Positive gearing is becoming Australia's rarest property investment

Profiting from property is now almost entirely down to capital growth, with positively geared properties harder to find than a platypus.

Unlike the platypus, which can detect its prey through its sense of electrolocation, property investors looking for investments in which the rent covers the mortgage are almost in the realm of the unicorn.

Newly released data from Cotality reveals that a mere 0.8 per cent of suburbs nationwide deliver positive returns under current market conditions.

At a time when reliance on property prices rising to make a profit or, for some, avoiding falling into negative equity, is becoming more fraught, rental yields and returns have taken on new precedence.

The removal of negative gearing from anything other than new home builds has also shifted the emphasis towards investment properties that can hold their own when it comes to paying their way on a monthly cashflow basis.

Rents are rising and, at least in Sydney and Melbourne, prices are falling. That boosts rental yields.

But in those cities, rental yields are coming off a relatively low base.

According to data released Wednesday (17 June) by the Real Estate Institute of Australia (REIA), annual yields for capital cities ranged from just 1.9 per cent for three-bedroom houses in Sydney to 4.1 per cent in Darwin. For two-bedroom other dwellings, yields ranged from 3.0 per cent in Adelaide to 5.4 per cent in Darwin.

That miniscule 0.8 per cent of the market delivering positive cashflow are limited to highly volatile property markets, according to Cotality’s Research Director, Tim Lawless.

“Gross yields in Darwin are significantly higher than in the other capitals, but this market has also shown significant volatility in housing cycles, or, in more extreme examples, mining regions like WA’s Pilbara or Queensland’s Bowen Basin tend to show extremely high gross yields, but severe boom/bust cycles in home values.

“The higher yield helps to compensate for risk.”

The reality for Australian property investors is that Australian housing is a low-yielding asset class. 

The gross yield measures annual rental income (before expenses) as a proportion of a property’s value.

According to Cotality, across the combined capitals, the gross rental yield was tracking at 3.45 per cent in May, a little higher for units at 4.47 per cent and lower for houses at 3.12 per cent.

“With less ability to offset rental losses against taxable income, it’s likely property investors will be paying a lot more attention to the yield,” Mr Lawless said.

“Additionally, financiers are already factoring in reduced borrowing capacity for investors and higher holding costs in the absence of negative gearing on established homes.”

Borrowing costs’ impact on cashflow

Rental yields don’t exist in isolation. Interest rates are also becoming a much bigger part of the equation.

During the emergency-low rate environment of 2020 and 2021, investors could often tolerate weak rental yields because borrowing costs were equally low. A property yielding 3 per cent looked far more attractive when mortgage rates started with a two than it does today.

While the Reserve Bank appears to have paused its tightening cycle, borrowing costs remain elevated by recent historical standards.

Even if rates have peaked, investors are still funding acquisitions at interest rates well above those available during the pandemic-era property boom. That means cash flow shortfalls are more noticeable, holding costs are higher and the margin for error is smaller.

In practical terms, a modest improvement in rental yields may not be enough to offset the impact of higher finance costs. For many investors, the question is no longer simply whether rents are rising, but whether they are rising fast enough to keep pace with the cost of debt.

Prospects for rental yields

There is some relief on the horizon for investors chasing stronger rental returns.

Rental yields typically move in the opposite direction to property prices. As housing values rise rapidly, yields tend to compress because rents struggle to keep pace with capital growth. Conversely, yields generally improve during softer market conditions when prices stagnate or fall while rents continue to rise.

That dynamic is now beginning to emerge across parts of Australia.

With housing values easing in some markets and rental growth accelerating, gross rental yields are showing signs of improvement.

“Rental yields tend to be influenced by housing cycles, trending lower as home values move through a growth cycle and rising as home values move through the down phase,” Mr Lawless said.

“Yields usually trend higher through a housing correction.”

Nationally, rental growth has accelerated to 5.9 per cent per annum, while vacancy rates remain exceptionally tight at just 1.5 per cent. Those competing forces – rising rents and softer property prices – are creating conditions that favour improving yields.

Melbourne provides perhaps the clearest example of this trend.

Just two years ago, Melbourne recorded the second-lowest gross rental yields of any capital city. Today, the city sits firmly in the middle of the pack for house yields and boasts the third-highest unit yields among the capitals.

As rents continue rising and housing values remain subdued, yields have steadily improved.

Not all markets are moving in the same direction, however.

In Brisbane and Adelaide, gross rental yields for both houses and units remain at record lows. Perth houses are also recording historically low yields.

The reason is simple: prices in those markets are continuing to rise faster than rents.

While landlords may be collecting more rent than they were a year ago, rapid capital growth is diluting the yield calculation, pushing returns lower relative to the value of the asset.

Investors hoping for a dramatic improvement in cash flow may need to temper their expectations.

According to Cotality modelling, yields are unlikely to rise sharply even if property values soften materially.

Under a scenario where capital city home values fell 10 per cent while rents increased 10 per cent, the combined capital city gross rental yield would rise from 3.45 per cent to approximately 4.27 per cent.

While that would represent a meaningful improvement, it would still leave most properties negatively geared once interest costs, maintenance, insurance, council rates and other ownership expenses are taken into account.

In other words, better yields do not automatically translate into positive cash flow.

Investors in a bind

The challenge for investors is that Australia’s housing market has been built around the expectation of capital growth for decades.

Property has traditionally been viewed as a low-yield, high-growth asset class. Investors have been prepared to accept weaker cash flow because rising property values compensated for the shortfall.

The Federal Budget’s changes to negative gearing may alter that equation.

Without the ability to offset losses on established properties against taxable income, investors are likely to place far greater emphasis on rental returns, holding costs and the sustainability of cash flow.

The question is whether this changes investor behaviour.

REIA President Jacob Caine believes tighter rental markets are likely to place additional pressure on rents in coming years, particularly if fewer investors enter the market.

“In a market where vacancy rates are already at crisis levels, and rents are rising every quarter, the last thing tenants need is policy that reduces the incentive for private investors to provide rental housing,” Mr Caine said.

“Private investors supply the overwhelming majority of Australia’s rental stock.

“Reducing the tax competitiveness of residential property investment in a supply-constrained market will reduce the number of properties available to rent, drive vacancy rates lower still, and push rents higher,” he said.

For investors, that may create an unusual paradox.

While policy changes make property investment less attractive from a tax perspective, the same changes could contribute to stronger rental growth if housing supply remains constrained and investor participation declines.

Ultimately, positively geared properties may remain as elusive as the platypus.

But as rents continue rising, property prices soften in some markets and investors adjust to a new tax landscape, rental yields are once again becoming a critical part of the investment equation.

Like the elusive platypus, the hunt for a positively geared property may still be difficult. But at the very least, the quest for high yield properties is no longer one investors can afford to ignore.