Capital growth vs rental income
By RUN Property CEO, Rob Farmer
It is one of the most debated questions in real estate: Which is better, capital growth or rental yield?
Successful long-term investors in both camps argue that their preferred strategy works best, but many believe a blend of both approaches is the safe and sure way to build wealth. Others say they can find individual properties which offer both strong capital growth and high rental yield.
Those who favour capital growth say it is the mose direct way to build a nest egg because their net worth grows hand in hand with the increasing property values and the Australian tax system helps pay for their investment through negative gearing concessions.
But investors who prefer rental yield (return) say their properties pay them more than the properties cost to own, ensuring positive cash flow from day one. "Cashflow is King," is the catchcry of the rental yield investors who love the security of having money in their pocket while they continue to build their portfolio.
In contrast, properties focused on strong capital growth usually need considerable amounts of their owners' cash to maintain them because the loan repayments are often far more than the rental income. Deciding which strategy is best is a real personal choice based on individual circumstances and goals. So there is no right or wrong answer and the debate proves one thing: there are many ways to make money from porperty investment.
Capital growth
Properties targeted for capital growth aim for an annual increase in value of 7 to 10 percent, or more for short periods, with a rental yield of 2 to 5 percent. Investors buy them banking on maximum increases in market value so they can be sold for a significant profit or used as equity to buy more properties. These negatively geared properties are generally more expensive to buy than properties which are cashflow positive and they tend to be in capital cities and major regional centres where there is strong demand from buyers.
While rental return is secondary for capital growth buyers, many find that rents are hauled up by increasing value of the property. The big worry with capital growth properties is that because investors generally have to contribute to the ongoing cost of the property, if interest rates go up too much too quickly they might not be able to afford to keep the property. This is where financial planning is critical and it is wise for investors to include buffer in their calculations to allow for increased costs.
Rental yield
Investors who buy cashflow positive properties rest easy knowing they can't go broke making a profit. Their risks are minimised when the property pays them more than its costs to own it. These properties therefore appeal to new and young investors, those with a low risk profile or those with less money to spend as comparable properties offerng strong rental yield are generally cheaper than those expected to have big capital growth.
Properties bought for their rental yield are expected to achieve a rental return of 6 to 10 percent a year and capital growth of 4 to 6 percent. Sometimes rental return investors can have their cake and eat it too when the property also enjoyes above average capital growth. For example, small towns in remote areas traditionally offer low capital growth and strong rental yield, but if the town enjoys a mining or tourism boom, capital growth can be exceptional.
The disadvantage with cashflow positive, high yielding properties is that their owners must pay tax on the income whereas negatively geared properties give tax benefits, especially for high income earners.
A mix of both
Many investors favour a blend of properties in their portfolio - some with strong capital growth to generate equity to buy more properties and some with high yield to provide the cashflow to cover the costs.
This balances the advantages and disadvantages of both strategies and means investors avoid putting all their eggs in one basket. Smart investors can also achieve the best of both worlds with one property - if they know what to look for and can think outside thw square.
Properties offering strong captial growth and high rental yield do exist, but they are hard to find. You might have seen one and not realised it. The key to incovering such properties is what I call buying property with a twist. The property needs to have a feature which can be twisted to generate additional equity or cashflow.
For example, a property expected to offer high capital growth might have a large garage that can be converted into a flat which can be rented separately, or a second living area might be made into a fourth bedroom, generating more rent.
A high yielding property can create instant capital growth if it can be subdivided into two or more allotments. Study planning schemes and local council zoning rules. For example, a property zoned rural that is scheduled to be rezoned to residential will grow in value immediately the rezoning is approved.
The numbers
Take a property valued at $400,000 and chart its progress over 20 years. In the blue corner, put the statistics for the property with a rental yield of 10 percent a year and 5 percent capital growth, and in the red corner put the comparable data for the same property calculated to have a capital growth of 10 percent a year and 5 percent rental yield.
After 20 years, the rental yield champion is earning an income of more than $132,000, flattening its opponent which is returning only $53,000 a year. On the flif side, it is in capital growht where the red corner property delivers the knockout punch. It's market value has soared to more than $2.6 million, smashing the opponent's highest price of more than $1 million.
So which is better? A difference in rental income of $79,000 a year or a difference in market value of about $1.6 million after 20 years? In reality, the question will always be more complicated than the maths might suggest. What works for one person will be uncomfortable for another. the main point is that there are two very different but very successful ways to build a financial future through property.
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RUN Property permits reproduction of its articles provided they are not edited and they include the author’s byline (By RUN Property CEO Rob Farmer) and the following attribution: RUN Property – sales, leasing and property management. For more information visit www.run.com.au
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