Rental apartments and Covid-19 – Investors facing equity and cash flow risk
Investors who buy rental apartments that are unsuitable for families are taking an enormous gamble, with both equity and cash flow risk expected to materially increase, according to RiskWise Property Research.
RiskWise CEO Doron Peleg said over the past few years, investors had already dealt with a variety of major events associated with rental apartments, including unit oversupply, credit restrictions and more recently construction defects.
However, he said the latest negative factor was the coronavirus which materially increased the risk for rental apartments, not only for price reductions but also for cash flow and serviceability.
Major events impacting rental apartments
“If someone needed additional evidence that rental properties carry a higher level of risk, in the past few years what we have seen is a series of events that resulted in price reductions due to oversupply of units in many major cities, followed by the credit restrictions on local and foreign investors and then the potential changes to negative gearing and capital gains tax,” Mr Peleg said.
“Last year the news of construction defects created major reputational damage to the whole industry, even in areas which weren’t affected, and now we have Covid-19 which also has a potential impact on property prices and serviceability.
“In fact, we have already seen an impact with a sharp reduction in auction clearance rates over the past couple of weekends falling to a preliminary rate of 61.3 per cent as of March 22 across the combined capital cities.
“Meanwhile, the Westpac-Melbourne Institute Index of House Price Expectations Index fell 6.6 per cent in March, the largest monthly decline since February last year.”
He said while some investors might feel it was a prime time to buy for long-term capital growth, it was highly likely prices would continue to fall as “things are moving fast”.
Reduced demand for properties
“As of the end of March, on the assumption there are no sudden and unexpected improvements, there are strong indications that a recession is almost certain with unemployment projected to be 7 per cent by the end of the year, and potentially more,” he said.
“The strong connection between employment, population growth and property prices has been clearly demonstrated. For example, in Western Australia due to continued weakness in the labour market, the state’s annual population growth of 1 per cent is low and, as a result, the housing market, particularly units, has also experienced continued weakness in recent years.
“In addition, population growth will further decelerate. The annual population growth has already slowed in the September quarter from 1.53 per cent to 1.48 per cent, due to reduction in external migration.
“With Australia closing its borders and the now dire economic projections, it is highly likely there will be a significant reduction in external migration. If Australia has a relatively high unemployment rate and it is far harder to find jobs, particularly for migrants with no local experience, then obviously not only is the ability to move to Australia reduced but the attractiveness of Australia is also falling.
“If Asian countries are bettered recovered and have better opportunities then they become more attractive than Australia especially as, generally speaking, a stable job market is fundamental in external migration decisions.
“While it is a bit early to say what the price reductions will be, if these projections are correct, they will be highly likely across Australia as unemployment and underemployment materially increase. And this is the first problem for the majority of people when they buy an investment property because the key driver is long-term capital growth and not cash flow.”
Cash flow risk materially increases
Mr Peleg said, however, that cash flow was becoming a major risk particularly for rental apartments where renters were generally younger, often single millennials with no children, who also had more flexibility to either stay with parents longer or make changes to their place of residence.
For example, in the Inner West of Sydney, about 74 per cent of units are rental properties and these are considered fashionable with the “young and trendy” who are now either unemployed or underemployed, making the risk of vacancy higher.
“With all the current stock in the pipeline (in seasonally-adjusted terms, dwelling approvals for the December 2019 quarter increased in several states and territories, especially in Victoria with 26.7 per cent and South Australia with 6.9 per cent), further increases in stock expected, a significant reduction in external migration and a large cohort of flexible renters who are likely to be materially impacted by the labour market … when you take all of this together, there is a higher material risk for rental apartments.”
Houses are less risky
He said while houses, from an investment perspective, also carried an elevated level of risk at this point of time, generally the cohort of renters, especially in the more established suburbs, comprised families and, in many cases, those with permanent full-time jobs.
Reduced buyer demand for rental apartments
According to the RBA, investors can amplify credit and dwelling price cycles especially given they purchase more off-the-plan dwellings than owner-occupiers, meaning they contribute to larger upswings in construction which, in turn, leads to the risk of future oversupply, particularly of units, in some locations.
Additionally, as rental properties are not fully substitute products with owner-occupied dwellings, there is inherent risk associated with them as they do not appeal to families looking for three bedrooms, with outdoor space, close to schools, transport and employment hubs.
“Investors respond to expectations of potential changes as was demonstrated with the introduction of credit restrictions and the potential changes to negative gearing which they started to take these into consideration even before the elections,” he said.
“Now we are seeing changes in consumer sentiment and auction clearance rates. So as these rental properties which are not suitable for families are largely bought by investors, many of them could be high risk regardless of cash flow from tenants as they could also be at risk due to serviceability issues.
“They have the two-fold problem of lower rental return (if they don’t have tenants) as well as their own ability to cover the shortfall between the rental income and the overall costs associated with the property. Even if there is a honeymoon from the bank, it still means while they are not paying the principal, interest will be accrued, and the cash flow will be way below their expectations.
“The bottomline is investors need to be careful at this point of time. First, they should ensure that financially they are in a very strong position to service the mortgage or to potentially address longer periods of vacancy or provide a discount on the rent. Then, if they do want to invest, they should pay a discounted price for the unit to reflect both the risk for a price reduction and the cash flow risk associated with the property.”
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