The trend of yield compression, which started in 2014, continued through to the 4th quarter, 2015. This is the finding of the latest FNB-TPN Residential Yields Review.
Through the entire 2015, the TPN-FNB National Average Gross Residential Yield has continued its downward trend which, according to the latest revised estimates, started back in early-2014.
The national average yield declined further from 8.53% as at the 3rd quarter of 2015 to 8.48% in the 4th quarter.
Although the home buying market began to show signs of slowing demand growth last year, to date the market has remained well balanced, with significant supply constraints, keeping house price inflation mildly faster than rental inflation.
FNB and TPN had expected a little more in terms of rental inflation by now, given the trend of gradually rising interest rates. “But against this we have had a very weak economy, and this may be placing significant financial constraints on the tenant population and its ability to absorb rental increases,” says John Loos, FNB Home Loans household and property sector strategist, co-author of the report with Michelle Dickens, MD of TPN Credit Bureau.
Loos expects “better opportunities for buy-to-let investors in a few years when house price growth is slower, and perhaps slower than rental inflation, causing a gradual rise in yields. At present there is limited capital growth, and yields that are in many cases low relative to the cost of finance.
“What slows buy-to-let buying is yields vs interest rates. For some ‘less seasoned’ investors, capital growth is more important, and this doesn’t look wonderfully exciting at the moment. So I would expect buy-to-let buying to be moderate in the near term given the significant financial constraints on the tenant population and its ability to absorb rental increases,” he says.
The TPN-FNB Residential Yield dataset is the combined result of TPN rental data, along with FNB’s house price data and its Automated Valuation Model (AVMs). In short, the approach has been to take all of the properties for which TPN rental data exists, utilise the FNB AVM to estimate a current value on the property, and then to calculate the Gross Initial Yield on all such properties. The latest dataset has undergone considerable revision, as the compilers have converted to an upgraded AVM.
The national yield trend
Looking at the data of the TPN-FNB National Average Gross Initial Yield on Residential Property, back in the 3rd quarter of 2007, the yield was estimated at a lowly 6.46%. That 2007 low more-or-less co-incided with a multi-decade real house price peak, following a house price boom during the prior years. By the final quarter of 2013, the average yield had recovered some attractiveness (from a buy-to-let point of view) to measure a revised 8.78%.
By 2013, however, a strengthening in the home buying market had begun to boost house price inflation noticeably, with home buying in a low interest rate environment seemingly out-doing the rental option in popularity.
In January 2014 the Reserve Bank (SARB) began to hike interest rates gradually, and has continued up until this month, which the authors would expect to boost the rental market and possibly raise yields. However, the pace of interest increase has been very slow and mild in magnitude to date, and doesn’t appear to have yet done much for rentals to date.
Against gradually rising interest rates, is a very weak economy, so perhaps it is a bit too much to expect a significant strengthening in rental demand. Tenants and aspirant tenants also experience the negative impact of a deteriorating economy.
The yields calculated in this report are gross yields, meaning that landlord operating costs associated with the property have not yet been included in the calculation to get to a net initial yield.
Rode and Associates suggest that, as a rough estimate, one can take 1.5 percentage points off the gross yield to estimate a net yield. If one were to do this, it would leave the net yield at around 6.98%. Such a yield would, for many, still be below the cost of finance, given a most recent prime rate of 10.5%, and the average home loan rate somewhere above prime, and therefore perhaps still not overly attractive.
This perhaps explains why the estimated percentage of home buyers being buy-to-let buyers remains mired in single-digits at 9% in the 4th quarter 2015 FNB Estate Agent Survey.
However, the yield versus interest rate on mortgage credit is not the only variable determining buy-to-let attractiveness. It is also important to evaluate the yield versus the investment risk.
In this regard, the authors saw significant broad improvement from 2009 to 2014, with a significant decline in tenant risk following the recession of 2008/9. This was reflected in a rise in the percentage of tenants in good standing with their landlords, to 86% as at late-2014, a big improvement since the huge dip to 71% as at early-2009, around the time of the recession.
More recently, however, while still remaining high, the percentage of tenants in good standing is slightly off 2014 highs, but still strong, at 85% in the 4th quarter of 2015. With ongoing gradual interest rate hiking, and 4 years of economic growth slowdown to date, taking job creation and household income growth weaker, the authors expect some decline in this percentage in 2016.
This is something to watch closely, because while tenant payment performance is currently good, the dip to 71% of tenants being in good standing back in 2009 indicates just how sensitive tenants are to economic cycles and interest rates (interest rates having peaked at 15.5% prime in 2008 and the economy experiencing a recession through late-2008 and the 1st half of 2009).
Perhaps cushioning the blow this time around is a far more gradual interest rate hiking cycle compared to that previous one. Realistically, though, tenants cannot defy rate hiking and economic decline indefinitely.
Regional yield comparisons
Which regions have the best yields? Currently, the principle of higher risk = higher return/lower risk = lower return only appears to hold true when comparing yields of the Western Cape’s City of Cape Town with the rest of the major regions.
As at the 4th quarter of 2015, the 2 major Gauteng metros, namely City of Joburg (9.01%) and Tshwane (8.90%) had the highest yields, with Ekurhuleni a bit lower (8.53%). Similar, was Ethekwini metro (8.53%) in KwaZulu-Natal. At the same time, KZN and Gauteng Provinces recorded the poorest payment performance by tenants of the Big 4 provinces, with 81.2% of tenants in good standing in KZN and 85.4% in Gauteng.
By comparison, Nelson Mandela Bay (8.46% yield), the largest metro in the Eastern Cape, has a slightly lower yield than the Gauteng and KZN Metros, and a higher percentage of tenants in good standing (88.2%) than Gauteng and KZN. But the “Lower Risk = Lower return principle appears to work on the Western Cape, where Cape Town has a noticeably lower yield than the rest of the country’s metros, to the tune of 8.03%, along with the Western Cape having the highest percentage of tenants in good standing at 88.7%.
Segment yield comparisons
To gauge comparative yields by price segment suburbs have been segmented based on the average value of the homes in them, into 5 “area value bands”.
In Lower Income Areas (average home value below R600,000), the Median Yield was estimated at 9.27% for the 4th quarter of 2015. In Lower Middle Income Areas (average home value from R600,000 to R900,000), the yield was slightly lower at 8.76%, followed by an average yield of 8.32% for the Middle Income Areas (average home value between R900,000 and R1,2m), and 7.54% for Upper Middle Income Areas (average home value from R1,2m to R1, 5m). There then exists a more significant gap in yield between Upper Middle Income and Upper Income Areas (average home value above R1,5m), whose gross yield is a relatively lowly 5.96%.
Therefore, cheaper areas on average offer higher gross yields, whereas the high end areas appear less attractive. However, it is important to evaluate the return versus the tenant risk posed in the different segments.
Using TPN data showing the percentage of tenants in “good standing” regarding their rental payments, the lowest TPN rental band, i.e. homes with monthly rental below R3,000, has a relatively low percentage of tenants in good standing, to the tune of 79.5%, thus indeed appearing to be one of the highest risk segments. Therefore, having the highest yield appears justified in order to make it attractive for the investor. Many of these homes probably fall within so-called “Affordable” or “Lower Income” Areas.
Moving up to the next rental band, homes with rentals between R3,000 and R7,000 per month show a significantly better 86.2% of tenants in good standing, many of such homes probably falling in the Lower-Middle Income Area Value Band.
The percentage is still higher at 88.4% in the R7,000-R12,000 monthly rental band, with many of these homes probably in the Middle Income Areas, supporting the view up to this point that as one moves up the property/rental value ladder the tenant risk diminishes. This risk should be reflected in lower yields.
However, moving higher, the risk-return correlation theory no longer appears to hold, with the R12,000-R25,000 monthly rental band showing a lower percentage of tenants in good standing to the tune of 85.4%, which gets even worse in the R25,000+ monthly rental category at only 77.5%. Many homes in these highest 2 rental categories would fall into the Upper Income Area Value Bands, suggesting that this top area value band is a somewhat tougher place to operate for a landlord, while yields are not compensating for this apparent higher risk.
Therefore, the “sweet spot” from a landlord risk/yield point of view appears to be in the Lower-Middle to Middle Income Area Value Bands, and where many rentals probably fall between R3,000 and R12,000/month.
Some tenants can be difficult in other ways, too, however, and we admittedly don’t have data regarding how well the different segments’ tenants treat/look after the home, incidences of vandalism, and which segment’s tenants trouble landlords in other non-financial ways.
Yield by title deed and room number
When Gross Yields are estimated by Title Deed and room number, it is Sectional Title that generally looks to be the most attractive, but there is no clear cut “winner” when it comes to Sectional Title sub-segments at present. 1 Bedroom Sectional Title appears a moderately stronger market with slightly less attractive yields (8.61%) than the “2 Bedroom” (9.18%) and “More than 2 Bedroom” (9.0%) sub-segments. All of these 3 segments show considerably higher yields than the Full Title sub-segments though.
Of the Full Title categories, “smaller appears more attractive” from a yield point of view, with the “Less than 3 Bedroom” sub-segment having the highest yield (7.53%), followed by the “3 Bedroom” (7.25%) and “More than 3 Bedroom” (6.04%) sub-segments.
With regard to the direction of residential yields in 2016, much will depend on the movement of interest rates. In the near term, given that our estimate of national house price inflation has recently been around 6.5% year-on-year, albeit gradually slowing, while StatsSA still puts average rental inflation at a lower 5.17%, yields could still decline a little further.
In addition, TPN’s National Average Rental Escalation rate was a lowly 3.2% year-on-year in the 4th quarter of 2015, and slowing too, supporting this near term expectation of further decline in the National Average Yield.
While we ultimately anticipate slower house price inflation, given the multi-year weakening in economic and disposable income growth, for the time being those areas of residential demand that can significantly swing between rental and home buying still appear to be biased in favour of home buying.
The first such area of demand is that of first time buyer demand. In tougher times, aspirant first time buyers can hide out in the rental market in larger numbers, such as happened around 2008/9, where we saw very low percentages of first time home buying. However, first time buying at an estimated 26% of total home buying, as at the time of 4th quarter FNB Estate Agent Survey, remained a strong number….arguably still negative for rental demand.
A second potential source of rental demand emanates from households under financial pressure. Here too we don’t yet see major support for rental demand yet. Those sellers selling in order to downscale due to financial pressure remain low at an estimated 14% of total sellers. This was up from the prior quarter’s 11%, and may be an early hint of the start of a rising trend, but it is still too early to confirm the start of such a trend.
In addition, in the 4th quarter 2015 FNB Estate Agent survey, the agents estimated that the percentage of such sellers whom they believed would “rent down” as opposed to “buy down” was “treading water at 46%, off the 58% high recorded back in the 2nd quarter of last year”.
In short, rental demand’s time doesn’t appear to have come in a significantly bigger way just yet, while the home buying market remains well-balanced despite demand having slowed. FNB and TPN thus believe that the average residential yield may compress further in the short term, despite gradually rising interest rates.