Are rental properties still a good investment?

  By Mike Ross

For the past few decades, investing in New Zealand property has been like playing the game of Monopoly: buy property as quickly as you can and good things are likely to happen.

The golden age of property investment

To purchase a rental property you could borrow aggressively, use the rental income to pay the mortgage interest costs, and benefit from favourable tax treatment. When it comes time to sell you profited from the significant property price growth, magnified even further by leverage. Here’s a simple example:

1. You purchase a $500k property using $100k of your own money as a deposit (20%) and a $400k interest-only mortgage.
2. The value of your house appreciates at 5% per year over a 10-year period.
3. The rental income from the property is sufficient to cover the property expenses including interest costs. This is helped by the fact that the interest expense is tax deductible.
4. As long as you sell the property more than five years after purchase, you were left with a tax-free capital gain.

In this example, your investment of $100,000 has grown to $414k in ten years, more than four times your initial investment, or an after-tax return of 15% per annum*.

End of an era

Over the last few years, the economics of property investment has become much more challenging:

•  Interest expenses are no longer tax deductible (except in specific circumstances).
• A property investor generally needs a deposit of at least 40%, which reduces the potential returns you can get from house price growth.
• New regulatory and compliance costs on landlords have increased the ongoing property expenses.
• Rental yields, income relative to the value of the investment, have declined as rental growth has not kept pace with house price growth e.g. a property with a rental yield of 6% 10 years ago may have a 4% yield now.
• Mortgage interest rates have recently increased significantly.

The net result of these changes is that rental property owners (with mortgages) are increasingly having to contribute other income to cover the costs of a rental property. We demonstrate this below using another simple example:

1. You purchase a $500k property with $200k of your own money (40% deposit) and a $300k mortgage.
2. The value of the house appreciates at 5% per year over a 10-year period.
3. The rental income from the property is not enough to cover property expenses including interest costs, so you have to supplement it with $12k each year.
4.  If you sell the property more than ten years after purchase, you benefit from the tax-free capital gains.

In this example, your total investment of $320,000 (deposit plus annual top-ups) has grown to $514k in ten years. This is a total return of approximately 6% per annum, still attractive but nothing like the return achieved in the earlier example. Additionally, this return is heavily dependent on house prices growing at 5% per year into the future**.

The table below shows the assumptions for each scenario side-by-side.

Does this mean that rental property is no longer a good investment?

Absolutely not. There are still opportunities to achieve strong returns. However, the economics are now more challenging, particularly when using a mortgage to support the purchase. Interest rates have increased and this expense is no longer tax deductible so it can be significant drain on your finances.

It makes sense to have a mortgage when investing in property if you have a strong income to cover the associated costs. However, it may not be advisable if you are nearing retirement, planning to take parental leave, or intending to reduce work hours.

The section below shows some of the pros and cons of property investment as compared to other investments:

Investment Property

Pros 

     - Steady income
     - Ability to borrow to fund the purchase 

Cons

     -Expensive to transact

     -Cannot partially sell for income
     - Tenant risk
     - Becoming less tax efficient

Investment Portfolio

Pros: 
     -  Diversified across asset classes, sectors, and countries
     - Liquid, inexpensive and quick to transact
     - Ability to generate a steady income with access to both income and capital growth

Cons:
    - Volatility

Many individuals have had a positive experience investing in property over the past few decades. In NZ, investment property has been a primary way for individuals to invest and establish financial security for their retirement. Given recent changes, it is important to reconsider whether the same strategies will work into the future. Although property can still be a successful investment strategy, it is no longer the slam dunk it has been in previous years. As with any investment, it’s important to crunch the numbers, and consider all available options to be sure you are setting yourself up well now and in the future.

*This example is indicative only, and not reflect all of investor’s experiences.

**NZ house price growth has average approximately 6% per year historically but there is a strong case that this growth will not continue into the future given how expensive house prices are relative to incomes.