Property investors must return to fundamentals

Normalising interest rates require investors to focus on fundamentals.

Risk-free returns increase

Property investors must shun speculative bets and focus on fundamentals as bond yields have increased. Financial markets are often fairly efficient at discounting the future, and the drop in Australia’s bond yields through 2018 and 2019 was portentous, with the 10-year government bond yield falling to well under 1 per cent through the worst of the pandemic lockdowns.

The fiscal and monetary stimulus tipped in around the world was successful at averting a deep global recession, but also had the impact of driving speculation across many financial markets. That’s changing now.

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Although yields have now begun to ease a little lately, Australians can achieve a risk-free return of 3¼ per cent from a 10-year government bond, and therefore there will be correspondingly less need for highly speculative approaches.

Figure 1 – Australia 10-year bond yield
Figure 1 – Australia 10-year bond yield

In the U.S. many of the high-growth tech stocks have lost more than half of their value this year, and cryptocurrency markets have also experienced considerably less fervour.

The world remains in a state of flux, and you wouldn’t like to say with any confidence what will happen to interest rates and bond yields from here, but in the second half of 2022 inflationary pressures from rising rents and energy prices will see the cash rate target increasing in Australia.

Focus on fundamentals

Property investors should take a 10-year view, take stock of the fundamentals of the housing market, and take the opportunity to strike as more choice and listings come on to the market. Of course, in the short term, there is always going to be some uncertainty.

But with the unemployment rate at the lowest level in nearly 50 years and likely to fall further, national rental vacancy rates at extremely low levels of around 1 per cent, and population growth like to power back up to at least 350,000 per annum, there will be strong opportunities to generate excellent investment outcomes over the coming decade.

The unemployment rate at the lowest level in nearly 50 years and likely to fall further, national rental vacancy rates at extremely low levels of around 1 per cent.
Figure 2 – Unemployment rate

Normally we don’t see significant declines in housing prices when unemployment falls and inflation rises, nor when the housing market is as undersupplied as it is now.

While sentiment may be cooled initially by hikes in the cash rate, it’s unlikely that we will see many forced property sales when the labour market is in such rude health. For those with strong negotiation skills, there will be opportunities to negotiate an excellent deal, particularly in the premium end of the market.

Upper quartile price declines

There have already been some price declines as sentiment has cooled, particularly in the upper price quartile of the housing market. Over the past few months prices have eased in the most expensive quartile of the market, largely accounted for by properties in Sydney and Melbourne.

Properties that sell via auction campaigns tend to be repriced more quickly as they sell under the hammer, and higher risk-free returns tend to imply that the higher-priced and lower-yielding assets will see the most significant declines.

The more speculative and illiquid assets can also be hit by higher bond yields.

In many of the lower-priced and regional markets, we haven’t seen any price declines at this point, with stock listings remaining relatively tight.

In many of the lower-priced and regional markets, we haven’t seen any price declines at this point.

The residential construction sector is struggling with capacity constraints and delays and is feeling the significant impacts of higher land, materials, and labour prices.

Overall, property investors should be focussing on the land-locked ‘missing middle’ of the market, where supply will struggle to keep pace with demand over the next decade, and where housing rents are rising by 10 to 20 per cent this year alone.

Gradually we are seeing the cities come back to life as workers return to the office and international students and arrivals return, and we have already noticed a marked upswing in demand for well-appointed units and apartments.

Adverse headlines will probably see vendors become more reticent to list properties as the year rolls on, but there will be more choice and less competition this year for investors ready to strike, with many choosing property assets with gross rental yields of 3½ per cent to 4½ per cent.

We advise investors to focus on buying well and to look at 10-year returns and outcomes, rather than what might or might not happen over the next six months.

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