Forecasting property investing returns: 2023-2033. What can we expect?

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What if you could double your real estate investment in a decade? Join our host, Stuart Wemyss, as he ventures into the rich field of residential real estate returns, dissecting the figures to expose a fascinating average decade-long return of 9.7%. He pulls apart this promising percentage, exploring its components of 7.3% capital growth and 2.4% net rental yield. Yet what lies behind the volatility of these returns? Wemyss will take you through the highs and lows of the past four decades, bringing the figures to life with his insightful analysis.

But that's not all. We're also delving into the complexities of the Australian rental crisis and the impact it's having on private landlords. Why are they exiting the market? How is above-average rental growth influencing capital growth? And what actions can the government take to encourage more private investors? We're going to analyse these critical issues in detail. Lastly, we turn to the future, projecting the potential wealth impact in 10 years. This episode is packed with in-depth analysis and insights that could potentially have a significant impact on your investment strategy. Prepare to see your real estate investments in a new light.

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Transcript

Stuart Wemyss: 0:00

Hi, this is Stuart Wemyss and welcome to the Investopoly Podcast. My goal is to give you simple, easy to understand strategies, insights and tips to help you master the game of building wealth, and in this episode I thought it would be interesting to consider what investment returns I think are realistic to expect if you invest in residential real estate and, of course, to sort of frame these expectations. I think it's really useful to look back over history to see what does the evidence show us, and so I spent quite a bit of time over last week doing that. And what I did is I looked at the rolling 10-year investment property returns since 1982. So four decades of data there, really smoothing the return over a 10-year period. So that's sort of again, what we're trying to do is set an expectation for what the next decade will deliver.

Stuart Wemyss: 0:53

There's always a lot of commentary with respect to property prices and movements and expectations in short term. So you know, will property prices rise or fall over the next 12 months, and so forth? Well, that might make for an interesting topic to read about or discuss, and certainly media like it. I don't think it's very useful for property investors, because few property investors are going to say, well, I might go and buy a property tomorrow and then I might sell it in two years time Normally and I would certainly counsel people to take this time horizon but normally people are thinking, well, I'll hold the property for 10 plus years, and so therefore I think it's worthwhile to look over those sort of longer time periods. And so what I did is I looked at the median house price on average for Melbourne and Sydney so just the two key kind of capital city markets and also looked at the median rental yield for a house as well, and I reduce that rental yield by 30% to account for expenses associated with property. So I think 30% is the right number of, certainly from my experience, in terms of what net income you might receive from a particular investment. And remember, your return is going to be a combination of those two things. There's a capital growth and then the rental return after expenses, but of course before interest, because how you fund your investment is up to you. That's what the asset class will deliver, and so there's a. I drew a chart, which of course, you're going to find the link in the show notes to that blog. That includes the chart.

Stuart Wemyss: 2:26

But there's just a few interesting observations I would like to share with you from that analysis and I should say, whilst we're only looking at Melbourne and Sydney here, because I didn't want to sort of make the data too confusing I would imagine that the total return amounts won't be that much different to other capital city markets. I mean, they'll be lower, but not materially different necessarily. So here's the observations Over the past 40 years. The average decade long return is 9.7%, consisting of 7.3% in growth and 2.4% in net rental yield. So that kind of makes sense. We've always assumed that most of your returns going to be in capital, less in income. If you invest in property and I'll point out that this is median price data and if you apply the principles that make a you know the characteristics that make a property investment grade you should be able to achieve returns in excess of this, and the returns are you're most likely to exceed are the capital growth returns, not necessarily the income returns.

Stuart Wemyss: 3:33

Okay, so let's look at the volatility then. So the minimum decade return over the last 40 years was this is a rolling decade return was 4.7%, and that was between 1989 and 1999. That includes the early 90s recession that you know, the recession that we had to have, apparently, and the maximum return was 13.6% and that was between 82 and 92. So there was a in the 80s property did incredibly well, despite capital gains tax being introduced in the middle of that decade At two thirds of the time. Your average decade return will be between 7.7 and 11.7%, so there's not a lot of volatility, particularly if your whole property for you know a decade or more, which again kind of makes sense because it smooths out returns and that's not unique to property. Of course it's similar with the share market, although the share market does have much higher volatility than property does.

Stuart Wemyss: 4:34

It's interesting to note that growth and incomes are capital. Growth and income tend to be negatively correlated. So that means that if property investors experience a decade of lower than average growth, they tend to be compensated with a decade of higher than average yield, and the reverse is true as well and that's important to that. That observation is important when we sort of frame our expectations for the next decade. It's interesting to note that the recent periods are between 2009 and 2021. So that period there, which is 12 years, resulted in below average growth or below average growth and income. So total return of less than 8% per annum. Remembering the long term return is 9.7. So that's 20% below that long term average and it's just because of the COVID boom, both in spiking prices and then spiking in rental yields more recently have made up for a little bit of that lost ground. So, again, putting in perspective, when people talk about property prices during COVID and rental yields rising, where you put it in perspective, actually investors over the last 12 to 14 years haven't below average returns, and so that's important to note because mean reversion will kick in at some point. And remember, mean reversion means that returns always revert to their main, all their average, which means that if we have had a period of below average returns which we have then it's likely that in the future we'll have a period of above average returns. When that period of above average returns begins is unknown, but obviously the longer the period of below average returns persists, for the more likely that you will enter soon a period of above average returns.

Stuart Wemyss: 6:25

Now, given rental yields are a hot topic at the moment in terms of the rental crisis and rental incomes rising and so forth, I thought it would also be interesting to have a look at rental growth over the past period and past number of decades, and again, I calculated the rolling 10 year growth in rental yields because rental yields can be a little volatile. They'll have maybe a couple of years of strong growth and then a couple of years ago in sideways. So it's kind of good to look over sort of a decade long period. And again, that chart is in the on the blog on the website and the average growth in rental over a decade rolling period is 3.7%. So that means yields rental yields in a normal environment are growing faster than inflation, but certainly not keeping up with the growth in property prices. And so therefore, over time really rental yields are coming down as a percentage of the value of the property, which makes which makes sense because you know if a $2 million property today is going to rent for $800 a week, if that property is worth $4 million in 10 years, you know you're not necessarily going to get $1600 a week as a percentage of the market value. Your yield will compress over time, which again makes sense.

Stuart Wemyss: 7:45

Now, when you look at that decade rolling decade growth rate in rental yields, it shows that the average has been it's been below average for the decades ending 2017 through to 2023. So really, since 2007, rents haven't been rising. I've been rising less than what they have done in previous decades and, in fact, before 2007. So, yes, rental yields are rising strongly at the moment. Yes, it's a problem that needs to be solved because, you know, renters, from a financial perspective, tend to not be in a position where they can afford to continue to pay more, so you need to protect those vulnerable people. But, from an investment perspective, investors have been taking a bit of a haircut in terms of rental income. Certainly, for almost the last 20 years of the, you know, the rental growth has been less than average. So we're really just again making up for lost time and markets will move in cycles, of course, so we'll have cycles of below average and above average, and certainly the decades between decades ending 2008 through to about 2017, we had above average growth in terms of rental income. So, again, a bit of mean reversion here, but it's good to put a bit of long, longer term context around it.

Stuart Wemyss: 9:07

So let's talk a little bit more about the rental crisis then. I mean it's clear that there's a shortage of private landlords in Australia, the national vacancy rate dropped below 1% last month, which is a record low, and certainly in some states like Adelaide and Perth. The rental market is even tighter than that. They've got vacancy rates below half a percent, which essentially means that there's no vacancy really, and over the past year in some states rents have risen by more than 10%. So we're certainly seeing a lot of rental growth. I think it's very likely that it will continue until there's an increase in private landlords.

Stuart Wemyss: 9:46

So obviously a lot of private landlords have exited the market over the last couple of years. They've sold out of their properties for a bunch of different reasons could be higher interest rates they could have just wanted to take the opportunity to cash out, why prices were sort of booming and also tighter tendency laws, I think, which dissuade investors from renting out their properties, I think have also sort of played a role. And then you've had some land tax changes. So there's been a lot going on. It's difficult to put your finger on just one thing why private landlords have been selling up their investment properties, but they certainly have. And whilst we can build more properties, we really need to have those existing dwellings converted back into rental properties because of those investors that left the market over the last period of time. But it's important to know that history tells us that if we're going to experience higher than average rental growth, that typically won't. At the same time, we can't expect higher than average capital growth. So it's likely then, at least the next period of time, the next few years, we're probably likely to get okay capital growth, but a lot better income growth over that period of time. So I thought I'd talk a little bit about what we can do, or what the government can do, to solve the rental crisis, because I think it's important to consider that when framing our expectations for future returns, because that will have an impact on what the future returns will look like.

Stuart Wemyss: 11:13

The first thing that must be changed is borrowing capacity needs to be loosened off. So banks must impose a 3% buffer on top of a prevailing interest rate to assess a person's borrowing capacity. That means that prospective loan commitments are calculated at 9.5% to 10% on a principal interest basis over a 25-year period, which means that the loan repayments under that assessment are massive. They're huge and, to put it simply, I worked out that an investor must demonstrate that they've got an annual surplus cash flow of $67,000 after tax to be able to borrow $1 million for investment purposes. That's almost really $100,000 pre-tax to borrow $1 million, so there's not a lot of people out there that have that much surplus cash flow or can demonstrate they've got that much surplus cash flow and, as such, you've got a lot of willing-enable property investors that are kind of locked out of the banking system, unable to borrow and therefore unable to invest in property.

Stuart Wemyss: 12:15

And when we look at this borrowing capacity assessment on a reality perspective, if you look at, what does that actually mean? If we're going to calculate repayments at 9.5% on a principal interest basis over 25 years in a practical term on an interest-only basis, what does that mean? And essentially it is the same as assuming that the cash rate is over 10%. Now, the cash rate is never going to get over 10%. So we really need to make this borrowing capacity assessment more realistic and logical and I'm suggesting that the benchmark interest rate should be capped at, say, maybe 9% on an interest-only basis, which means that, okay, we can assess someone's borrowing capacity, but let's not assume that repayments are going to exceed 9% on an interest-only basis, because if you do, what happens is you lock people out of the market and actually for wealth equality it's not good, because people with very, very strong incomes aren't impacted by borrowing capacity things like this, but people with weaker incomes are, and so the rich get richer and the poor get poorer, of course, because of these sorts of policies. So that's the first thing that needs to change is borrowing capacity. It needs to be capped, and that's an easy fix and an easy change.

Stuart Wemyss: 13:28

Now, if loosening borrowing capacity isn't enough to solve the rental crisis and encourage private investors back into the market and remember, things like tenancy laws and land tax and so forth add a layer of cost and compliance and risk onto being a property investor, and so maybe what investors are doing are looking for better compensation for some of those things, and so I wrote an article for the Australian newspaper over the weekend. I put forth a few suggestions of what the government could do what the federal government could do to incentivize more private investors to come into the market, and what I was suggesting there is perhaps reduce the amount of capital gains tax that you might pay on your investment property if you hold it for a long term. So if you're a long term landlord, maybe you should get some concession from capital gains tax, and I had three different ideas. The first one was to increase the general 50% discount, so you're probably aware that if you hold any investment asset for more than 12 months and you sell that asset and you make a capital gain, that you can reduce that capital gain by 50% and therefore you only pay tax on 50%. Well, what I was suggesting is maybe if the landlord rented their property or was available for rent for 10 continuous years, that they could have an additional maybe 10% or 15% discount. So they discount the gain by 60% or 65% to sort of ease that capital gains tax burden.

Stuart Wemyss: 14:58

The next idea was in at the moment, if you sell a small business, you can use you might be able to use small business tax concessions, which essentially allows you to roll the capital gain into your superannuation and avoid paying any capital gains tax on the sale of your business. And they're very generous provisions and they really were drafted to suit people that you know that invested in their business and that was their nest egg, that was their super, if you like, and so by taxing that less allowed them to fund their own retirement and therefore they were less of a burden on the welfare system. Well, you could have similar concessions for property investors and to say, for example, if you go and sell your investment property instead of paying capital gains tax. If you roll those monies into super, you won't pay any capital gains tax. So similar to the incentives are already offered to small business owners. Maybe you could extend them to property investors.

Stuart Wemyss: 15:57

And lastly, another change they could make is allow expats to living overseas. So Australian citizens that are working overseas currently don't get access to the 50% capital gains tax discount. So therefore, if you've got a Australian working overseas, they're disincentivised to invest in Australian property while they're overseas because they'll pay a lot more tax on the capital gain for that period that they were a non-tax resident. So to reinstate that 50% discount, particularly for Australian citizens or permanent residents, I think makes sense and encourages then people that are working overseas to bring their money back home, invest it in the Australian property market and of course, if they do that it's not going to be for an unoccupied purpose. It will then increase the pool of rental assets. So there are some of the changes that the government could look at if loosing borrowing capacity doesn't really work.

Stuart Wemyss: 16:53

And again, the way I view these is it's sort of additional compensation for the other taxes and obligations that property investors have had to deal with over the last few years, particularly because of state legislation and something that the federal government can do, but they should only ever do it as a last resort. So they should really try to do everything else first, because I really don't like it when governments kind of interfere in a free market, and I also don't like it when a different type of asset attracts a different type of tax treatment, so it rather property and shares and commercial property and everything else be treated the same, as opposed to sort of having some unique incentive just for residential property. So I'd like to avoid that if possible. But again, the rental crisis needs to be solved, so this could be the lesser of the two evils in terms of providing those incentives I just sort of suggested. Okay, so to wrap it all up, what do I expect in terms of future returns over the next decade for residential property investors?

Stuart Wemyss: 17:55

Well, I think over the next couple of years, they can expect to enjoy strong growth in rental incomes and together that they still achieve some okay capital growth. But capital growth might be sort of in the 4% to 6% kind of range. I don't think it's going to run away on us. However, once this rental crisis thing is solved and remember, it's got to be a combination of increasing in building property numbers, like some new new dwellings, but new dwellings can only be built in areas where there's land supply. Of course, that's not going to solve the full rental crisis. To do that you've got to attract more private landlords, and so if you attract more private landlords into the property market, that then stimulates demand for property and that will then translate to price growth.

Stuart Wemyss: 18:42

So I think over the next couple of years we'll probably be a lot of income, okay, capital growth, and then over the after that's done and private landlords are returning, I think then we'll see stagnant income and a lot more capital growth, and I think over the next 10 years the chances are of achieving a total return of more than 9.7%, which is a long term average.

Stuart Wemyss: 19:06

Is the probability I think is high. How much more? Not really sure, but you don't really need a huge return to have a massive impact on your wealth. You know a 7.2% return in totality after tax will see your assets doubling value every 10 years. So, forgetting 10%, it's going to double in a period of time shorter than 10 years Again, their average returns. So I encourage you to check out some of those charts that I've published on the website and I have a little bit of a longer one this week, so apologies for that, but I hope it's been interesting and a bit of food for thought and of course I look forward to looking back in 10 years time to seeing you know how correct was I in terms of predicting those returns. Okay, thanks very much, until next week. Bye for now.