When investing in property, one of the most critical decisions involves balancing rental yield and capital growth. Both these factors significantly influence the financial return on your investment.
Here’s why achieving a balance between the two is crucial:
Understanding Rental Yield and Capital Growth
Rental Yield is the annual rental income as a percentage of the property’s purchase price. It provides an immediate return on investment through regular cash flow, making it crucial for investors who need a steady income. We call this the short term money.
Capital Gain refers to the increase in the property’s value over time. Properties with high capital growth appreciate significantly, offering substantial returns when sold. This is key for long-term wealth accumulation. We call this the long term money.
The Inverse Relationship
Typically, properties with high capital growth have lower rental yields, and those with higher rental yields often experience slower capital growth. For instance, established suburban properties in cities like Sydney and Melbourne have strong historical capital growth but lower rental yields compared to other properties. Conversely, regional properties might offer higher yields but less capital appreciation.
Importance of Balance
Cash Flow Needs (Rental Yield) vs. Wealth Building: (Capital Gain)
Cash Flow Needs: Investors who require immediate income to cover expenses or loan repayments should prioritise rental yield. High-yield properties ensure a steady cash flow, reducing the need for additional financial support. The challenge in this approach is that the big money is in Capital Gain
Wealth Building: For those aiming to build wealth over the long term, capital growth is crucial. Properties in areas with strong growth potential, although offering lower yields, can significantly increase in value, resulting in greater overall returns when sold. The challenge in this approach is that there is likely to be high negative gearing, meaning that one needs to subsidise the property investment from your after tax income. This reduction in your after tax disposable income can severely influence your lifestyle and hence is not desirable Especially since the banking calculators will reject further loans due to the negative gearing and negative cashflow. This impedes the building of a property portfolio, which is the ultimate in securing long term wealth and financial independence.
The Blended Strategy
Adopting a blended strategy of balancing rental yield and capital gain makes sense and provides for many positive outcomes. This approach ensures that lifestyle is not impacted while still achieving capital gain. It’s a long-term strategy that allows continued property investment, leading to multiple investments due to increased serviceability in bank calculators. Ultimately one can continue to invest whilst having little or no influence on cashflow and lifestyle. This has to be the ultimate in investing.
Affordability and Investment Strategy
Investors must align their property choices with their financial goals, affordability, and stage of life. Younger investors or those with higher disposable income might opt for capital growth-focused properties, accepting lower initial yields for higher future returns. Conversely, investors nearing retirement may prefer high-yield properties to ensure a stable income. This is why a personalized approach and strategy is so important. Whilst there is no once size fits all property investment system, for most people a balanced approach provides for the best long term outcomes. The strategy has to be developed and customized to each individual investors circumstances and desired outcomes, to render optimized outcomes.
Market Dynamics
Each area has a property cycle. Whilst time in the market is more important than timing the market, it is obviously highly desirable to find the right entry point as to when to purchase. This is where the early capital gains have a very significant effect on the long term leverage of the property investment.
Long-Term Perspective
Even if a high capital growth property starts with a lower rental yield, the rental income typically grows in line with property value increases. For example, a property with 7% annual capital growth and a 3% rental yield may see its rental income grow at the same rate as its value, maintaining the yield percentage but increasing the absolute rental income significantly over time, which will still render it cash flow negative
Opportunity Cost of not optimizing for Capital Gain.
The difference in growth rates has a significant impact on long-term returns. For example, a property growing at 6% per annum will be worth substantially more over 30 years compared to one growing at 3%. The opportunity cost of not investing in a optimized growth property can be substantial, as illustrated by the hypothetical scenarios showing a difference of almost $2 million over 30 years for properties starting at $600,000.
Real Value Considerations
It’s also essential to consider inflation, as measured by the Consumer Price Index (CPI). Real growth must outpace inflation to increase the property’s true value. A property’s capital growth rate must exceed the CPI to represent actual value increase. For instance, if the CPI is 3% and the property’s growth is 7%, the real growth is 4%.
Balancing rental yield and capital growth is absolute vital in property investment. While high-yield properties provide immediate cash flow, high-growth properties build long-term wealth. Investors must evaluate their financial goals, cash flow needs, and market conditions to choose properties that offer an optimal balance, ensuring both immediate income and substantial long-term returns. This especially when one wants to build a portfolio of properties, which is the ticket to financial independence, choices in retirement or leaving a legacy. This cannot be achieved with one property investment, it generally requires a minimum of three investment properties to achieve the capital base. Assuming that the long term goal is to build a portfolio of a minimum of three investment properties, the balance between income and growth is of highest importance.
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