Investors have to weigh up the pros and cons when determining whether to chase capital growth or high rental yields when buying properties. Property investors commonly fall into one of two camps – those who are disciples of capital growth, and those who think cash flow is king. So which is better?
Going for growth
Capital growth should be seen as part of a medium to long-term strategy, with properties being held for up to a decade or more. The aim should be to achieve an annual increase in the property’s value of about seven per cent to 10 per cent.
Rental yields on such properties are likely to be a modest five per cent or lower because they are often in highly desirable areas in and around capital cities or regional centres. They usually come with a high price tag as a result of strong demand from buyers.
However, this high cost/low yield scenario plays into one of the biggest strengths of capital-growth properties: negative gearing. In simple terms, this situation means the interest you are paying on a loan is more than the income from rent.
Cash flow-positive property
Investors who buy cash flow-positive properties draw comfort from knowing they will usually get a monthly return.
This strategy is based on finding reasonably-priced properties that have high rental yields. They are usually found in smaller regional towns, or developments such as student accommodation.
Positively-geared properties often appeal to new or younger investors who have not yet built up a lot of equity in their property portfolio or who are on lower incomes. Some of the disadvantages with cash-flow positive properties are that they usually don’t grow anywhere near as well or as consistently as capital city property, and can require a relatively larger deposit as they are often considered to be a higher risk by lenders.
Best of both worlds?
Clearly, it would be great if a property could deliver high capital growth and a strong cash flow, but finding such a gem is difficult.
In the past decade, some mining towns experiencing a boom have defied the norm – delivering soaring rents and phenomenal capital growth. However, such cases are the exception to the rule.
So how do the two philosophies stack up? That will depend on your risk profile, but it is worth remembering it requires high cash flow to pay down a mortgage and create a situation whereby you have sufficient equity to buy again.
Contrast this with the power of capital growth. With only five to seven per cent capital growth, just one property worth $500,000 will grow by $500 to $700 per week, plus this growth is essentially not taxable until the property is sold a long time later and any capital gain is taxed at half the rate of income tax. Rental yields of cash flow-positive property can almost never hope to match such a gain, especially after they are taxed.
This article was written by Richard Sheppard for the April 2015 edition of Peninsula Living Magazine.