Investing For Yield Vs Growth
Sometimes, investors like to argue about which is better – investing for rental yield or capital growth?
In truth, both strategies have their merits, depending on what you are trying to achieve. Usually, they are mutually exclusive.
Investing for the future – capital growth.
Simply put, if you are borrowing up to 100% of the value of the property, you will most likely want to invest for growth. Properties will typically be in high-demand areas where demand outstrips supply. This puts upwards pressure on the value of the property over time, resulting in capital growth or increased value. However, due to the higher cost of the property, rental income (as a percentage of the value of the property) will be relatively low.
On the other hand, if you are paying cash for a property and the budget is lower, you will most likely want to invest for rental yield. This means you are improving the ‘cashflow’ of the property ownership as it is positively geared (money coming in vs money going out). This can be a good strategy for investors seeking improved cashflow out of their investment compared to the more long-term focus of a capital growth strategy.
How do you know which is best?
For many investors who are buying with the aim of improving their long-term prospects, such as retirement planning or reducing their home loan quicker, a growth strategy is more suitable. These investors are not interested in paying off the investment property. Instead, they are looking at the potential for that property to give them a big pay-off when they sell it, or utilising the equity they can achieve in the property (through its capital growth) at sometime in the future.
Investors who are looking to minimise the amount of tax they pay every year, will often look at brand-new or off-plan properties. The tax minimisation can also help with owning the property over the course of the investment as it can help with cashflow (with the use of a tax variation for example).
Whilst there are plenty of investors who pay cash for their investment properties, most investors will use finance to leverage the property for growth. So long as the interest rates associated with the loan are less than the amount of capital growth achieved each year. For example, for a property to double in value over a 10-year cycle, the yearly growth it will need to achieve is 8%. Assuming an investment loan of around 3%, this represents a good investment.
For a growth strategy to be effective, there must be some growth over a long period. Particularly if the property is costing the investor money (negatively geared) and the rental yield is not enough to cover all expenses.
People who are looking for cashflow will often sacrifice some growth for improved rental returns. This can be an attractive option where the investment property holds no debt, is in an established location and still achieves some growth over the long-term.
Investors purchasing a property inside a Self Managed Super Fund (SMSF) may also prefer a high yield strategy, particularly if there are no borrowings.
The simplest way to think of this is yield = investing for cashflow/the present, where growth = investing for a significant payout in the future.