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The Yield Gap

Let’s say the long term interest rate average sat around 7.0% and a certain market gross yield (rent return) was around 5.0%.

Can we all agree there was a minus 2.0% ‘gap’, before you even began?

Adjust these figures how you want, but something similar is what has been the accepted norm in many suburbs across this country for eons.

I know there is positive geared property, I am a big believer in it.

Today however, I want to show you why there is so much room to move in the current market, based on interest rate alone. I touched on this already in this article here.

In Timbuctoo, a standard house returning $500 per week was valued at around $500,000. In the past, it had sold for $400,000 when it was rented at $400 per week. This was all during a time when the interest rate on loans was around 7%.

This produces a negative yield gap of 2% (5% rental minus 7% loan = minus 2%)
(Yes I know there are deposits involved so it is slightly skewed)

If our Timbuctoo house does not encounter rental increases for a time, and the cost of debt drops, it enables investors to pay more for the home, but still be in the same financial position (relatively speaking).

If the loan rate drops from 7% to 4% and everything else stays the same, then investors can pay more for the property.

If we kept a similar ‘minus 2%’ outcome, the price change would look like this:

$500 per week = $500,000 sale based on a 7% loan rate and 5% rent figure (minus 2%)
$500 per week = $1,250,000 sale based on 4% loan rate and 2% rent figure (minus 2%)

As you can see there is a huge upswing in price if investors accept a lower gross rental return, due to an equally lower interest rate.
Remember, this does not include any form of rental increase.

If our Timbuctoo property increased rent by $100 per week and then an investor accepted a lower gross return it could look like this:

$500 per week = $500,000 sale based on a 7% loan rate and 5% rent figure (minus 2%)
$500 per week = $1,250,000 sale based on 4% loan rate and 2% rent figure (minus 2%)
$600 per week = $1,500,000 sale based on 4% loan rate and 2% rent figure (minus 2%)

From a small adjustment in rent, a large adjustment of loan interest rate and investors accepting a lower gross yield, means a 3 times price increase in property value.

Is that crazy?

We have already had two of those things, increases in rent and decreases in loan interest rates. All we need is for investors to accept a lower gross yield and yet still be within the long term averages, and we have a recipe for massive price growth.

Let me be clear, I don’t think this is the road map for the future and going to happen.

I do think you need to be mindful of this when you are assessing the market and what might be coming towards us for the next 36 months.
When someone asks me where I think the market is going, I try to refer to this way of thinking to at least paint a worst case {or best case} picture of potentials.

As soon as you start thinking in this way, you begin to see why the market is still moving like it is and how it has ‘potential’ to keep the run upwards.
Not that it justifies it or makes it easier to jump in with both feet, but more understanding is always helpful for your decision process.

Since 2004, Scotty North has been helping people buy the best properties for their needs at prices that simply speak for themselves.
Scotty has been instrumental in bridging the gap between financial planning and traditional real estate transactions through his property advice model.

Scotty North is a Qualified Property Investment Advisor (QPIA), with accreditation’s in financial planning, mortgage broking and real estate.

By carefully considering his clients’ goals and planning for market changes via demographics and trends, Scotty designs a future proof outcome not only specific to the client’s needs but dynamic in its execution with performance indicators and exit strategies built in.

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