To develop an effective strategy for your property portfolio, it's important to understand the different strategies and how they work to create wealth. Josh Masters, Buyside explains the difference between seeking capital growth or high yield.
Many people are left clutching at straws when it comes to choosing the right property investment strategy. Read the papers or the latest property magazine and there will often be an argument for pursuing capital growth rather than high rental income, while many others will say the opposite.
For most investors though, there is often no real understanding as to why they bought that particular property in that particular area for that particular price. Many investors look for a property that will “look after itself” in terms of income vs. expenses, but may not understand how that may affect the overall performance of the asset in the long-term.
If you’re looking to develop an effective strategy for your property portfolio, there are three main points to consider:
- understanding the difference between yield and growth
- knowing how each strategy works to create wealth
- deciding on a sustainable investment strategy that works for you.
HIGH YIELD OR HIGH GROWTH?
The return on any investment is usually divided into two parts; income and asset growth. For shares, this is seen as the dividends you may receive and the price of the share itself (hopefully increasing). For property, it is the rental income and the capital growth of the property.
The relationship between rental yield and capital growth is usually an inverse or opposite one. Typically, the stronger the rental yield, the lower the capital growth, while those properties experiencing stronger capital growth will usually achieve a much lower rental yield.
The following chart outlines the general behaviour of high-yield properties vs. high-growth properties. Keep in mind that both yield and growth are important in building a portfolio. The balance of each will depend on the strategy you decide to take.
General characteristics of yield vs. growth properties
Lower-value properties tend to attract higher yields especially in the capital cities because there tends to be a floor to how low rents can go. If a property has a reasonable rent but is well under $300,000, it’s reasonable to expect a stronger yield. For this reason, high-yield properties tend to be found in the outer ring suburbs or in regional areas where property prices are not as high and demand is not as strong.
Although the majority of properties bought in Australia are cash-flow negative to start with, meaning the expenses are greater than the rental income, over time many of those properties will become cash-flow neutral or even cash-flow positive as rents increase and/or the debt is reduced. So which one is right for you?
CHOOSING A HIGH-YIELD STRATEGY
The decision to purchase a high-yielding property can come down to a number of factors, and just because you decide to pursue a high-yield strategy today, doesn’t mean you can’t change your strategy further down the line.
So what would make you decide to choose a strategy that focused on generating more income?
You have few years remaining to service debt
If you’re moving into retirement or semi-retirement, it can be beneficial to start focusing more on high-yield properties than on high-growth properties. High-growth properties are often cash-flow negative, taking money out of your pocket rather than contributing to your income. This lack of income in retirement can affect your lifestyle much more than if you were still in the workforce, leaving you with far fewer resources to draw upon should there be a shortfall.
High-growth properties also tend to require a longer-term commitment to the market as they take approximately 10 years to move through a full growth cycle where the gains can be fully realised.
If you move into retirement before your investment has had a chance to fully realise its gains, and the investment still has a negative cash flow, then you could be forced to sell the property at a time that doesn’t get the best outcome. Your efforts may be better spent purchasing a lower-value, high-yield property that will provide a good rental income regardless of the growth you may or may not receive.
Your income is quite low
High yielding properties can often be better for low-income earners simply because there may be very little extra cash flow to channel to an investment. Any additional income that can be generated from the investment is not only welcomed, it’s often needed to get ahead.
As low-income earners are on lower tax rates, the tax breaks from negatively-geared properties are often less of an advantage to them as they are to high-income earners.
Generally a low-income earner will have a lower asset base to work from, so diversification with many lower-priced properties can be better than having ‘all your eggs in one basket’ with a higher priced property.
Less financial stress
Cash-flow positive properties are often favoured for their ability to make money from day one. They don’t put the investor under the financial strain as cash-flow negative properties do (where you have to contribute to the investment). This can make it easier to purchase additional high-yield investments, especially for those on lower incomes, as they’re not losing money with each purchase.
Keep in mind that while the rental yield must be reasonably high to create a cash-flow positive situation, it’s also necessary to have relatively low interest rates. In a market where high interest rates exist, additional cash flow can be hard to come by. For this reason, it is important that you can service the debt even if interest rates rise to unexpected levels.
Yield targets – what to expect?
Although Australia is a big place, the numbers are generally the same across the country when it comes to rental yields. Here is a guide as to rental yields in the Australian property market.
General guide for rental yields in the Australian marketplace
Those properties attracting yields above 6% are quite strong and would be ideal for low-income earners or for investors looking for strong rental returns once they’ve paid down their debt. If a lower-income earner can identify a property with reasonably strong growth and yields above 6%, it’s definitely worth a second look. A yield between 4% and 6% is considered fair for most properties but will generally result in a negative cash flow situation if you have put down the usual 10% or 20% deposit. Provided there is strong growth, this mid-range yield would be suitable for higher income earners who can take advantage of tax concessions. Properties that generate yields between 1% and 3% tend to be premium priced properties above $1 million. There tends to be a much smaller market at this level and people are only prepared to pay so much in rent, so yields are typically much lower the higher the property’s value.
CHOOSING A HIGH-GROWTH STRATEGY
As shown in the earlier table, choosing to pursue a high-growth strategy typically means that the property is taking money out of your pocket in terms of cash flow, at least for the first five to seven years.
As a result, only those higher income earners who can afford to sacrifice some income along the way can usually afford to hold these higher growth properties. In return, they’re typically rewarded with a better quality investment that grows a greater amount of equity over time.
This type of property is ideal if you’re a medico as salaries often far outpace living expenses. These excess funds often provide the financial freedom to invest in assets that will often double or triple their value during the working career.
Here are some of the reasons where this strategy may make sense for you:
You’re looking for better quality property
Higher-value properties in stronger growth areas usually result in less maintenance being required and a better quality tenant who pays on time. This can mean a lot less risk and a lot less worry. Conversely, low-value properties can result in higher yields, but they may equate to lower-quality builds in lower socio-economic areas.
You’re earning a high income
High-income earners often have much more discretionary income and can afford to take the loss on a more expensive property in exchange for potentially stronger growth and less risk. In addition, the loss is reduced through government tax concessions (negative gearing).
While someone on a lower income may find it difficult to diversify their portfolio with a more expensive property, a higher income earner can spread their risk as they can afford to buy higher-priced properties.
You’re building a portfolio
If your focus is on building your portfolio and you have sufficient time left in the market for the property to mature, your primary focus should be on growth. Growth will provide you with the equity you need to outlay for the next deposit, which in turn allows you to purchase more property. While it’s nice to have a positive cash flow from your investment, it can be a long time before that additional cash amounts to a deposit large enough to fund another purchase.
WHY EQUITY OFTEN BEATS INCOME
Choosing between a high-growth strategy that generates equity vs. a high-yield strategy that generates income can have a significant impact on your portfolio. Let’s take a look at the following example to illustrate.
Two friends, Marty and Frank, each purchase a property. Marty purchases for yield while Frank purchases for growth. Both are on modest incomes so their tax rates are both at 30%. After 10 years, the results are as below. As you can see here, when it comes to generating wealth, the growth strategy is the single biggest contributor to the creation of a property portfolio over the long term. Growth not only contributes more equity to the bottom line but it can also provide the much-needed funds required for the deposit on the next purchase.
So whether you decide to pursue a growth strategy or one based on strong yields, it often depends on the amount of time you have available in the market, your level of income and the eventual result you’re hoping for.
While a healthy yield eases the burden of holding the investment and can provide a steady stream of income into retirement, strong capital growth will build substantially more wealth for you in the long term.
Need help choosing the right property?
Property can be a lucrative investment, however researching the market and buying the right property can take time. This is where an expert property consultant can help. If you would like assistance with choosing and buying the right property, please contact us for an introduction to Josh Masters.