Buy smart to avoid property pains – yield vs capital growth
Congratulations, you are in a financial position to consider an investment property. Let’s talk about what makes a good investment. The two main factors property investors seem to concentrate on are yield and capital growth. Now before we go any further I would like to point out that I am in no way a financial advisor. If this blog happens to get the wheels turning in your head a little I am glad but please do not use it as your sole reason for why you make your next investment the way you do.
What is yield?
Yield is the return as a percentage. You could work this out by multiplying the weekly rent (lets say $500 per week) by 52 (number of weeks in a year). In this case it would be $26,000 per year. To obtain a yield percentage you would divide the $26,000 by the value of the property (lets say $500,000) and multiply by 100. So (26,000/500,000) x 100 = 5.2%
The gross yield is 5.2 percent. You would be smart to take out rates and insurance (not to mention maintenance money) to calculate a net yield but let’s not overcomplicate it.
What is capital growth?
Capital growth is essentially the amount a property goes up in value each year. This is normally expressed as a percentage. Say a property was worth $500,000 this year and is worth $550,000 next year the property has increased in value by 10%. Inflation should be considered to be completely accurate but again, let’s not get complicated.
So, what works out financially better in the long run?
Let’s compare two properties that have differing strengths, one has better yield and one has better capital gain.
Property one – starting worth is $500,000 with an 8% yield per year but an average 4% capital gain.
Property two – starting worth is $500,000 with a 4% yield but an average 8% capital gain
This table below shows what would happen to the capital gain of the properties over 6 years.
This second table shows the yield (rental income) over 6 years
So what does this mean? Over 6 years property one has increased by $132,659 in value and property two has increased in value by $293,436. Boy that extra capital gain percentage really does add up. Over this time property 1 has obtained $275,930 worth of rent and property two has obtained $158,454 worth of rent.
When all is said and done there is a net benefit to owning property 2 of $43,301.
However, the real benefits are to be had if you own a capital appreciating property longer term.
After only 10 years property 1 has increased in price to $740,121 and property two has increased in price to $1,079,460. Over this time property 1 has earned $499,450 in rent while property 2 has earned $312,906.
The net benefit to owning property 2 over 10 years is now $152,795. Holding on to the property for an extra 4 years increased the net benefit by close to $110,000.
You maybe asking the question “Ok Kahn that is great, but what type of property would obtain great capital gain with a lower return and what type of property would obtain a great return with lower capital gain?”
Location and type of property are the two factors in play here
Location – let’s compare the market in a small rural town called Kaitaia where I grew up to the Wellington market.
Location wise, Kaitaia would be an example of a property that would achieve lower capital gain but higher return as the rents are generally high compared to the sale prices. As you can see comparing 2008-2018 there haven’t been massive increases in prices overall and the dips can be more pronounced. It isn’t uncommon to see rental returns in Kaitaia over the 10% mark though, so you could no doubt buy a home in Kaitaia and have it paying itself off from the get go….
Wellington, due to a number of factors, will have much more capital gain than Kaitaia but you will struggle to achieve the same rate of return. The population and demand will mean that a larger city like Wellington will stay more stable even when there is minimal growth as there was during 2008-2015 ish. A note on capital growth, you have to be willing to hang on for the long term when investing this way. You might only get 1-4% growth (or even go backwards a little) for years then achieve 20 + percent growth for 2-3 years. When looking at the overall picture where would you rather own?
Type of property – The second factor is the type of property you choose to buy. Let’s say you were looking at two properties in Wellington. One is 3 flat property with minimal useable land and one is a single level, drive on 3 bedroom home with a small backyard. Usually the 3 flat property will have slower capital gain (for the sake of this blog it would be the 4% capital gain property) but a higher return. A single level 3 bedroom home would usually have the higher capital gain but lower rental yield. If the returns were as explained in the table above, you would have a better net return on the 3 bedroom single level home.
However, there are many investors who would much rather work on a good return rather then capital gain. A good return decreases the chances of things like you having to put money in when expenses arise or having to top up the mortgage out of your own income. Multiple tenancies can also be an advantage when wanting to upgrade one unit or when one unit becomes vacant, there is still income coming in from the others. One advantage of a property with one tenancy however is exactly that, there is only one tenancy to look after.
Shouldn’t I just put my money in the bank?
Let’s say you had $500,000 to invest which is a huge amount of money. I have seen bank 5-year interest rates at 4.1% recently. After 5 years your $500,000 would now be worth $611,256. This is similar to the property example above at the lower return without the benefit of the rental income (although you do have rates, insurance and maintenance on a property). The added benefit of property, a huge one, is you can leverage and achieve these returns on investment with $100,000 or less (your deposit) on a $500,000 home. You don’t have to save up the whole $500,000.
So what should you do?
This is totally up to you, and it depends on what you are looking for. Personally, I have gone down the route of investing in single level, one income type properties for the moment and it seems to be working. This is not necessarily what I set out to do it is just the way the cards have fallen to some degree in my house hunting journey. I don’t get the return I could elsewhere but should theoretically achieve better capital gain down the track. I have been very lucky in (for the most part) having families that are looking for long-term rentals wanting to live in these, so we look after each other.
Being mid 30’s with an income that has been ok investing this way works for me but may not for everyone. People nearing retirement, for example, may not want to invest this way as they would rather have the return immediately as opposed to waiting for capital gain which, as we have seen from the graphs above can be a very inconsistent and more long-term thing.
Hey, if you have another investment strategy other than property that returns well go for it. I am no financial advisor, just trying to pass on a little of what I have found useful. What I wouldn’t do personally though is let my money just sit in the bank if I could help it!
Thank you for making it to the end! I hope this has been of some assistance.
Happy house hunting
*Every effort has been made regarding the accuracy of figures used in this article but we encourage all readers to completed their own research.