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The seeds for today’s rental crisis were sown years ago, during the last great housing property boom. And as is the way in this cyclical industry, the rental adjustments now under way are laying the seeds for the next housing upturn. But don’t hold your breath. While the construction outlook is certainly improving, a major upturn in house prices still seems some way off.

Lets recall the last home boom, first driven by the fall in inflation and interest rates from the mid-1990s. Lower interest rates enabled households to afford larger mortgages, for a given level of income, which in turn has increased their buying power on the home market. House prices started to rise.

But the uptrend in house prices which began along the east coast in the mid-1990s attracted the attention of investors, who thought they could buy a house, rent it out and ride the home price cycle. Unrestricted negative gearing – deducting the difference between rental income and interest payments off other income – together with a 5 per cent discount on capital gains from 1989 made this a no-brainer and a speculative bubble developed and rolled across the nation.

Investors began buying houses irrespective of the likely rental returns, on the “bigger fool” theory that they would be able to sell them later for a whopping capital gain. It was the surge in investor interest that created the affordability “crisis” for new home buyers a few years ago and it still lingers today. It also created paper capital wealth for existing owners.

But alas, bubbles eventually correct. It turns out house prices got so high, and rental returns so pathetically low, that the prospect of strong further capital gains that would more thank offset the net rental losses started to look a dicey proposition for investors.

Meanwhile, relatively cheap rents meant younger would-be first home buyers stopped bidding on properties and simply stayed in their rental digs.

Indeed, according to data from the Real Estate Institute of Australia, the average house price nationwide is up 150 per cent since 1997, compared with an increase in the consumer price index of about 25 per cent. Rents have increased by 60 per cent.

Accordingly, the effective nationwide gross rental yield (annual rent divided by the price of a new home ) has fallen from about 5.7 per cent in the late 1990s to a mere 3.7 per cent. According to the REIA, in the September quarter last year, the average Sydney house cost $520,000 and the average weekly rent for a three-bedroom home was $270. That gives an implied gross rental yield of only 2.7 per cent.

The reserve Bank of Australia’s timely interest rate increases also helped prick the bubble. And more recently, the sharemarket’s advance – with juicy dividends which are only effectively taxed at 30 per cent – has attracted investors. The new game in town is chasing blue chips rather than red bricks on borrowed money.

If that’s not all, we can add the federal government’s recent changes to superannuation, which are encouraging many asset-rich households nearing retirement to liquidate investments and pump it all into superannuation.

All this has produced the seeds of the latest “rental crisis”. Investors have lost interest in supplying cheap rental houses to the market and first-home owners are still more inclined to rent.

While politicians shed more crocodile tears, the market is quietly operating as it should to restore equilibrium. Rental vacancy rates have plummeted and rents are starting to rise. Rents will need to keep rising relative to house prices to restore some value to property as an investment, and encourage more potential first home owners to stop renting and buy instead.

But does this mean that house prices have hit bottom and are now more likely to rise? While the seeds for the next housing upturn  are being sown by the tightening rental market, don’t hold our breath. The overall level of house prices is still high, given interest rates and incomes, and low affordability seems to provide little scope for significant strong capital gains anytime soon.

In fact, part of the rental market adjustments may come from further weakness in house prices – due to low investor interest – not just rising rents. That said, the tightening rental market does provide evidence that earlier fears of a “glut” of homes hitting the market from the boom times have not been realised. Due to strong underlying demand, the boom in construction a few years back has been easily absorbed.

We can be more confident that the seeds for an upturn in housing construction this year are now being sown.

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