Landlords feeling the pinch

Brendan O'Donovan

House prices have soared while rents have barely moved, leading many to conclude rental property is overvalued. But research by economists challenges that conclusion.

Over the past five years house prices have doubled while rents have risen just 14 per cent.

As a result, rental yields have fallen from nearly 6 per cent to little more than 3 per cent.

Rather than seeing that as evidence of a house price bubble, Westpac economists Dominick Stephens and Brendan O'Donovan argue in a report published yesterday that the fall in yields can be explained by a trend towards lower mortgage rates and the rise in the top income tax rate in 2000.

The return on an investment property is the rent plus the expected capital gain, less expenses. Lower mortgage rates reduce expenses, allowing landlords to accept a lower rental yield while still getting an adequate return.

Tax rates are important because of negative gearing. Often landlords' expenses including interest, maintenance costs and depreciation exceed the rent they get but that operating loss can be used to reduce their tax liability on other income. The higher their tax rate the more they can deduct.

Capital gains make the investment worthwhile and those are not taxed.

"When the top marginal tax rate increased [in 2000] from 33 per cent to 39 per cent those earning the highest incomes had more incentive to get into rental property," they say. And an increasing number of people are in the top tax bracket.

Meanwhile, rents have fallen relative to wages, making renting more affordable than it was a decade ago.

"The tax system is effectively subsidising landlords and the subsidy is partially passed on to tenants in the form of low rents."

The losers are would-be first home buyers who face house prices bid up to reflect the tax break high-income people get from owning rental property, the Westpac economists say.

They recognise that not all landlords are in the top tax bracket and not all landlords have a mortgage.

However, Auckland Property Investors Association president Andrew King doubts that the theory is borne out in practice.

"People in the higher tax bracket, like professional people, tend not to invest in property. It's too hard. Property investors tend to be people on more modest incomes."

And banks' appraisal of risk limits the extent to which people could take advantage of negative gearing. But King agrees with the economists' conclusion that rents may be set to rise faster than they have in recent years.

The Westpac model suggests rental yields have now fallen to the levels justified by the fundamentals of lower mortgage rates and higher tax rates.

King said with landlords' costs rising, returns falling and demand increasing, rents would keep rising.

The gap between the costs of home ownership and renting had grown too large over the past few years and was likely to move back to more historically normal levels, as it had in Australia, he said.

Need for shelter

* Rental yields have dropped to low levels.

* This usually means house prices have risen too high and landlords are being squeezed.

* But economists say it is justified by lower interest rates and higher tax rates which make rental property more attractive as a tax shelter.