Low rental yields do not indicate house price bubble

By Andrea Milner

Over the past five years house prices have doubled, but rents have increased just 14%, fuelling speculation that a house price bubble may have developed.

However lower rental yields can be simply explained by lower mortgage rates and the higher top marginal tax rate, compared to the 1990s, says Westpac’s chief economist, Brendan O’Donovan.

Since the 1990s, mortgage rates have fallen and the top marginal tax rate has risen.

Rental yields fall when mortgage rates do, because lower interest rates reduce landlords’ expenses, allowing them to accept a lower rental yield while still receiving an adequate return.

The other factor allowing landlords to accept lower rental yields is higher marginal tax rates, which amplify the tax breaks associated with owning a rental property.

Landlords can claim a tax rebate on rental property losses at their marginal tax rate.

Since 1999 when the top marginal tax rate increased from 33% to 39%, those earning the highest incomes had more incentive to get into rental property. And far more people today are affected by the 39% tax rate than were affected in 1999, so an increasing number of people have that incentive.

“The inescapable conclusion here is that despite all the price rises, despite all the exhortations from the Reserve Bank, and despite all the nay-saying, rental property is not overvalued at all,” says O’Donovan. “Certainly, the residential property market is not inflated by unrealistic expectations of future capital gains.”

Instead, house prices have been bid up to reflect the tax break that high-income people can get from owning a rental, O’Donovan says.

This has also contributed to falling home ownership rates for low and middle-income first homebuyers, who must first outbid a high-income person who is chasing a tax break.

“Rental yields have reached their floor and rental property is fully valued,” O’Donovan says.

“House price inflation for rentals is likely to be much more moderate in coming years.”
 
“And with landlords no longer enjoying such outsized capital gains, rents could rise slightly faster than they have in recent years.”

But one risk is that long-term mortgage rates rise, which could drive down property prices.

And the biggest risk, O’Donovan says, is a drop in the top marginal tax rate, as this would suddenly reduce the tax benefits of owning a rental property and spell a drop in prices.