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Which is better: capital growth or rental yield?

Which makes a better property investment strategy – capital growth or rental yield?

Whilst it is possible to have both strong capital growth and a high rental yield, it is rare.Better property investment strategy

More often than not it is a choice between one and the other.

The answer to this question is not as straight forward or obvious as one would hope because different personal and financial circumstances and investment strategies give rise to different responses.

On the one hand going for strong capital growth seems an obvious choice because of the potential to generate long-term capital profit.

However, rental yields on high growth properties tend to be low meaning these properties are almost always negatively geared (that is, expenses like mortgage interest and other costs exceed the rent earned).

Whilst this provides the investor with some useful tax breaks (under current tax legislation) it still means they will be out of pocket each month until the property is sold.

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Properties with a higher rental yield on the other hand, usually provide for a positively geared investment property (that is, where the rent exceeds all costs) meaning the investment pays for itself.

It also means the property is generating cash reserves which can be used to pay down the loan or for any other purpose.

The downside is that when it comes time to sell, the capital gain is likely to be substantially less than that of the strong capital growth property, especially when taking into account the compounding impact of year-on-year growth.

Importantly, whilst it is possible to have both strong capital growth and a high rental yield, it is rare.

More often than not it is a choice between one and the other.

And this in turn comes down to what best fits the investor’s objectives, risk profile and is the most affordable.

Strong capital growth strategy

Whenever you invest in residential property you want to generate a decent capital growth.

The question becomes the quantum of this growth.Strong capital growth strategy

I would define strong capital growth as inflation plus 4 per cent to 5 per cent annually over the long term.

So you are probably looking at growth rates at between 6.5 per cent and 7.5 per cent.

The risk with this strategy is, as alluded to above, that you’ll likely be out of pocket while you hold the investment and will be subject to interest rate risk, whereby increases in mortgage rates can be painful, especially if there are contractual and market constraints which limit the ability to raise rents.

There are ways to mitigate these risks, like borrowing less and taking out a fixed rate loan, but generally speaking this is an ongoing problem for this type of strategy.

In addition, a strong capital growth strategy places all your eggs in the one basket whereby all the profit is made sometime in future when the property is sold.

In the meantime, investors typically run at a loss and with negative cash flow.

High rental yield strategy

A high rental yield strategy is all about generating positive cash flows now thereby helping protect the investor from interest rate shocks and significantly reducing the potential need for ongoing cash injections.High rental yield strategy

This is a less risky investment strategy and as result, the overall return (due to the lower capital growth) is normally not as great.

Plus there may also be the need to pay tax if the assessed revenue is greater than the allowable expenses (including depreciation) thereby reducing cash flows to the investor.

Rental yields can vary but yields considered high are usually in the vicinity of 8 per cent to 10 per cent whereas for high capital growth properties rental yield is typically anywhere between 4 per cent and 6 per cent (even lower in some cases).

By the numbers

To illustrate the point let’s assume we have a choice of two properties both costing $400,000.

Property A has an expected capital growth rate of 7 per cent per annum and a rental yield of 4 per cent while Property B has a capital growth rate of 4% and a rental yield of 7 per cent.

Acquisition, finance and holding costs are the same.

The table below illustrates what the financial situation might look like after fifteen years:

By the numbers

As can be seen Property A’s value after 15 years would be substantially greater than Property B’s (almost 50 per cent more), whilst Property B would generate significantly more cash during the course of the investment.

You can also see that the rent differential narrows after fifteen years on the basis of the superior capital growth on Property A.

However this assumes rent levels can be moved in line with capital growth movements in order to maintain yields, which may or may not be the case.

Yield versus growth

So which is the best option? Yield versus growth

Both strategies provide for good overall returns and a profit but represent quite different strategies with different financial rewards and risks.

The answer boils down to individual needs and objectives and is best determined by a detailed financial analysis including running some what-if and cash flow scenarios.

As an aside, if you are running a portfolio of properties it might make sense to include some high yielding ones and use the surplus cash to cover net outgoings for low yielding properties.

This would help you balance your portfolio.



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About

Peter Boehm was the Finance Editor for Onthehouse.com.au. & has more than 30 years' experience in banking and financial services - Visit www.onthehouse.com.au


'Which is better: capital growth or rental yield?' have 3 comments

  1. Avatar for Property Update

    March 16, 2015 @ 12:06 pm Dan

    As a younger property investor i had absolutely no trouble choosing to go for high yield over high capital growth. I simply can’t afford to make up an extra $1,000 a month to cover the negative cashflow. While i am still negatively geared, it’s closer to $1,000 a year and that works well for me.

    Most importantly i can build my portfolio without adding much stress to my budget, i can (relatively) easily end up with 20 properties like this, which could amount to a very high income by the time i hit retirement. Whereas if i had to fork out for high growth, i would get stuck on the first or second property.

    I understand this article is aimed more at the first time property investor however i don’t think it’s taken a long term view for people who want to build an income-based property portfolio without the need for selling. As soon as you sell a property, you stop making money from it.

    Reply

  2. Avatar for Property Update

    March 15, 2015 @ 5:52 pm Sky

    The issues facing all property investors now is the high purchase price, uncertain (& unlikely) capital growth, and the massive holding cost. The risk is so much greater than, say, before the 2003 boom. Good luck to all those thinking to put their hard earned money in real estate.

    Reply

  3. Avatar for Property Update

    September 11, 2014 @ 4:20 pm Amayzingone

    Very good article. Typically young investors are looking for high capital growth whilst older investors are looking for good income streams. However capital growth over a short to medium time frame (under 7 years) should never be relied upon and cannot be guaranteed, especially after a boom in prices!. Certainly for some Sydney suburbs they did not see any positive gains in apartment values from the 2003 peak until just this year! On the other hand rental incomes are much more reliable and have steadily increased over the same period making property more appealing and affordable for investors right until the recent rise in property prices. Most of the time rising rents over 2 or 3 of years (resulting in high rental yields) are a precursor to a boom in property prices and certainly a rental boom resulting in high yields has nearly always occurred just before a boom in property prices. On the other hand increasing difficulty in letting properties along with falling rents (as we have right now) have nearly always lead to property prices eventually falling back to more affordable levels. So in summary you can’t bank on capital growth in the short term but you can definitely bank on getting your rental income! And where rental yields have steadily increased over time you can expect good price growth to occur eventually.

    Reply


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