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  • Writer's pictureCOMPASS

The residential risk: five things to consider before you seal the deal

An article courtesy of Cromwell Property Group.

Spring is usually one of the busiest times for residential property sales. Despite there being fewer homes on the market this year, the COVID-19 pandemic has done little to stifle the property markets.

Across the country, residential house prices rose by 18.4% in the 12 months to July, property researcher CoreLogic reports. Apartment prices grew by 8.7% over the same timeframe.

Index results as at 31 July 2021

This strong price growth, coupled with low interest rates reducing borrowing costs, has enticed investors into the market. Figures from the Australian Bureau of Statistics show the total value of new home loans to investors more than doubled over the 12 months to May 2021.

Approach with caution

Fast-rising prices and low interest rates make residential housing sound appealing, but investors should beware of the potential downsides.

Rental growth has failed to keep pace with rapid price rises, lowering the yield on property investments. SQM Research data shows that in August 2021, gross rental yield on houses and units in Australia’s capital cities were the lowest they have been in over a decade.

Additionally, the tax benefits associated with negative gearing are diminishing with current historically low interest rates. Negative gearing allows any net rental loss that an investor incurs during the financial year to offset income from other sources, such as salary, hence reducing the overall tax liability.

Escalating prices and a competitive market for homes means there is currently a risk of over-paying for an investment property, reducing the potential for capital growth and profit on eventual sale.

A big commitment

Buying a residential property is obviously a significant investment. According to Domain’s June house price report, the median house price in Australia is close to $1 million, while the median for apartments was more than $600,000.

Investment property loans typically require a higher deposit than owner occupied home loans, meaning that investors must commit a substantial sum to buy upfront. Tying up such a large amount of capital in a single asset can leave investors exposed to risk. For example, changes to the appeal of the local area may make it difficult to attract tenants or can potentially reduce the value of the property.

Spread your investments to manage risk

To mitigate risk, investment professionals recommend diversification. This involves spreading capital across a range of different investment types (such as shares, commercial property, infrastructure, and bonds), or investing in a larger number of similar assets through a pooled investment trust or managed fund, for example.

The theory behind diversification is that if any individual investment loses value or produces a lower return than expected, that loss is compensated by gains in other investments. As the old saying goes, don’t put all your eggs in one basket.

Property in self-managed funds

Self-managed superannuation funds (SMSFs) are obligated to consider risk and diversification as part of their regular investment strategy review. Regulators view superannuation as a standalone investment, designed for the sole purpose of providing a retirement income for each member of the fund.

Owning a property in a SMSF is different to owning a rental property personally as there are a number of specific requirements and potential limitations that need to be considered to ensure the fund remains compliant. SMSFs that invest in just one or more residential properties need to be able to justify how they are managing risks such as diversification, liquidity and how the investment will achieve varying objectives such as capital growth for accumulators and an income stream for retirees.

With the average SMSF having a balance of $1.3 million and, as mentioned, the median house price being close to $1 million, the numbers suggest the average fund would struggle to justify the investment from a diversification perspective. Investment risk must be spread so any single asset class, including property, does not dominate the SMSF’s risk and returns.

The appeal of the real

There are many reasons why investors are attracted to real estate. Property is tangible and it is comforting to know that a physical, real-world asset sits behind the investment. Real estate also offers investors the opportunity to boost the value of their asset by renovating or upgrading the property, which is not possible in financial investments such as shares or bonds.

Many investors gain exposure to residential real estate with the goal of benefiting from capital growth over the long term, while taking advantage of tax breaks along the way. However, with house prices already high, rental yields at decade-long lows and reduced tax advantages, investors should consider their options carefully.

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