There have been many discussions on the recovery of the real estate market. Some experts say a new boom is underway, while others predict that a gradual return to growth is more likely. Some even call the recent price hike a "dead cat bounce", predicting that further price cuts will not be far off.
Whichever theorist is right, investors have a second string to their bow – cash flow – which will provide them with a steady source of income even if prices don't go up.
In fact, history shows that when house prices have stagnated or even declined, rents have generally increased dramatically at the same time. This is demonstrated in Figure 1, which shows the average annual rent indexed for houses in Australian capitals relative to the average house price from 1901 to the present.
You will notice that house rents (the red line) have increased dramatically at times when house prices (the black line) did not rise at all, such as during the Great Depression from 1930 to 1936 and the boom of post-war migrants from 1951 to 1969. Indeed, in these periods of our past, new households could not obtain housing finance and were forced to rent instead, which tended to drive up rents.
Rents or prices have always gone up
Figure 1 also clearly indicates that prices rose in our capitals when rents stagnated, as in the years immediately following each world war (1918-1920 and 1946-1950), when soldiers returned have received buy properties and start families.
This brief overview of the historical performance of our real estate market shows us that when prices have not gone up, rents have gone up and, if rents have gone up, prices have generally not gone up.
There were also significant periods when rents and prices both increased, but the only two periods in our history when prices and rents fell at the same time were during the Great Depression and the tightening from the 1960s credit.
These events were both preceded by episodes of excessive housing construction, followed by years of declining housing demand.
Let's move on to the present and we see that house prices have dropped in most capitals over the past year, and in some cities like Perth, Adelaide and Darwin, they haven't gone up for many years, but the rents of the capitals have not increased in any of them. Does this mean that developers have built too many homes too quickly, which has resulted in temporary overproduction in our capitals?
Overdevelopment leads to overhangs of stock
The boom in the real estate market like the one we have experienced recently in Sydney and Melbourne is leading to a rush for new housing projects. These usually start a year or two after the boom, when developers are motivated by the recent price hike. Investors are attracted to the purchase of these new properties as they expect price growth to continue. They are also offered incentives to purchase by agents of sellers and project marketers, such as low deposit bonds and rent guarantees.
The longer a real estate boom continues, the higher the number of new developments, which are mostly high density housing sold off plan. When the growth period ends and demand slows, the rate of construction of new housing begins to exceed demand for them, and developers are left with a backlog of unfinished and even unstarted projects, to which they are committed. This is when supply exceeds and demanded prices and rents fall, especially in the more developed suburbs.
Booms in the real estate market, as we have recently seen in Sydney and Melbourne, are leading to a rush for new housing projects
Although such periods of real estate overproduction are quite rare and short-lived, this is exactly what our main urban markets have known for two years.
However, while the rate of housing development lagged behind demand, it eventually slowed down, and it did. The current rate of new home construction in Australia has bottomed out in six years, so the overdevelopment crisis is coming to an end.
The other historical cause of a joint decline in house prices and rents has been a decrease in housing demand following this type of overdevelopment boom. If we are about to enter such a phase, then there is no real prospect of rising rents or prices in the near future.
On the other hand, if our population continues to grow, then we can be sure that rents or prices, or both, are about to rise again.
Population growth reaches a record level
Population growth is an important dynamic for generating demand for housing, for the simple reason that we all need housing.
This request could relate to the rental or occupation by the owner, of units or houses, but as our population increases, we need more housing. Figure 2 shows the annual population growth rates of our capitals since we became a nation in 1901.
This growth rate ranged from collapse during the two world wars to peaks in the years immediately following their end, but the important thing is that our population has always grown. We have the highest annual national population growth rate of all Western countries, at 1.6%, and it is obvious that the cause of our poor performance in the real estate market is not a lack of demand for housing but too much supply.
While our national demographic growth is currently 1.6% per year, the growth rates of our three largest cities – Sydney, Melbourne and Brisbane – are much higher, as shown in Figure 3.
Such high rates of population growth have not been recorded in these three cities since the demographic explosions of the post-war baby boom years of 1948 to 1969. New residents of the Australia also shows a clear preference for living in big cities, and the reason is that most of our population growth (around 65%) comes from permanent arrivals abroad.
Many of these new residents prefer to live in the three major cities because they offer immediate employment, housing and good public transport facilities. They also have ethnically friendly communities where new arrivals can shop, adore and educate their children according to their social and religious customs.
Permanent arrivals now come from countries like Iraq, Syria, Pakistan, Nepal, Sri Lanka, Afghanistan, Sudan, Nigeria and Ethiopia, but despite their various countries of origin, virtually all arrivals abroad have one thing in common – they need a place to live.
Because they generally cannot buy property on arrival, migrants rent for a few years, until they are well enough established to secure a housing loan and buy their own house.
Rental yields too low?
All of this would indicate that investors in the cities sought by newcomers should also get high rental returns, but that is not the case – not yet, anyway, as shown in Figure 4.
The reason for the low rental yields is that the amount of recent overdevelopment has led to overhangs of rental property stocks. The excess of vacant housing keeps yields at their current low levels and, with no prospect of steady capital growth, many investors simply put their money into stocks or commodities that can provide better returns.
However, the sharp increase in demand for rental housing from arrivals abroad will soon combine with the reduction in approvals for new housing and result in a shortage of rentals. This is when yields will start to increase and provide investors with positive cash flow.
Booms in the real estate market, as we have recently seen in Sydney and Melbourne, are leading to a rush for new housing projects
The positive tipping point of cash flow is reached when the cost of owning a rental property, such as maintenance, repairs, rates, services, property tax, fees property management, insurance and loan repayments, is less than rental income. For most properties, this requires investors to obtain a rental return of at least 6%.
Figure 4 shows that the average yield is well below this, so that real estate investors looking for cash flow are looking for short-term rental solutions of the boutique type, such as Airbnb, high resolution rentals and vacation group rentals.
Statistics down – and forecasts of higher yields
While such active rental strategies may appeal to some investors, others prefer a more passive approach to real estate investing, and the good news is that the statistics are irrelevant. Rental yields in capitals have averaged around 11% since 1901, but more recently, the average rental yield of a house in the capital has fallen to just 4.3%.
Yields are well below their long-term historical averages, but the decline in the number of new homes, combined with an increase in arrivals abroad, means that rental demand will soon begin to exceed the availability of an appropriate stock.
It is likely to happen first in the suburbs of the capital most sought after by new households, and it will not be long before investors take advantage of a long-awaited boom in flows cash in these areas.
John Lindeman is an author, educator and commentator on the real estate market
