Property Yield vs Capital Growth: Which is Better?
Should I invest for growth or yield when buying property? It’s an important question that every property investor must answer. Here we look at the pros and cons of each tactic.
Heading into property investment without a strategy is one of the biggest mistakes that you can make. You need to know about the type of property you want to buy and which locations offer the best prospects. Moreover, you need to know where you’re getting your money and what your exit strategy is.
But before all of that, you need to ask yourself a simple question.
Should I invest for growth or yield when buying property?
Property yield vs. capital growth is one of the big debates among property investors. Choosing your side and creating a plan based on your choice is the key to property investment success.
This article examines both strategies in detail. It tells you what they entail and the pros and cons related to each.
What is Rental Yield?
When most people think about investing in property, they think of the rental yield model. This involves buying a property and then making it available to tenants. When you have a tenant, you earn a weekly or monthly income based on the rent that you charge.
Several factors affect your rental yield. The quality of the property and its location are the two biggest. The better the property, the more you can charge. If its location suits your audience, you can charge even more.
When you invest for rental yield, you’ll usually secure a home loan. You use this to purchase the property, then you invest in the property to make it attractive to tenants. When you think the property is ready, you advertise it and accept tenants. This generates an income, which you can use to both repay the mortgage and earn a little profit. As you build your property portfolio, that profit increases.
That’s the general idea. In truth, there are several pros and cons of investing for rental yield.
The Pros of Investing for Yield
The pros of investing for yield include the following:
- A Consistent Income. As long as you have tenants, you will earn a monthly or weekly income from the property. If you buy a property that’s ready to rent out, you can start earning money from it within a couple of months of making the purchase. Investing for yield generally means that you don’t have to wait around to enjoy a return on your investment.
- More Cash in Your Pocket. Earning a regular yield from the property also means that you have more money in your pocket. Instead of relying on other income sources to pay the mortgage, you can use the money you earn from rent. Usually, your yield will exceed the amount you repay on your home loan. This means you have spare money to take care of any problems with the property. On top of that, you should be able to generate a profit.
- Buying in Growth Areas. Most people who invest for yield buy properties in established locations. This means they can turn an instant profit. However, investing in a growth area doubles the benefit. As the location grows, you can charge more in rent. However, you also benefit from the value of the property increasing.
Generally speaking, investing for rental yield works best if you need an immediate income from your property.
However, there are some drawbacks to this strategy.
The Cons of Investing for Yield
The following are the cons of investing for yield:
- Marketing Costs. You’ll incur a lot of additional costs when you invest for yield. The marketing involved catches a lot of people out. When you don’t have tenants, you need to invest in ways to attract people to your property. This often involves taking out listings and working with real estate agents. All of this costs money. Moreover, you won’t have money coming in from the property when you’re searching for a tenant. As a result, you have to pay for marketing out of your other income sources.
- Vacancies. Related to the above point are vacancies. Whenever you don’t have a tenant, you lose an income stream. Those who rely on their yield to repay a home loan often struggle when this happens. With no yield, you can’t make your repayments. In the worst case scenario, this results in you losing the property. It’s advisable to have alternative income streams to ensure this doesn’t happen to you.
- Possible Low Growth. If you’re investing to maximise yield, you’re generally going to avoid underdeveloped areas. You’re not looking to the future so much because you want to generate a return immediately. Typically, this means that you invest in established areas. While this means you get a good weekly or monthly return, it also means the value of the property won’t increase by much. If and when you sell, you often can’t expect to make a large return on the initial investment.
Don’t invest for yield without understanding the responsibilities you assume when you rent a property out. In addition to the above, you also have to maintain relationships with your tenants and handle maintenance issues. A lot of extra work goes into generating that regular income.
What is Capital Growth?
Capital growth refers to the increase in value of an asset over time. In the case of property, it relates to the increase in the value of your property.
For example, you may buy a property for $500,000 with the aim of implementing a capital growth strategy. Over 10 years, that property may increase in value to $600,000. This means you’ve enjoyed $100,000 in capital growth. If you sell the property at this point, you enjoy a $100,000 profit.
Investing for capital growth can be either a long or short-term strategy. Some buy properties in developing locations and wait for several years. The idea is to buy low and sell the property for a profit when the region reaches its potential. This often takes several years to occur.
Others buy properties with the aim of flipping them. This means that they carry out extensive renovations to increase the property’s value. They then sell it on, often within a year or two of the original purchase. In these cases, it’s the extensive work of the investor that leads to capital growth.
In both cases, the aim is simple. You buy a property at one price, then try to sell it later on at a higher price.
As with rental yield, there are several pros and cons of capital growth that you must understand.
The Pros of Investing for Capital Growth
The following are some of the pros of investing for capital growth:
- Negative Gearing. This is an investment tactic that experienced investors with large portfolios often favour. It involves investing in property with the knowledge that you’re going to make a loss. You can then deduct this loss from your taxes. With proper manipulation of the market, you can use negative gearing to pay less tax while managing your cash flow. However, it’s something that you can’t do if the property turns a profit through rent. It’s also a complicated technique that requires the help of experienced tax advisors.
- Less Work. When you invest solely for capital growth, you don’t have to worry about tenants. This means no dealing with unruly tenants or trying to satisfy maintenance issues. It also means that you don’t have to spend money on marketing the property.
- Possible Better Returns. Many who invest for growth focus on buying properties in developing areas. As these areas reach their potential, the value of the property shoots up. In some cases, this increase in overall value outweighs the amount you’d earn from rental yield from another property.
Those who invest for capital growth usually do so with the knowledge that they need a little patience. They won’t see immediate returns. As a result, they must feel secure enough financially to follow this plan. If they are, the rewards can outstrip those of investing for yield.
The Cons of Investing for Growth
The cons of investing for growth include the following:
- No Regular Income. It’s difficult to invest for yield and growth at the same time. Not taking on tenants means that the property doesn’t generate an income during the course of your ownership. This means that you have to pay expenses, such as home loan repayments and maintenance, using your other income.
- Misreading the Market. Investing for capital growth often means reading the future potential of the market. Getting things wrong means that you may not generate the return that you expect when you sell. Generally, property rises in value over time. But misreading the market means it may not increase to the point where it turns a profit.
- Capital Gains Tax. Your capital gain is the difference between the property’s value when you sell it and its value when you bought it. When you make a gain, you have to pay capital gains tax (CGT). The Australian Taxation Office (ATO) considers money earned from capital gain as income. Moreover, the ATO doesn’t withhold tax for capital gains. As a result, you may need to set aside money to pay the tax bill after selling the property. On the plus side, you can claim a capital loss from your income tax.
Investing for capital growth requires a lot of research. You need to feel certain that the property will grow in value to the required amount. If you don’t, you may end up experiencing one of these drawbacks first-hand. Furthermore, you need to have enough money to sustain the property during your ownership. You can’t rely on yield to provide this when investing for capital growth.
The Final Word
This all brings us back to the initial question.
Should I invest for growth or yield when buying property?
There’s no right or wrong answer. The best strategy depends on your situation. If you’re secure financially and can take a risk, you may prefer investing for growth. Moreover, experienced investors may choose this option as a way to access the benefits of negative gearing.
However, those who need an immediate income may prefer to invest for yield. It involves more work, but you can usually rely on this strategy to give you a regular income. That’s why it’s often favoured by those who are new to property investment.
Whichever choice you make, Cohen Handler can help you to find the ideal property. Contact one of our buyer’s agents today to start your search.