Over the last few weeks, lenders have aggressively cut fixed rates, particularly for investors that borrow on an interest only basis. Three and five year fixed rates now range between 3.18% and 3.40% p.a. This means the cost to hold an investment property is as low as it’s ever been.
This doesn’t mean we all should run out and buy an investment property.
Historic investment property holding costs
The graph below charts the annual after-tax holding cost of a median value house (average of Melbourne & Sydney) expressed in today’s dollars. As you can see, a property’s after-tax holding costs have typically ranged between $10,000 and $30,000 per annum over the past 40 years.
The red line is the estimated annual after-tax holding costs based on current fixed rates.
A $800k apartment will cost $500 per month to hold
Let’s look at the cost to hold an $800,000 investment property (apartment) using actual data as an example.
Therefore, this property, for example will cost you circa $505 per month (after-tax) to hold.
Low rates will likely inflate property values
It is a commonly accepted economic principal that lower interest rates typically lead to an increase in asset values (i.e. the value of equities and property rise). The reason being is that the lower cost of debt means higher profits to owners which means assets are worth more.
The graph below charts three variables:
- The rolling average capital growth rate over 20 years for median houses in Melbourne and Sydney; and
- The cost to hold an investment property (as charted above). This is calculated as the annual after-tax holding cost of a median house based on prevailing interest rates at that time, expressed in today’s dollars; and
- The average rolling 20 year growth rate between 2000 and end of 2019.
This chart demonstrates that periods of higher capital growth have tended to follow periods of time where holding costs were below average.
It may cost you less cash flow to generate similar capital growth rates
As you can see from the chart above, the rolling 20 year capital growth rates have ranged between 4% p.a. and 9% p.a. It’s a big range because of the particular periods of time. For example, the low growth in 2009 measures how property values changed just prior to the early 1990’s recession and during the midst of the GFC – two unfortunate points in history. Similarly, the peak in 2003 measures growth from the early 1980’s when property boomed.
Perhaps the best long-term indicator is the average rate of 7% p.a. The average inflation rate since year 2000 is circa 2.5% p.a., so the real growth rate (i.e. excluding inflation) has been 4.5% p.a. In today’s terms, that equates to a growth rate of circa 6% p.a., assuming inflation will continue to hover at around 1.5% p.a.
Investing in an asset that generates a growth rate of 6% p.a. that only costs $500 per month to hold could produce tremendous financial outcomes.
- Cost flow cost in today’s dollars over 20 years = $100,000
- Value uplift in today’s dollars after 20 years = over $1.3 million
But interest rates will surely rise one day
Of course, the above calculation is academic and as such could be misleading. Lots of things could change, which would change the above calculation. Capital growth rates could be lower, interest rates could rise, the property might require capital improvements and so on.
I freely acknowledge all these factors. The point I’m trying to make is that if capital growth rates remain the same, which I think is likely given population growth and lower interest rates, then the lower holding costs will lead to better overall investment returns. How much “better” will those returns be? Only time will tell. No one really knows.
Low rates can encourage mistakes
Asset mispricing is more likely to occur in lower interest rate markets as a result of the inefficient allocation of capital. Put simply, people, businesses and institutions take higher and maybe less diligent risks because the cost of money is so low. This can include overpaying for assets. Relating this to the property market, it is possible that most property prices will rise i.e. good and bad properties alike.
And, if lower rates lead to higher values, the reverse can be true also. When rates eventually rise, values can fall, particularly for lower-quality assets that don’t have strong fundamentals.
The best way to mitigate these risks (i.e. being caught in an overinflated market) is to level up on quality. This means investing in the highest quality property that your budget will allow. Focusing on quality is vital in all markets, but arguably even more important in a lower interest rate market.
What to do next
As I said above, you should not take this blog as an indicator that I believe everyone should rush out and invest in property. No. I think you should develop your own investment strategy that suits your personal circumstances and risk profile. Then implement that strategy without being too distracted by market conditions.
The point of this blog is to point out that maybe the stars have aligned for property investors due to: (1) all-time low property holding costs (2) low interest rates will which likely lead to higher asset values and (3) improved sentiment in the property market will further stimulate price growth. And if your personal strategy includes investing in property, now could be the time to do it. As always, if you have any questions or need any assistance, we are here to help.
