Residential property has been an incredibly popular investment choice for New Zealanders over several decades. It plays a crucial role in economic activity and wealth storage, and has been a smart choice for a generation of investors. But is it still a smart choice for the next generation?
A generation of solid investment returns
Traditionally, investors have been rewarded for their investment in residential property. The average capital growth over the last 30 years has been roughly 6% per year. Combining this with the average gross yield of around 4%, suggests a historical gross total return in the vicinity of 10% per annum. This is a pre-cost figure – costs such as insurance, rates, maintenance and the like will typically equate to around 1-2% of total return, so the historical net total return is likely in the vicinity of 8-9% per annum.
The chart below shows the growth of $100 invested in property, over the last 30-odd years. Note, this is house prices only and doesn’t account for rental return:
Credit: Forsyth Barr analysis
How does residential property compare to other investment options?
The NZX-50, representing the 50 largest companies in New Zealand, has averaged a total return of 7.7% per year since 2005. That includes capital growth and dividends. The S&P500, essentially representing the 500 biggest and best companies in the USA, has returned 10.8% per year, on average. Data for NZ Government bonds doesn’t go back as far, but since 2010, the NZ Bond Index has returned around 3.8% per annum.
So, over the long-term, the housing market – at around 8-9% net total return – has beaten all but the high-flying US stocks.
From a purely financial perspective, buying a residential investment property and sitting on it while you wait for those capital gains has been a smart choice.
And this doesn’t even take into account one of the biggest strengths of property as an investment: leverage.
The power of leverage in investing
Around 70% of all investment property purchases are funded, in part, by a mortgage. Leverage acts as an amplifier to your capital gains (or losses). If you buy a $1 million property with cash and it goes up in value by $100k… great, you’ve made a 10% return. But if you only had to put in $500k of your own money and borrowed the rest, suddenly your $100k increase in value represents a capital growth of 20%.
It’s easy to see how, with the help of leverage, many residential property investments will have significantly outperformed stocks, both here and abroad. The same level of leverage just isn’t available to the typical retail stock market investor.
All this growth has caused the total value of residential real estate in this country to grow to $1.65 trillion – almost ten times the total market cap of all NZ listed stocks, which sits around $185 billion.
Kiwis clearly love investing in property. The chart below shows the proportion of NZ household investment assets. Rental properties are second only to private businesses, and easily more popular than shares.
Credit: Forsyth Barr analysis
Relying on future capital gains? Think again.
But what about the next 20 years? The traditional model of passive leveraged property investment has worked in the past. But it relied heavily on tax-free capital gains to justify low or even negative initial cash flow. Historically, investors could tolerate low yields, knowing that mortgage interest was tax-deductible and consistent capital gains were largely untaxed.
But I don’t know if this playbook will work again.
As I’ve written about before, there are a number of reasons to believe the 6% average capital growth we’ve seen over the last 20 years will not be repeated. This performance was largely propelled by a unique confluence of powerful, multi-decade structural tailwinds. These include a secular decline in interest rates from generational highs (20.5% floating mortgage rate in 1987) to historic lows (4.37% by 2021), and a one-off societal shift that saw a dramatic increase in dual-income households.
Regardless of what happens with OCR announcements over the next couple of years, the wider trend cannot be repeated, unless mortgage rates are to somehow go deeply negative.
My advice for those considering residential property as an investment is: don’t rely on the historic playbook. Buying a property with low cash flow and expecting capital gains to provide a world-beating total return is going to leave you disappointed.
The property investment playbook of the future
That’s not to say residential property cannot be part of a portfolio. But much more of the return will need to be generated from the rental cashflow side than in the past. Success is unlikely to come from buying an average property in a major centre and hoping for market uplift. Instead, investors will need to focus on higher yielding options.
Higher yields can typically be found in multi-unit or multi-tenanted properties (think, a block of flats). Refurbishing and repositioning a property to generate higher rental returns will also be an option. You’ll also find higher yields outside of Auckland and Wellington, as the chart below shows. This chart is limited to the six largest cities. But yields will typically be higher again in regional centres, such as the West Coast at around 7%, and Manawatu, Gisborne and the Hawkes Bay, all close to 6% on average.
Credit: Cotality
In short, while property has been the backbone of wealth creation for past generations, the dynamics of the next 20 years look very different. Investors who continue to rely solely on capital gains may find themselves disappointed. But those willing to adapt – by prioritising yield, adding value, and looking beyond the traditional markets – can still uncover strong opportunities. The residential property investment playbook isn’t dead, but it does need a serious rewrite.
