Our latest episode in the Reminiscing with Richard series picks up where we left off in our last chat, where we discussed the five key principles surrounding property investment – capital growth, income, personal control, adding value, and tax advantages.
Now that the fundamental principles are understood, let’s explore the key considerations for buyers when searching, assessing and purchasing a property.
The relationship between capital growth & rental yield
It’s often mistaken or misinterpreted, as to how the components of yield and capital growth come together.
Essentially, an investment property has either a high income yield or strong capital growth, but not both.
Those in the market for high quality capital growth properties are willing to accept a lower income return in order to own a quality asset.
That’s because capital growth and income tend to work at cross purposes, which is typically true across most asset investment classes. To put it simply, high percentage rental yields are a red flag that the property you’re considering is a poor low growth investment.
The better the asset, the lower the risk. And the lower the income return, while one is holding it.
Conversely, a lower cost property with a high rental yield will have low growth value prospects, because demand for it as an asset is poor.
Many investors think they can live with that trade off. Unfortunately, this is a big mistake, because despite its low rental yield, the capital growth oriented property will eventually deliver a higher cash flow than its high yield counterpart.
A comparative hypothetical – yield vs growth
Suppose that Property A has attributes that deliver modest capital growth, and the property’s market value increases by around 5 per cent per annum. Because it’s a property with a weak capital growth, it has a high yield, let’s say in this instance, a yield of 10 per cent.
Meanwhile, Property B has all the attributes of a capital growth driven property – delivering 10 per cent per annum, and a low income yield of 5 per cent.
Notice that if you add the average annual rental return to the average annual rate of capital growth, you’ll get a total return of 15 per cent.
However, and this is the important point, just because these figures add up to approximately 15 percent, the benefit will differ vastly depending on the exact combination of rental yield and capital growth. These figures are hypothetical, but help simplify the mathematics behind the principle.
To have a really successful investment strategy, you need to put together the components of that total return in a very particular way.
Sub-investment grade properties, with their lower growth and capital values, have lower growth in rental income dollars over time than investment grade properties, despite having a high percentage rental yield.
So as the market value of a property goes up over time, so too, does the rent in dollars. It’s absolutely typical – as we see of high quality investment grade property – to exhibit a lower percentage yield than other properties, but a strong dollar growth.
Having explained the overall framework, we can now delve into the specifics of property choices.
Where & what
Where is the geography of capital growth – the most important component being land. It’s all about buying property on land that has finite supply, and has strong demand.
Everyone knows at least one phrase when it comes to investment in property, and that’s ‘location, location, location.’ That’s because it’s a crucial element in property investment. But sadly, many investors get the location wrong.
Finding the right location is a systematic process. The objective is to find a property with high land value and optimal capital growth, within 10 to 15 kilometres of the CBD. In regards to location, first and foremost, it’s the proximity to lifestyle factors, such as community shopping village and parks, as well as practical considerations, such as access to public transport and major roads and schools.
Finding the right suburb is just the start however. Investors must ensure that they’re situated on the right street, where livability isn’t compromised.
That means a street zoned for residential use, which isn’t a thoroughfare for traffic, as well as a streetscape, which is relatively architecturally consistent, and a locale which isn’t compromised by commercial or industrial activity.
Location is about finding areas with multi faceted demand from all types of homebuyers, tenants and investors, including first time buyers, upgraders, downsizers and more.
It’s important to note, we don’t include outer suburbs in our investment ring. Very simply outer suburbs are dominated by houses built for traditional families that require a lot of accommodation at an affordable price.
Because demand is less consistent, growth is very compromised. CBD fringe areas dominated by high rise apartment towers and commercial zones also show poor investment results from residential property.
What to buy is the next factor. The ideal range for a single investment is between $700,000 and $1.5 million, and it’s your financial capacity that will dictate what kind of property you choose.
There are three different types of properties to consider – a house, villa unit and apartment.
We don’t tend to look at townhouses as much, as they can be more easily replicated, which hurts their scarcity value.
Villa units in the right areas can offer strong opportunities, as they can be undercapitalised in regards to the amount of land per dwellings, particularly in some of the middle ring suburbs.
Apartments can perform well in certain areas, particularly those with a high notional land value component. However, it’s important to note apartments have shown reduced growth levels over the last five to eight years, due to high levels of new apartment construction.
With houses, we typically look at single fronted houses that have a land component, scarcity value and multifaceted demand.
Take home message
While property decisions may sometimes feel overwhelming, if you stick to core fundamentals and considerations you’ll ensure your investments are based on robust foundations – helping to deliver strong returns and wealth creating opportunities for the long term.