Property investors commonly fall into one of two camps – those who are disciples of capital growth, and those who think cash-flow is king.
Which is better? Before you opt for one over the other, it’s important to understand the key differences between the philosophies and how they are likely to suit different investors at different phases of their investment cycle.
Going for growth
Proponents of capital growth are adamant that it’s the best way to build real, sustainable wealth. They buy properties expecting reasonable increases in market value over time so they can be sold for a big profit or used as equity for further investment.
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 7 to 10 per cent.
As these properties are often in highly desirable areas in and around major capital cities or regional centres, rental yields are likely to be around 5 per cent or lower. Depending on the city, they may also come with a relatively high price tag as a result of strong buyer demand.
However, this high-cost low-yield scenario plays into one of the biggest strengths of capital growth properties: negative gearing. Put simply, the interest you are paying on a loan is higher than the income from rent, so there is usually a small cost of $50 to $100 a week after tax to hold the property until the rent increases enough to cover all costs.
Cash-flow positive property
Investors who buy cash-flow positive properties draw comfort from knowing they will usually get a monthly return as rental returns are higher than the outgoings, including mortgage payments and maintenance costs.
This strategy is based on finding reasonably priced properties with 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 are on lower incomes. Disadvantages of cash-flow positive properties are that they usually don’t grow anywhere near as well or consistently as capital city property and can require a relatively larger deposit as they are often considered 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 a gem like this isn’t always possible. In the past few decades, some mining towns experiencing a boom have defied the norm – delivering soaring rents and phenomenal capital growth. This tends to be the exception to the rule though, and some investors have been caught out when the boom goes bust.
How the two philosophies stack up will depend on your risk profile, but it’s worth remembering that it requires years of very 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 the help of an experienced property investment advisor, it’s often possible for buyers to pay less than $50 a week to fund an investment property. Yet with only 5 to 7 per cent capital growth, just one property worth $500,000 will grow by $500 to $700 per week. In addition, this growth is essentially not taxable until the property is sold in the future 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 this gain, especially after tax.