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Does capital growth or cashflow matter most for investors?
27 Sep 2020

One of the oldest debates in the property circles is whether you should invest for capital growth or cashflow. 

Today, then, let's look at a few of the important factors in answering that question.

In truth, it's not really an 'either/or' question, and most investors would ideally like to see a combination of the two. 

But it's worth looking at a few numbers to understand the concept.

Below is a stylised example comparing two properties, one $500,000 property purchase which experiences 5% annual capital growth and a 3% rental yield, and another which experiences a 3% annual price growth and a 5% rental yield.

Of course, in the real world, numbers are never as smooth or as consistent as this, but these numbers do help to demonstrate a few useful points.

Year

5% capital gain

3% yield

 

3% capital gain

5% yield

 

$

$

 

$

$

1

500,000

15,000

 

500,000

25,000

2

525,000

15,750

 

515,000

25,750

3

551,250

16,538

 

530,450

26,523

4

578,813

17,364

 

546,364

27,318

5

607,753

18,233

 

562,754

28,138

6

638,141

19,144

 

579,637

28,982

7

670,048

20,101

 

597,026

29,851

8

703,550

21,107

 

614,937

30,747

9

738,728

22,162

 

633,385

31,669

10

775,664

23,270

 

652,387

32,619


One of the first things you may notice is that where a consistent capital gain is achieved, in dollar terms the increases get incrementally larger each year. 

This is the phenomenon of compound growth, which is one of the most widely touted benefits of investing in real estate as an asset class. 

As you can see in the stylised example above, the property with the stronger capital gains delivers the higher overall returns to the investor over time, due to the compounding growth of the property's value.


The higher initial yield of the second property is certainly attractive, but after tax the benefits of the additional income are likely to be somewhat lower. 

The benefits of compounding capital gains

The combination of leverage (borrowing) and compounding growth together can drive powerful results, and it's precisely this potent combination which has made residential property so popular as an asset class. 

It should be noted that leverage magnifies both good and bad results, which means that it's doubly important to borrow and invest sensibly. 

One of the neat benefits of investing for the medium- to longer-term is that the gains can be allowed to compound away in a tax-deferred manner.

In other words, there's no capital gains tax to pay until you decide to sell, which is one of the reasons that real estate tends to work more effectively as long-term investment, at least for most investors.  

Where to get cashflow

Of course, everyone has different circumstances, and it's important to run some projected cashflow numbers on any potential investment to understand how the figures might look over time. 

If cashflow is important to you then generally speaking the higher rental yields tend to be found in outer-suburban or regional locations, and on properties of below median price, although there are always exceptions. 

Units and apartments also often deliver higher initial rental yields than houses (although this is not always the case, and investors also need to be mindful of strata or body corporate fees). 

One word of caution is to be wary of chasing yield at any cost: there's an adage of investing and economics which states that there's no such thing as a free lunch, and high rental yields tend to be representative of a risk of some sort.

High rental yields are often found in relation to commercial property types or niche investments, which may be illiquid or have a more limited resale market. 

Where to get capital growth

It's often said that land appreciates but buildings depreciate, and there's an element of truth in that statement. 

Although the price of building new property does tend to increase over time, existing dwellings tend to incur costs for maintenance and upkeep.

It's typically the scarcity of well-located land which drives the price of residential real estate higher over time, which implies that capital growth is likely to be found in landlocked areas where demand is consistently growing over time, and where good blocks of land are inherently scarce.

This also tends to lead investors to the conclusion that the best investments are those where the land value comprises a significant proportion of the overall property value, since it is the land value which is likely to do most of the heavy lifting over the life of the investment. 

Bringing it together

As a general rule it's hard to build wealth from cashflow in real estate, partly because the income is taxable, and partly because there are often repairs, rates, management fees, and other unforeseen costs which tend to chip away at the net returns.

It's probably fair to say that if it's a flow of income you're seeking then there are often more efficient ways to achieve this outcome in other asset classes.

Most investors tend to look at real estate as an effective inflation hedge, expecting the price growth over time to compensate them for the holding period of the investment, but most will still want the cashflow to be consistent and manageable over the life of the investment too. 

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