By Tim Farrelly – CEO of Farrelly’s, and asset allocation consultant to Australian Unity Personal Financial Services

“If returns came out of history books, then librarians would be the richest folks around.”

Warren Buffett

Residential property has been a wonderful investment for millions of Australians over the past 30+ years. However, as Warren Buffett also noted, past returns and future returns are quite different things. We believe that the days of stellar growth in residential property prices in Australian cities are over. The factors that have driven that growth in the past, falling interest rates and a shortage of supply of property, are coming to an end.

What has driven the price rises in residential property?

It is useful to study past returns from residential property to arrive at a basis for forecasting future returns. To understand where the price rises came from, it helps to be able to break apart the role of fundamental factors, such as growth in rents, from market factors, such as how much the market is prepared to pay for each dollar of rent.

A good way to think about the price of a property is to calculate the net rent and to then work out the amount the market is prepared to pay for each dollar of rent. We call this second factor the Rent Multiple. If we have a property that produces $10,000 per year in net rent and the market is prepared to pay $40 for each dollar of rent, then that property is worth $400,000. For the property to increase in value, either net rents must increase or the Rent Multiple must increase – or some combination of the two.

When looking at past price increases in Figure 1, it is clear that neither increases in rents (nor inflation for that matter) have been responsible for much of the gains.


Figure 1: Capital gains and rental increases on median 3 bedroom houses (1985-2016)









Total  % increase

Price increase







Rent increase








Increase % pa

Price growth







Rental growth







Source: RESI, farrelly’s analysis


As can be seen in Figure 2, a soaring Rent Multiple, the amount buyers are prepared to pay for each dollar of rent, has been behind most of the price increases over the past 30 years. And as the market pays more for each dollar of rent, the yield received by investors also falls.


Figure 2:  The Rent Multiple has soared as yields have tumbled

In the case of Sydney houses, the Rent Multiple has risen from around 15 times rents in the 1980s to a massive 65 times rents today. Other capitals have experienced similar increases.

From an institutional investor’s perspective, Sydney residential property is outrageously expensive. By way of comparison, commercial property trades at around 13 to 20 times rents and shares trade at about 16 times after-tax profits.  As a result, institutional investors rarely invest in residential property.

Why is residential property so expensive?

Farrelly’s believes it is because prices are set by owner occupiers and private investors rather than investors with institutional mindsets who look at the earnings power of an investment and the potential for growth in those earnings. In trying to make sense of residential property prices, it helps to think about how residential buyers and sellers go about deciding what to pay or accept for a property.

Typically home buyers pay whatever they can afford. 

After their first day of house hunting, home buyers invariably return deflated. “Is our dream home really that far out of our range? I can’t believe how little we get for our money.” After that first day, the buyers’ strategy becomes clear – work out the maximum they can possibly borrow and then go looking for the least worst place they can buy for that amount of money. Concepts like yields or the Rent Multiple just don’t come into it. They just want their own home to live in and in which to raise a family.

So, what do they spend? Whatever they can afford, which turns out to be whatever the bank will lend them.

The banks assess the amount they will lend on the ability of the borrower to meet the interest payments which depends on the amount of the borrowers’ weekly income that can be spent on interest. So, if the borrowers’ earnings rise or, if bank interest rates fall, the banks will lend more to a given borrower. Similarly, when interest rates rise, banks will lend less for each dollar of household income.

When interest rates fall substantially, buyers all over Australia simultaneously find they can borrow, say, 20% more to buy their ‘dream’ home. You would expect that, in this environment, prices should rise by around 20%. And, more or less, this is what actually happens, if not immediately.

Note that this only works if the supply of houses is relatively stable. If the supply of houses responded rapidly to increasing demand and rising prices, bank lending would no longer drive prices to the extent suggested here. In Australia, we have some nine million dwellings growing at around a little over 1% per annum – and that is with a building boom underway.

Now, home buyers don’t automatically pay more for a given property just because they have had a pay rise and can borrow more. In practice, they study the market for a while, work out what is the going rate for houses in a particular area, and then go looking for a bargain, or at least something that seems reasonable. Sellers go through a similar exercise. They find out what other houses in the street have sold for and hope to get a price a little bit better than that.

The impact of thousands of such buyers, all making similar assessments, will gradually move prices up when average weekly earnings rise, or if interest rates fall.

In the long term, prices should rise in line with the amount the banks are prepared to lend. 

How investors decide what to pay

Because home owners aren’t the only buyers in the market we need to investigate the market impact of investors, who, as we have discussed, are rarely institutions who worry about income and how fast that income grows.

Private investors are more concerned with the amount of capital appreciation that may be achieved over a period of time, without being too concerned where that appreciation might come from. For a private investor, a bargain is a property that is cheaper than the house next door, even if both are ridiculously expensive from the viewpoint of an institutional investor.

Private investors believe that residential property will increase in value. Their experience, and the experience of just about everyone they know, is that property prices rise in the long term. So their process for investment turns out to be much the same as home owners. They work how much they can borrow and find a property at a half decent price compared to other properties in the area. And the banks’ attitude to them is much the same – how much interest can you pay and can you pay a deposit?  

Cash rich investors – generally foreign investors – don’t need the banks. But they will still be guided by the previous prices paid. From time to time they will pay over the odds and when these investors dominate a market prices can continue to rise above levels suggested by affordability considerations.

Affordability explains the price increases

Affordability can be best thought of as how much the bank will lend to the average buyer; as discussed earlier this will be related to average weekly earnings divided by interest rates. In the short-term, prices can take a while to respond to changes in affordability and, at times, get driven beyond the levels one would expect if they were set by affordability alone. Often this will be due to the activity of investors or speculators.  However, as shown in Figure 3, in the long-run, prices rise in line with home loan affordability.


Figure 3: House prices and Affordable Values

Source: REIA, ABS, RBA, Farrelly’s calculations

Looking ahead – what factors will influence property prices?

If affordability continues to be a key driver of residential property prices, then the major drivers of prices will be wage growth and interest rates.  Let’s look at how they might impact prices in the future:

  • How fast could wages grow?

Historically, average weekly earnings have grown around 0.5% to 1%pa faster than inflation. While real wages growth in Australia is currently very slow, we expect average income growth at around inflation plus 0.75% per annum in the long term

  • Are mortgage interest rates likely to rise or fall?

It is our expectation that cash rates generally will increase modestly over the next decade from the current 1.5% to, say, 3.0% or 3.5%, or even a little higher. Mortgage rates should rise by a similar amount. What they will not do is go much lower.

This is important because falling interest rates have been the great driver of the residential property market – and that has now run its course.

From here, interest rates will be an impediment to growth in property prices.

Forcast returns

All this suggests that capital growth for properties around Australia is likely to be around 2.0% – 3.0% per annum or less for the next decade, which, when added to the extremely modest rental yields on offer, suggests very modest pickings for residential property investors, as is summarised in Figure 4. Note we are not suggesting a collapse in prices – rather a long period of slow growth.


Figure 4: 10 year Forecast Returns for Residential Property (before transaction costs)








Net yield on houses1(%)







Capital growth %pa2







Total return %pa







Source: 1. REIA, farrelly’s estimates of costs. 2. farrelly’s forecasts

Other factors which could impact property prices

Forecasts are based on assumptions, many of which could prove to be wide of the mark. In this case, there are many factors that could lower residential property returns below even these modest forecasts. 

  • Foreign investors have been a factor in markets of late. Unchecked they could continue to drive prices higher. However, Australian politicians have woken up to the idea that housing affordability is a major issue for a large part of the population and are now introducing measures to restrict the impact of foreign buyers. We expect their attempts will, eventually, succeed. If the politicians don’t succeed, then we could see prices rise faster than suggested here.
  • Changes to the capital gains tax treatment or negative gearing – these are possible but unlikely to have much impact. Negative gearing was curtailed in the 80s with minimal impact to prices. Any changes would in all likelihood be grandfathered and so would not affect existing investors but may slow new investors entering the market.
  • Massive overbuilding – As seen in Figure 5, building activity in Sydney, Melbourne and Brisbane has exploded in recent years. If it continues at current rates it certainly will result in oversupply and much lower capital growth. In the short-term, the Brisbane unit market has rising vacancies and has an enormous number of new units under construction so price falls can be expected there. In Sydney and Melbourne the rental market is still very tight and so we see little signs of excess supply at this stage, but they too have a very large number of new units under construction. However, building approvals are slowing and so the long-term impact should be modest.


Figure 5: Building activity, units under construction by state

  • Tighter regulatory controls on bank lending practices – this has already been happening to some extent and will slow capital growth. Further tightening of lending standards will further lessen potential capital growth even further.
  • An economic recession in Australia – if we did experience a recession, it could hurt returns in the short term and medium term, as recessions tend to move the actual value of properties below Affordable Value for a while. On the other hand, recessions tend not to impact affordability in the long term.
  • Much higher interest rates – would cause prices to fall and would be devastating for highly geared investors and home owners. However, this is a quite unlikely scenario as the Reserve Bank will be very cautious about lifting rates too far too fast.
  • Transaction costs – the cost of buying and selling a house normally comes close to 8% to 10% of the purchase price, enough to reduce returns by 1% per annum on a 10-year investment. This will apply to all new investors considering a residential property investment.
  • Renovations – have been responsible for a meaningful amount of past price increases. The price increases forecast here include the impact of renovations. That being the case, capital gains will be less than the raw increase in prices.

Conclusion – Now is not a great time to be investing in residential property

Low returns, high transaction costs, and the threat of rising borrowing costs all make residential property a dubious proposition at this time, despite magnificent past performance.