 a year on short-term leasing.

At this point, faced with all these costs, administration and paperwork, the apartment owner draws on two sources of comfort: tax savings and capital gains.

First, tax savings. If the property is negatively geared, there is a deduction against other assessable income. Other costs make the tax deduction even higher. What many owners fail to recognise is negative gearing is a polite way of saying ‘loss’. A loss is still a loss, even if tax reduces the size of it. Furthermore, tax is paid in an SMSF at only 15% in accumulation stage or nil in pension phase, so the tax savings are far less than a high marginal tax-paying individual.

Second, capital gain. It is irrelevant to someone buying today that prices are up 10% this year. All that matters is the future. Buy an apartment for $700,000 and sell it for $750,000 a year later and there won’t be much left over to pay for all the hassle. It costs most of the gain to buy, finance, repair and keep it. It’s easy to believe that property prices are one-way traffic, but Sydney has only just recovered in real terms the prices from 2004. That’s almost a decade with no real growth. It’s as convincing to make a case for prices falling in years to come – rising interest rates, increasing unemployment, historically high price-to-rent ratios – as it is to bank on capital gains.

Apartment

Apartment

Of course, any of these assumptions can be varied (including using lower rents and higher costs), but the net rental income from residential investment, ignoring interest costs, is around 2% to 2.5%. Rents do rise over time, but not much in real terms, and so do costs.

There’s a decent chance the day the apartment is bought, when the thrill of owning a property is matched by dreams of income and capital gains, is the highlight of the investment. After the calculations, paperwork and administration are done, taking phone calls from agents saying the toilet needs fixing quickly becomes tiresome.

Like any investment, residential property must be the right asset bought at the right price and the right time, not anywhere based on the need to get into the market quickly due to FOMO. It might be that the recent price rises have already delivered the best returns for some time.

8 Comments
Tony
April 24, 2015

This is a very sobering article. I did a project for a friend who invested in a negatively geared property. It needed renovation to make it habitable for tenants but he did it economically. The property was a freestanding block of units, so no strata fees etc, and he did his own maintenance, gardening, replacing bulbs, and did not use an agent so collected the full rent. This sounds like a wonderful combination to maximise the returns.

The property was sold after 7 years for 50% more than the purchase price, pretty good. The loan was 100%, so maximum leverage. My friend was delighted with the outcome.
When I did the calculations, the return achieved on the money outlaid, ie losses, weeks without tenants etc, he achieved a return of 3.2%pa.

When he considered all the hard work he had put into the his investment he was horrified. I suspect there would be very few investors who were able to calculate their return on investment, so the myth of negatively gearing property as a step to wealth continues.

I have negatively geared into a good, self constructed share portfolio, . The returns are really amazing, it is agile, low cost and flexible. Much more successful in building wealth and far less maintenance and stress.

Faruk
October 15, 2013

The money is lost either way; pay tax - you get nothing; pay interest and expenses -
you get a property.

Warren Bird
October 10, 2013

The aspect of property investing that surprises most people that I talk to in social contexts is the real meaning of 'negative gearing'. Most have some awareness that it means 'the tax man helps pay your mortgage', but that's all.

Then I explain that this comes about because your interest payments aren't covered by your net rental. You make a loss each year, which you are able to be offset this loss against other income. They begin, then, to wonder if this tax aspect is such a blessing after all.

I then point out that for you to end up making a good return on this, the value of the property has to increase by the accumulated after-tax losses plus a reasonable investment return on those losses. Or putting it another way, add the tax loss to your cost base - how much you've invested - and then get a return on that amount which is elevated above the purchase price. The smarter ones then begin to think that it is highly risky.

In times of house price inflation, this can happen of course. Whether the eventual return is really competitive with other assets or not is another matter. My experience tells me that it often isn't and it really depends on the individual property rather than "property" as an asset class delivering.

I'm all for sensibly geared property within a balanced portfolio for many investors. But negative gearing is a spade that should be called a spade, not dressed up as a diamond.

Noel Whittaker
October 09, 2013

Article by Graham Hand is brilliant!!!

Manoj Abichandani
October 08, 2013

Graham

Your article ensures that novices do not enter the game without doing their homework.

I have only only couple of points to make -Firstly, as more renters become house owners - due to lower interest rates - there are fewer tenants in the market place - which means lower rental return and lower occupancy rates.

Further the benefit of depreciation claim is not highlighted as when the property is sold, it is added back, many experienced property investors fail to understand this point.

Lastly, negative gearing should be seen as grossed cost and not after tax - as the same amount can be salary sacrificed in super and lower tax may apply - hence claiming that that property costs only $60 per week (after tax) is incorrect - this should be highlighted.

I want one too or follow the Jones is not new in any society...

Manoj Abichandani
SMSF Specialist Advisor

Peter L
October 04, 2013

Interesting article Graham. We sold our house last month and it’s settling on the 16th. The Asian-based buyers are already asking if they can show it to renters prior to settlement…

We were ecstatic to make back (almost exactly) all our stamp duty and improvements after 3 years. Then we figured out we didn’t make back the real estate agent expense (which is pretty minor, but still), but we still count ourselves lucky.

We love the house we’re renting, and the cash rate on the proceeds of our sale is more than enough to cover the rent – and there’s no stress so far. Getting the house ready to sell was a huge stress. It seems like such a no-brainer after the fact.

I’m glad our buyers didn’t read your article!

Stephen Lazar
October 04, 2013

Very well written with intention / purpose to put someone off investing in property ?

Most of costs quoted are over exaggerated and are on high quality Owner Occupied type apartments with concierge, pools, gym etc which is not your average investors product based on affordability to buy or rent by the majority of population.

The rest focuses on Short Term stay where he has once again blown costs out of proportion, I am aware of one short term providers guarantees just over 7% yield after all expenses (blows this blog out of the water doesn’t it!)

Anyone can write a blog today, anyone can say what they want and quote any figure that suits the purpose of their article

I can give the writer hundreds and thousands of examples right now that will disprove his blog ….

If 'facts' in this blog were accurate, why have the wealthy ammassed a financial fortune by investing in property over the last 150 years and continue to do so?

This is my opinion.

Stephen Lazar

Brent B
October 10, 2013

While the article is clearly somewhat negative, it provides at least some balance for the almost constant, rosy assumptions on property investment in the market place thrown around by those who make far more from selling the dream of property investment than they ever have or will from property investment itself.

Your average real estate agent certainly isn't sharing such facts.

The point is Stephen the average investor is simply not running these numbers, the old one liner from their agent of "property doubles every 10 years, plus think of the tax deductions" is enough for most people.

And what is so wrong with the assumptions for the long term lease scenario??? I too can use realestate.com and while I would suggest the body corp figures could come down, the rest is pretty much on the money for a 2bdrm inner city/west Sydney apartment? Its certainly on the money for what the average investor is buying in my area right now??

 

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