Capital Growth vs. Rental Yield: Which Investment Strategy is Right For You?

Understanding the components of property investment, such as capital growth, rental yields, and taxes, is essential for any investor.

This article explores these key elements to provide a clear picture of how they influence investment returns in the Australian real estate market.

Capital vs Cash Flow

Different property syndicates are going to be pursuing different strategies; neither is better or worse; it's just a question of what you're looking for.

There is some truth in that, and if you believe in an efficient market, both of these numbers should equal the same Total Return in the long term.

To attract investment capital away from the stock market, property syndicates need to deliver a higher total return than investors can find elsewhere, which should also be adjusted for a liquidity premium.

What it mean by that is that if a syndication and a stock would both give you 10% and your returns, investors would take the stock because they can buy and sell it at any time on an exchange. 

Therefore, to attract investment capital into an illiquid investment, that investment must offer higher returns to compensate investors for the lack of liquidity.

What this means is that the Total Return should be higher, but understanding where that's coming from will help you both lead and invest in the right opportunities.

Gross vs Net Yields 

Evaluating the short-term returns of real estate can be complicated, and there's lots of numbers people look at when making decisions.

That said, the two easiest ways to evaluate current returns are by comparing gross yields and net yields.

Evaluating the short-term returns of real estate can be complicated, and there's lots of numbers people look at when making decisions.

That said, the two easiest ways to evaluate current returns are by comparing gross yields and net yields.

In the residential market, brokers often refer to gross yields, and while these gross yield figures can be attractive, they may not fully represent the true potential of a property investment.

That's because high gross yields do not necessarily equate to a high return on investment, as they don’t take into account the ongoing expenses associated with owning a property.

Ongoing expenses can include council rates, repairs, maintenance, and various taxes, including state-based land tax.

Lastly, gross and net yields are not a definitive guide to a property's potential for Total Return.

Capital Growth Trade Off

The Australian property market displays a range of investment characteristics:

• High Capital Growth Expectations: Often associated with lower rental yields.
• Lower Capital Growth Expectations: Typically features higher rental yields.

What Drives Property Prices

There is a common saying around many dinner tables in Australia that property doubles every 10 years.

But there is something some people fail to miss about this concept. For prices to increase, rents need to go up or yields need to go down.

So when people talk about doubling every 10 years, is it rents or yields that are moving?

Thankfully for property investors, history shows rents increasing (albeit at a slower rate than prices), allowing the cycle to continue but also seeing yields get compressed.

So while doubling has played historically, it can only continue over the long term if rent growth keeps up, because if you have a property price at double and keep the rent the same, you halve the yield.

Property markets go through ups and downs, so it's never going to be a one-to-one coefficient of rent growth to property price growth, but something to keep in mind is understanding what's changing.

If the price is going up, one of two things is happening:

1. The earning power of the property is going up (i.e., rents are increasing)
2. The yield of the property is being compressed (i.e., the yield is decreasing)

Total Return

Remember what we said about total return being the rental and capital growth? It's important to understand where this is coming from.

In areas with high capital growth but low rental yield, property values are expected to grow over time and make up more of the total expected return. 

This scenario is favourable for investors looking at property value appreciation rather than immediate rental income. 

Real estate is a local game, so the local economy plays a huge part in the equation.

A big city like Sydney has lots of people and lots of businesses, as well as a pipeline of new infrastructure and immigration. This means lower risk for investors, who will pay higher prices, which then create lower yields.

There are a lot of regional towns and properties in those towns that could make great investments to syndicate, but there is also more risk, which leads to lower prices and higher yields.

Whether your priority is capital growth or rental income, understanding market dynamics and the syndicate's investment strategy is key to aligning what you’re looking for.

Conclusion

Investing in real estate requires a thoughtful approach to balance potential growth with ongoing returns from rentals, all while navigating the tax obligations that accompany property ownership. 

By focusing on these fundamental aspects, investors can make informed decisions that align with their financial goals and capitalise on opportunities within Australia's unique market conditions.

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