Rental yields start to rise as the residential market slows

(Article by John Loos)

In the second quarter of 2016, the TPN-FNB national average gross residential yield rose slightly for the first time since the first quarter of 2014.

The yield rose to 8.62 percent from a revised first quarter level of 8.59 percent.

Although it is early days, a rise in residential yields, after a prior few quarters of slowing rate of decline, appears to be reflective of a slowing home buying market, which has translated into slowing house price growth. At the same time, StatsSA estimates of rental inflation show some recent mild acceleration. The combination should be expected to translate at some stage into rising yields, and it is possible that such a trend is in its early stages.

However, we would be cautious to draw hard conclusions after only one quarter of increase.

The TPN-FNB residential yield dataset is the combined result of TPN rental data, along with FNB’s house price data and its automated valuation model (AVM). The approach has been to take all of the properties for which TPN rental data exists, utilise the FNB AVM to estimate a current value on the property, and then to calculate the gross initial yield on all such properties.

After the -2008/9 recession, the housing market’s gradual recovery of subsequent years finally gained enough momentum to begin to compress yields mildly as from 2014.

By late-2013, home buying demand had reached what was arguably its strongest post-recession levels, with interest rates still at a multi-decade low where prime rate had bottomed at 8.5 percent.

In December 2013, year-on-year house price growth, according to FNB estimates, had reached 8.6 percent. This would be sufficient for some broad yield compression, given average rental inflation languishing at around 5 percent at the time, according to StatsSA surveys.

And so, from a post-recession high of 8.79 percent in the summer quarters of 2013/14, the estimated national average yield slowly declined to 8.59 percent by the first quarter of 2016.

Now, after over two years of gradual interest rate hiking by the SARB (Reserve Bank), and into the fifth year of broad economic growth stagnation, it may well be that the home buying market has lost sufficient momentum for yields to begin to rise, and the second quarter of 2016 saw such a very slightly rise from 8.59 percent previous to 8.62 percent. And there certainly appears to be an argument for yields to rise, given their currently low level relative to where mortgage loan borrowing rates are.

We emphasise that the yields calculated in this report are gross yields, meaning that landlord operating costs associated with the property have not yet been included in the calculation to get to a net initial yield.

Rode and associates have in the past suggested that as a rule of thumb, one should subtract 1.5 percentage points from a gross yield to allow for home operating costs, to get to a net yield. That would imply that the national average net yield could be as low as 7.1 percent, given the gross estimated yield of 8.62 percent. This level would not appear overly attractive, given recently low capital growth on housing, and the fact that a prime rate at 10.5 percent translates into an average mortgage lending rate near to 11 percent.

Not surprisingly, therefore, buy-to-let home buying has moved broadly sideways since around 2012, rarely moving out of single digit territory when expressed as a percentage of total home buying, according to the FNB Estate Agent Survey. The most recent estate agent survey for the third quarter of 2016 did show a slight rise to 10.1 percent, from 7.6 percent previous, but such fluctuations on a quarter to quarter basis can be largely volatility rather than the start of a significant trend. And 10 percent in a relatively thin market compared to the pre-2008 boom years implies slow growth in available rental property on the rental market.

While moderate buy-to-let home buying implies moderate growth in available rental space, the rental demand fundamentals may be strengthening of late. We say this because the combination of interest rate increases and less certain economic times appears to be putting the brakes on first time buying. In the third quarter 2016 FNB Estate Agent Survey, estimated first time buying slowed to 18 percent of total home buying, down from the prior quarter’s 21 percent, and now significantly below the 28 percent multi-year high reached in the second quarter of 2014.

When aspirant first time buyers hold off on their home purchase due to a less certain economic environment, many remain in the rental market for longer, thus driving stronger demand for rental property. This can ultimately contribute to stronger rental inflation as well as slower house price inflation in such times.

The rental market has yet to set the world alight, but StatsSA rental data has shown a gradual acceleration in average rental inflation since 2012, from 4.26 percent in mid-2012 to 5.3 percent year-on-year by mid-2016.

This is not a strong acceleration, but with average house price inflation having recently been slowing, the combination may be just sufficient to start the ball rolling in terms of a national average yield increase, and ultimately a more attractive buy-to-let opportunity.

Looking to the near future, we would indeed expect a gradual further rise in residential yields. SA is well-into its economic super-cycle stagnation, which can be a more volatile and uncertain period socio-politically too. This environment should typically bring about a less confident and more conservative household sector. Certainly, the recent weakness in the FNB-BER Consumer Confidence Index appears to reflect this, and we believe that we are seeing signs of more conservative households in various of our residential market surveys and data emerging too.

Such an environment can be beneficial to an extent for the rental market, as a greater portion of aspirant home buyers adopt a wait-and-see approach, postponing home buying, and renting for longer. The declining first time buyer percentage is one indicator of such an attitude emerging. As yet, we have not seen major movement in the estimated percentage of sellers selling to downscale due to financial pressure, which recorded 12 percent in the third quarter 2016 FNB Estate Agent Survey. But it is possible in this economic environment that this percentage could rise, and that a larger portion of this group of sellers could rent down as opposed to buying down.

We believe the economic environment may be turning mildly more in favour of the rental market, and against the home ownership market, which bodes well for a further rise in average residential yields in the near term.

Download the full reports:

- Residential Rental Monitor Q2 2016
- Vacancy Survey 2016
- Property Barometer Q2 2016

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