When it comes to purchasing property there are a multitude of factors to consider. Where should you buy? What should you buy? How much should you pay? While these are the most common questions investors will ask, perhaps one of the most pertinent questions that needs to be answered before anything else is ‘Why should I buy?’
To put it more clearly, you need to have clear goals for why you’re investing in property, and then devise a strategy to help you achieve those goals. Surprisingly this isn’t something many investors do, but it’s essential for success.
A large part of your strategy will be determining whether you need to buy properties that offer strong capital growth or rental yields.
There are those in each camp espousing their respective benefits, but which one takes precedence is often different for each investor depending on their financial circumstances. Ultimately, however, every investor should be aiming to acquire a property that offers both – not one or the other.
Having a capital growth strategy means you’re aiming to buy a property that experiences strong growth in value over time.
A property that has the best chance of growing in value is one for which demand outstrips supply. It’ll be in high demand due to its investment fundamentals – that is, it’s in a good location, close to employment, amenity and public transport, and there are imminent growth drivers such as infrastructure projects.
Often properties with high potential for capital growth have lower yields and are therefore negatively geared, with expenses exceeding the income.
Having a high-yield strategy means you’re aiming to find a property where the rental income covers most, if not all, of the costs associated with owning it.
Having a strong rental return is more important than many investors realise because it enables you to hold onto a property for the long-term while you wait for capital growth. If your portfolio is too strongly negatively geared you can run into financial trouble – if interest rates rise, for instance, or you have a big unexpected expense, you’ll be forced to find more to pay out of your own pocket.
Can you have it all?
Believe it or not, you can have a property that offers both good rental returns and capital growth.
It may not be easy to find, but if you do thorough research the right property in the right location will provide both. That’s not to say a high-capital growth property will necessarily provide an investor with positive cash flow, but it may be only minimally negatively geared after tax deductions.
What you should be aiming to buy is a property that offers the best possible cash flow for the best possible growth. You need both to invest as the former will keep you in the market, enabling you to service the debt, while the latter will eventually get you out, enabling you to realise a profit.
If you can’t find a property with both capital growth and a solid yield from the outset, then find one that has all the fundamentals for capital growth and where the yield is likely to increase soon due to strong rental demand.
Your yield can also be improved through measures such as minor renovations, adding extras or even by furnishing your property (for more on this see our upcoming blog providing 13 suggestions for maximising your rental yield).
How can you decide which to prioritise?
The broad goal of property investing is to create wealth over the long term, and it’s clear that focusing on capital growth is the way to do this.
While a property investment’s yield is crucial to its success, it’s not the key to wealth creation, and when investors make the mistake of prioritising yield over growth, they usually end up losing money.
High-yielding property might seem tempting, but when you do some simple calculations it’s evident that in the long-term you’ll make more by focusing on capital growth. Not only will your property be worth more, but the rental income will also be higher. Consider the following example:
|Purchase price||Yield||Capital growth||Value in 20 years||Income in 20 years|
|Capital growth strategy||$500,000||5% pa||10% pa||$3,363,750||$168,188 pa|
|High-yield strategy||$500,000||10% pa||5% pa||$1,326,649||$132,666 pa|
Capital growth will also largely be the key to expanding your property portfolio;
it will give you equity, which you can leverage off to buy more real estate.
Ideally with each purchase you’ll be aiming to have both strong capital growth and decent yields, but if you have a portfolio of properties you may also opt for balance – that is, to have some that are negatively geared and some that are more cash flow positive. The surplus cash flow from the high-yielding properties can be used to cover the costs of the low-yielding properties.
Tax deductions can also help you service debt and hold your property, minimising any shortfall between rental income and expenses.
Just how much of a shortfall you can afford will depend upon your circumstances at the time you buy. If you don’t have a great deal of surplus cash you’ll need to look at focusing on high-yielding properties so your holding costs are smaller, while someone with an adequate surplus will be able to comfortably meet the shortfall between rental income and the costs of holding the property, and will be able to focus on a capital growth strategy.
This may change over time – once you have acquired a few high-yielding properties your improved cash flow might allow you to focus more on capital growth.