You’ve probably seen this question floating around the property forums if you’ve spent any time online checking out investment strategies.
The question of whether to invest in property for rental yield (cashflow) or long-term gains (capital growth) is one of the key strategic discussions you will find amongst property aficionados.
Any advisor making sweeping claims about one being better than the other should be treated with caution: like with many decisions in property, the most suitable strategy for you as an investor will depend on your own unique goals and financial circumstances, as well as your attitude towards risk.
Staying focused on the big picture
It can be a little confusing, but the key point is to stay focused on what really matters, rather than get distracted by the details and end up making emotional decisions: it doesn’t matter how beautiful the kitchen is if it doesn’t make sense financially!
Savvy investors are focused on the end-game and they have one main question in their minds: “Will owning this property help me achieve my long term investment goals? “
Unless the purchase fits in with the long-term wealth creation strategy the savvy investor walks away, as the main goal is to have multiple properties before retirement.
They are able to make an informed decision by understanding what drives capital growth and also why some properties have higher rental yields (and deliver more cash flow) than others. This helps them to choose properties that may deliver both cash-flow and capital growth: the best of both worlds.
Whether you invest for cashflow or capital gains will probably depend on the main points of each strategy discussed below.
Investing for capital growth
Those who invest purely for capital growth usually do so on the assumption that particular types of properties in particular locations will probably have above average capital growth over the long term.
Many such properties are in high demand in ‘hot’ suburbs or in well-established areas that have always increased their value. This makes them expensive, and the rental yield on them may be rather low.
Expenses may also be high. When the expenses involved with an investment property – not just the mortgage but also maintenance costs and rates – exceed the rental income this is called a ‘negative gearing’ strategy; and it may not be possible, nor attractive, for many average investors.
Consider, for instance, a four-bedroom home in Castle Hill, Sydney, with a purchase price of $1.2m and an expected rental return of around $800 per week. This would incur higher costs than the rent received and would be expensive to hold while the investor ‘waits’ for the capital growth – and even more expensive when interest rates go up by 1%!
Capital growth can often be the key to lasting, long-term wealth because of the tax advantages over rental income. But there may be a catch…
Unfortunately, many inexperienced investors mistake property marketers or ‘spruikers’ for trusted and impartial property advisors. They are essentially ‘salesmen’ trying to sell a particular property, often in new developments, for the substantial commissions they receive from the property developer. The spruiker’s selling pitch will often highlight features such as tax benefits through negative gearing, rental guarantees, and the suburb’s population projections and the like. They rarely focus on the suburb’s supply and demand numbers, its vacancy rates or, indeed, ways to add value to the property to increase the investor’s equity.
The reality is that brand new properties seldom make good investments as it is usually the second and third time purchasers of the property that realise the capital growth. There is simply too much of a developer’s premium (or profit) built in to the purchase price to achieve good capital growth over the first five years.
You may be better off buying the second-hand property around the corner, or in one of the adjoining suburbs, to lower the risk of excess supply when many new properties are being built in one area.
Investing for cash flow
Investing for cashflow usually means purchasing properties with above-average rental yields and sacrificing lower capital growth trends for the excess cash generated.
The idea is that the rental income covers not only the mortgage and maintenance costs of the property itself, with zero out-of-pocket expenses for the owner, but also creates surplus cash supply.
The ‘positive gearing’ strategy is generally seen as lower risk – but again there can be a catch…
Again many inexperienced property investors take advice from ‘salesmen’ rather than independent property advisors. An investor looking for positive cash flow properties may be convinced to buy a property in a mining town or high-risk properties like student accommodation and serviced apartments.
Many investors lost a lot of money when the mining bubble in Australia burst. I was told by one that he attended a property investment seminar and then purchased (through the seminar promoters) a house in Dysart QLD for around $700,000 with a rental of $1900 per week – it sounded great. Within two years, the mining bubble had burst, all the workers left town and the property was re-valued at around $350,000 with a rental value of $300 per week – not so great!
Investing for both
Most investors just starting out (or with just one or two properties in their portfolio) will probably want to consider investing for both capital gains and cashflow, rather than allowing one strategy to dominate. Diversification is important – and a less risky strategy than backing the one horse all the time.
If you are negatively geared after buying three or four properties it may be appropriate to balance your portfolio with some high-rental properties; investors owning several cashflow-positive properties may want to put more emphasis on capital growth in their next property.
The key to real long-term wealth is the capital growth because you can use the assets to buy further properties – but first you need to generate the cashflow, and that requires a balanced approach.
Chris White is an established and experienced buyers agent and can provide invaluable, independent property advice to help you purchase the right property in the right location – developing a balanced strategy that considers both cashflow and capital gains.