Are significant rent rises on the way?

ANZ chief economist Sharon Zollner speaks with Sally Lindsay on the outlook for rents and the influencing forces at play.

Monday, October 18th 2021, 6:00AM

It sounds a bit like a perfect storm. House prices have surged along with debt. Policies favouring first-home buyers may be crowding out rental supply.

Regulatory costs (and risks) for investors have risen. Interest rates are rising and landlords can no longer deduct this cost.

And rental yields have fallen to low levels – possibly weighing on the incentive to build more rental properties – at least from a cash flow perspective.

Does this mean rents will go up?

Even though the Government has stuck with its plan to remove mortgage interest as a deductible tax expense, ANZ chief economist Sharon Zollner says rents will rise but not markedly.

“There are constraints to rent rises. Chiefly, landlords need to balance these forces against tenants’ ability to pay.

However, benefits and wages have risen and she says it is fair to say, the solution to rising rent pressures isn’t tighter regulations on landlords, it’s more supply of housing generally.

ANZ estimates there is a housing shortfall of 65,000 homes.

Although this is reducing as more dwelling consents are issued – construction is going gangbusters and immigration has all but stopped constraining new demand for houses.

Yields falling

From an investor’s perspective, rental yields have fallen quite sharply over the past 18 months or so following interest rates lower, says Zollner.

As interest rates fall, future benefits associated with home ownership become more attractive – both relative to other investments and due to lower mortgage costs.

As a result, house prices tend to rise and rental yields fall – even if rents themselves are unchanged or are increasing.

But rental yields don’t capture the full story when it comes to an investor’s decision to buy a property. The opportunity to add value and/or expectations of capital gains are also relevant.

Capital gain is a non-cash flow benefit that’s only realised when the property is sold, possibly with tax to pay. So, to the extent that investors have operating costs to cover, rental yields are pretty important.

Falling yields over the past year have been a broad-based phenomenon.

However, at about 2.6% in Auckland versus 5.5% in the West Coast, there is considerable regional divergence.

Zollner says that’s to be expected as different regions will likely carry different expectations.

With yields lower in areas where house prices are already high relative to incomes, and capital gains might be expected to be higher, and where market liquidity risks are lower.

“It can take literally years to sell a house in a small town, and houses trade at a discount accordingly.”

She says overall, falling rental yields are exactly what is expected as interest rates fall.

But now, with yields low, construction and land costs high, and policy seemingly getting tighter by the year, it’s not clear the private sector is well-incentivised to invest in building new rental properties.

In some regions, given land and construction costs, it’s now literally impossible for the market to build “affordable” houses to meet the needs of lower income buyers.

And rental yields on new-build properties at that end are also decidedly unappealing.

“That suggests the Government will need to keep its social housing construction pipeline going at full steam ahead for a long while yet.”

What determines rents

While aggregate housing supply relative to demand is important, it’s certainly not the only factor that influences house prices and rents, particularly in the shorter run.

House prices and rents don’t always move together.

Houses are long-lived assets providing a stream of imputed or actual rents, meaning that house prices capture both current and expected future demand and supply of housing.

Relative to rents, house prices are also affected by expectations of population growth, the responsiveness of future housing supply, credit availability, interest rates, and at times animal spirits – commonly being branded as FOMO.

Policy settings are an important overlay for rents too, as they can add costs and uncertainty to landlords.

They may also directly or indirectly shift the rental supply and demand balance by impacting either new supply and/or how the existing housing stock gets utilised, says Zollner.

And these don’t have to be policies directly targeted at investors.

For example, policies that favour first-home buyers at the cost of investors could result in fewer properties available for rent ¬– as the former sell houses to the latter.

“Of course, less supply would generally signal higher rents and that signal should eventually lead to more construction of rental properties.

“But building supply is highly constrained, and while many investor-targeted policies have carve-outs for new builds, the general direction of policy change in recent years adds considerable uncertainty to the mix.”

Uncertainty and investment are not the best of friends. Further to this, says Zollner, there is little evidence to suggest rental yields are on the incline in an absolute sense – quite the opposite, in fact.

Rental yields may still be attractive to some relative to other investments – particularly if investors are anticipating capital gains.

Though ANZ has significant reservations about that approach with the 30+ year tailwind of falling interest rates now behind investors.

“Other policy changes, such as the removal of interest deductibility, increased tenant rights, Healthy Homes standards, while all well-meaning, are not without externalities.

“For investors these also represent a structural shift in the calculus of property investment,” she says.

“But even if we were able to isolate and account for all these dynamic forces that put upwards pressure on rents, there’s still one important constraint to rental inflation to consider: the income of renters and therefore their ability to pay.

“Generally speaking, landlords don’t want vacant properties, and therefore price their rental accordingly.”

A renter’s perspective

The 2018 census showed home ownership rates were at their lowest since the 1950s – just over 1.4 million people were living in rental housing.

For these people, based on median rents and income, rental affordability has gone in the wrong direction over the past year or so.

According to a Statistics New Zealand report more than 40% of renter households spend more than 30% of their income on housing costs.

Auckland’s median rent actually isn’t the most unaffordable in the country.

Northland takes that spot, while the West Coast is the cheapest. But again, income distributions will matter a lot.

The same report also shows that housing costs are much lower for those who own their home.

Given how dramatically house prices have risen relative to income, the prospect of a renter eventually switching to home ownership is being eroded from both ends.

“That is, assuming debt servicing is not an issue, rising house prices are increasing the amount of savings required for [a] deposit at a time when rent is eating up more income,” says Zollner.

“All up, the state of housing affordability in New Zealand is grim, and has deteriorated dramatically in the past 18 months.

“While the increase in the cost of renting relative to income has been less dramatic than the rise in the cost of buying a home, both of these factors adversely affect certain cohorts ¬– chiefly lower income earners and younger people – at the benefit of capital gains-earning owners, who skew older,” she says.

“Housing supply policy changes are the key to fixing this, though it can’t be denied that there are trade-offs between going all-out on building anything anywhere, and long-term liveability.

“In some cities, it’s really hard. And climate change makes it even harder.”

Zollner says while lower interest rates have obviously contributed in a cyclical sense, it would all be a lot less bonkers if the fundamental housing undersupply problem didn’t exist.

Long-term migration targets are another factor to consider closely, given our extreme growing pains, but obviously that’s a moot point for the moment.

The outlook

There are many forces at play that make the outlook for the rental market uncertain, she says.

“Population growth is obviously weak, and will remain so as long as the borders are closed.

“Adding to that, the pipeline of new homes coming on stream is seeing the overall housing supply-demand imbalance improve gradually.”

The removal of interest deductibility for investors, however, means rising interest rates will put more upwards pressure on rents than before.

Zollner says other policies favouring first-home buyers or adding costs and risk to landlords may also lead to higher rents and/or lower rental supply than otherwise.

“All the while, low rental yields, combined with high land prices and construction costs, are likely diminishing the incentive to invest in additional rental accommodation – at least at the margin.”

When it comes to the outlook for rental inflation, Zollner says the expectation is that this can’t exceed the pace of household incomes for a sustained period.

The bank’s forecast for relatively robust, but not off the chain, wage growth, suggests rent inflation is likely to accelerate a little further over the year ahead, but not markedly.

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