One of the areas in relation to property investing that is least understood is around the property investment strategy and cashflow versus Capital Growth.
In our role, we speak to so many property investors who do not understand what type of property is best suited for them based on their goals, risk appetite and their personal circumstances. Property investing should NEVER be a one-size-fits-all approach, and yet so many investors select a strategy that may have unintended consequences for them in the future. The purpose of this article is to highlight the difference between a high capital growth and a high yield strategy when selecting an investment property here in Brisbane.
As a member and participant on a number of property investment facebook groups and online chat forums, I see many individuals seeking advice in relation to what is the best suburb in Brisbane to invest in for a specified budget. It always amuses me when others jump in with their suggestions and recommendations, based purely on price. This approach comes with so much risk, because there has been no thought given to the requirements for growth and yield for that individual.
How to determine the right investment strategy for you
To get an understanding of what investment approach might be best for you there are a number of considerations that you need to make:
- What are your investment goals? That is, are you looking for more income now, or are you looking to create a future nest egg for yourself and your family?
- What is your current taxable income? Remember any income that you generate through investments owned in your own name now will be taxed at your marginal tax bracket so this needs to be considered before you buy.
- What is your exit strategy? Consideration must be given to whether you intend to hold the asset into retirement and live off the income it generates, or if you intend to sell at some stage in the future. The tax implications associated with this must also be considered up front.
- At what stage in life are you now? The duration of the investment period that you have to work with can influence the type of property that you might target based on your specific needs at that time in life.
- What is your risk appetite? We all have our own comfort levels and these need to be considered so that you can sleep at night!
Let’s take a look at a high yield asset first
Brisbane is a higher-yielding city than the likes of Sydney and Melbourne, so many investors are attracted to our city because of this benefit. Properties that return a higher yield are usually positively geared and are often cashflow positive properties as well.
A positively geared property means the property is producing income from a tax perspective. A positive cash flow property is one that puts money in the bank each week, once you account for all holdings costs, interest on the loan, and any repayments that you may be making towards the principal of the loan.
Properties are more likely to be cashflow positive on interest only lending – especially in the current environment where interest rates are at record lows. Fewer properties remain in a cashflow positive position once they convert to principal and interest loan repayments.
An investor can control the gearing and the cashflow position for an investment property through the finance structure that they implement for the purchase. For example, paying a higher deposit through cash would mean that the interest charges are lower due to a lower loan-to-value ratio and therefore the property is more likely to be positively geared, or even cashflow positive.
Investors MUST keep in mind that high-yielding assets have lower growth when assessing assets over the longer term. There is an inverse relationship between growth and yield. As one goes up, the other goes down and vice versa.
We can select an “example” high yielding suburb in Brisbane and determine the long-term performance of an asset based on historical data. Whilst there is no guarantee that the past is a reflection of the future, we do know that the past is going to tell a story that investors need to consider.
Let’s assume that the property value is $500K. The example property has a gross weekly rent of $600 which provides a strong 6.12% yield.
These are the additional assumptions:
- Annual Vacancy rate of 2%
- Borrowing at 80% Loan-to-Value Ratio (ie: $400K loan on the $500K purchase)
- Paying for the remaining 20% property value and purchase costs via cash
- The Interest Rate of 3% pa remains unchanged over the investment period
- Principal and Interest Lending
- Rental expenses = 27.37% of Rental Income (this covers property management fees, rates, insurance, maintenance etc)
- Inflation on rental expenses set at 2%
Being a high yielding location, the capital growth rate is set at 3.5%. This is representative of historical growth rates in suburbs within Greater Brisbane that achieve higher yields like this example. For this reason, the Rental Price growth is also set at 3.5% pa (in line with capital growth).
The two most important things to note in relation to the cashflow in this scenario are as follows:
- The pre-tax cashflow position is +$10,035 in the first year.
- By year 31 the annual pre-tax cashflow position is +$70,350
In relation to the FUTURE VALUE, based on the compounding growth rate of 3.5%, this property will look like this:
- By year 31 the value will be $1,453,000
- This is an INCREASE of $953,000 from the time of purchase.
Now let’s look at a high growth Asset as a comparison
Consider now that the location selected is a high growth location which is in most cases going to generate a LOWER yield. In this example, we will again assume that EVERYTHING remains the same as in the higher yielding example, however, we will switch the growth rate the yield around. Therefore, the growth rate is assumed to be 6.12% pa and the yield is assumed to be 3.5% (based on a weekly rent of $343 per week on a $500K purchase). We can also assume that the rental price growth will be similar to the capital growth because the more scarce locations will achieve higher rental returns over time due to limited supply and higher demand. This ensures that a rental yield of 3.5% is maintained over time based on the property value. All other variables in the modeling will be exactly the same.
The cashflows in this scenario are as follows:
- The pre-tax cashflow position is -$9,870 in the first year.
- By year 31 the annual pre-tax cashflow position is +$134,161.
In relation to the FUTURE VALUE, based on the compounding growth rate of 6.12%, this property will look like this:
- By year 31 the value will be $3,153,000
- This is an INCREASE of $2,653,000 from the time of purchase.
Of course, this example is provided purely to illustrate the difference that a small change in the compounding growth rate can make over many years. TIME IN the market makes a huge difference when investing for capital gains for the future.
The reality is that generally the higher growth assets are located in the more scarce locations and therefore they are already priced higher. So it would not be realistic to expect that you can shop with the same budget and expect to choose between either high yield or high growth.
The difficulty for investors comes, when they have higher investment budgets, and they are presented with a CHOICE.
Should I buy One Higher Growth Asset or Two Higher Yielding Assets?
We also often get inquiry where people may have a budget of more than $1M to spend in Brisbane, but they ask if it is “better” to buy two properties instead of one with this budget. Again, the answer always depends on the unique circumstances of the individual.
If we look at the higher yielding asset and we consider buying two of these at $500K each, the numbers look like this:
- Total Pre-Tax Cashflow for first year = +$20,070
- By year 31 the annual pre-tax cashflow position is +$140,700
- Total combined asset value = $2,906,000
- Total INCREASE in value from time of purchase = $1,906,000
BUT … if you are a high-income earner, on the highest marginal tax bracket, then you would be paying tax of $4,770 in the first year for EACH property, which REDUCES your cash position from +$20,070 to +$10,530.
By year 31, assuming you were still paying tax at the highest marginal tax bracket, then your annual pre-tax income of +$140,700 would be reduced to $74,570 AFTER tax.
Over the life of the 30-year loan on each property, you would have paid a total of $481,670 in TAX which works out to be $963,340 across the two properties of TAX PAYMENTS in this scenario!!!!!
The after-tax cashflow position over the 30 years would be a total of $143,145 for each property, which provides after-tax cashflow of $286,290 across the two properties over the 30 year period.
Therefore, the TOTAL return would be:
- Total after-tax cashflow across 30 years = $286,290
- Total Growth over 30 years = $1,906,000
- TOTAL RETURN over 30 years = $2,192,290.
Now let’s look at the alternative – buying a single high growth asset with the total budget of $1M and therefore targeting a higher growth asset.
If we look at the higher capital growth asset and we consider buying just one of these at a purchase price of $1M, the numbers look like this:
- Total Pre-Tax Cashflow for first year = -$23,415
- By year 31 the annual pre-tax cashflow position is +$134,161
- Total asset value = $6,305,000
- TOTAL INCREASE in value from time of purchase = $5,305,000
AGAIN … every investor must consider the tax implications of their investment decisions. Using the same examples, if you are a high-income earner, on the highest marginal tax bracket, then you would NOT be paying tax, in fact you would get a TAX REFUND of $3,155 in the first year. This is because at this time the property is NEGATIVELY GEARED which means you will be paying a portion from your own funds to hold the asset because the costs associated with holding the property exceed the income from rent that is being achieved.
By year 31, assuming you were still paying tax at the highest marginal tax bracket, then your annual pre-tax income of +$134,161 would be reduced to $71,105 AFTER tax. This is only $3,465 less than in the high yield example!
Over the life of the 30-year loan on the single property, you would have paid a total of $602,705 in TAX which works out to be $360,635 LESS TAX compared to the scenario of buying the two properties with the higher yielding returns.
The after-tax cashflow position over the 30 years in this high growth scenario would be -$120,353, mainly because the income from rent has not fully covered all costs as well as principal repayments for this property over the life of the loan.
Therefore, the TOTAL return would be:
- Total after-tax cashflow across 30 years = -$120,353
- Total Growth over 30 years = $5,305,000
- TOTAL RETURN over 30 years = $5,184,647.
When we compare the two scenarios, the difference in the TOTAL RETURN, puts the single high growth property ahead by a HUGE $2,992,357!!!
So, which Strategy is better?
The answer to this question is still – It DEPENDS!
Of course, looking at the overall returns, targeting the high growth asset results in significantly higher levels of wealth after 30 years. There is no doubt about that from the numbers above.
But, some would argue that having all your eggs in one basket presents as higher risk. If the property is vacant, for example, you have no income at all. But if you buy the RIGHT asset then the risk of vacancy is minimized.
Also, given you would have one high value asset instead of two lower valued assets after 30 years, some would argue that it is better to own two properties so you can sell just one if needed and still hold the other. As I said previously, the exist strategy is very important to consider before you buy as these decisions need to be included in selecting the overall approach.
Finally, your own income levels and risk appetite will influence how much you have to spend and that may limit the type of strategy that you can afford to buy.
As we always say – the right strategy for an individual investor depends on individual circumstances. We always need to consider the investment strategy alongside the tax strategy and the finance strategy. There are so many moving parts to consider before an investor even starts to look at properties to buy. It is so important to plan prior to executing!
I hope this article has helped you to understand that investment strategies need to be tailored. Too many investors start off blind and make mistakes. Getting professional advice can help you tailor the right mix of growth yield based on your unique circumstances.
Get in touch if you would like to know how we can help you. You can make an enquiry with Streamline Property Buyers Team. We are the Most Qualified Team of Brisbane Buyers Agents.
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