There is an age-old tug of war going on in the property investment world in regards to what is the best strategy when investing in property.
There are generally only two schools of thought about the best way to build wealth through property.
One favours properties that grow in value – capital growth, or high growth properties.
The other focuses on properties which produce an income in excess of what it costs to own – cash flow positive properties, or high yield properties.
The biggest challenge is that those two indicators are generally linked in a “seesaw” effect, when one is down the other is up and vice versa.
Let’s investigate the two options a bit and check out on some positives and negatives.
The backbone of the high growth strategy is to buy properties in prime locations, usually inner city suburbs that are expected to grow in value more than any others. This is usually the inner ring of major cities, say within the 10km circle. Property selection is usually based on historical data which shows the suburbs in which properties have a proven track record in producing the most outstanding price growth. This is typically driven by supply constraints of available land, which is already built on, hence scarce.
While most investors would love to own a portfolio of inner city terrace houses or art deco apartments, the obvious barrier is the price. Only the wealthiest can afford to buy such properties, and perhaps more importantly, pay to keep them. The price of the best high-growth properties is such that once they are tenanted, many investors cannot afford to make the loan repayments, even after receiving the rent. This is a function of both the high pricing levels and the relatively low rental income levels.
On top of this conundrum sits an upcoming strong oversupply of apartments in just about all major cities in Australia.
Unless an investor has a significant deposit, these properties are strongly negatively geared, meaning their costs far exceed their income. This means invariably a subsidy is required to fund the ongoing running of the property investment, a contribution that is usually coming from the investors own after-tax monies.
There is no doubt that high growth properties are great investments. After all, the escalating value of an asset is pivotal to its ability to generate wealth. But in today’s market, the best high growth properties come with price tags of at least $700,000. And they produce low rental yields, of about 3 per cent, meaning that for every $1,000 they cost, they produce an annual income of $30. This leads to a severe shortfall in cash, usually of thousands of dollars that the investor has to find and fund, in after-tax dollars!
Not many people have a sufficiently high disposable income, combined with a spending regime that leaves some cash in the bank, to reasonably pay for this shortfall, which in turn leads to a necessitated reduction in lifestyle that no one likes. Who in their right mind would like to invest in such an “asset”, whereby the corresponding flip side of the equation means no more dinners out and holidays are cancelled for the foreseeable future, i.e. reduction in lifestyle?
All of that is in the hope of future capital growth, which no one can guarantee, so in other words, we hope and pray. Whilst usually the growth spurt comes at some stage, it can be some very long periods, as in the recent examples in Sydney, where there was little if any growth for about a 7 year period. Such periods are very hard to stomach and even harder to go through, especially when there is a substantial shortfall/negative gear to be made up.
At the other end of the spectrum, some properties produce high yields, of 6 to 8 per cent, or more, with some of the best cash flow positive properties earning 15 per cent of their cost every year. And when interest rates are around 5 per cent a year, it’s easy to see the attraction to high yield properties.
Investors who favor this type of property believe that “cash flow is king,” because anything that earns more than it costs to hold has got to be good for the bottom line.
The downside to high yield properties is that they generally increase in value far less than high growth properties. So while they pay an income, they sometimes contribute little else to wealth creation, so an investor usually needs to own a large number of them in order to replace their income.
Another difficulty with high yield properties is that they tend to be in remote areas, such as mining towns, or in locations that do not generate buyer demand.
The big advantage they have is that the best high yield properties will pay the investor handsomely. However, that income is often dependent on a single factor and if anything happens to that source of demand, such as a downturn in the mining industry, the income stream can, and does, diminish very quickly. Once the underlying demand for these properties is gone, they typically plummet in value quickly, creating a very fickle and risky market. This has been proven true time and time again, especially in the mining towns of Queensland and Western Australia, such a Moranbah, Blackwater or Karratha, Kununurra, that have plummeted both in value as well as in rental income. Properties once worth in the $700,000 range with rental incomes of $1,650/week, only two years later are on the market unsold for around the $300,000 and are untenantable due to strong oversupply.
However, there are investors who have bought properties in high-yielding mining towns and they were earning $20,000 to $40,000 a year from a single property. Despite the favourable returns during the good periods, they need to watch these investments very closely because bad economic news in the region could lead to disaster. The biggest issue at those times is that the market is likely to change very quickly and it is usually very challenging to sell in times of downturn, simply because everyone else is in the same situation. Moreover, the speed of the turnaround makes it an extremely volatile market to operate in. This in turn creates an unacceptably high-risk profile.
A balance of growth and yield
It stands to reason then that the best type of investment would be one which offers high growth and high yield. Unfortunately, most properties usually offer one or the other, not both.
At Property Friends, we suggest a balanced approach. This business model is based on a healthy blend of growth and yield. Not the highest level of either category, because trying too hard for one usually discounts the other, but a sustainable mix of the two which comes from selecting properties that will grow solidly in value in locations that offer above-average yields due to a broad range of economic influences around them.
Generally the capital growth is described as the long-term income, which is where the money is made, however it takes rental yield which is described as the short term income, to survive for the long term.
Whilst it not a proven fact, it makes sense that the reason why the vast majority of property investors hold only one investment property is simply that they cannot financially survive with any further cashflow drain.
A historical example has been the purchase of a new house and land packages in Rockhampton, on Queensland’s coast, which offered annual yields of 6 to 7 per cent and projected capital growth based on previous sales results of 7 per cent a year. Additional uplift in values was expected due to Rockhampton’s proximity to several major projects in the area.
Rockhampton produced growth and yield because it is a thriving regional centre and it has a diverse economic support base including a big beef industry, agriculture, mining in the hinterland and tourism.
Locations such as this are safe havens for investment because they do not rely on the success of one sector to keep the property market thriving. This means they will contribute to wealth creation through capital growth and they won’t require large amounts of cash from investors to retain the properties, so property owners won’t have to drain their lifestyle to pay for their investments.
An example that works
In Rockhampton, investors who were buying new, four-bedroom properties off the plan in 2013 for $441,000 have found they are worth well in excess of that figure by the time the houses have been completed less than year later. The first tenants were paying $520 a week, providing a gross rental yield of 6.15 per cent, against a vacancy rate of 0.7 per cent, which showed that demand for rental properties was extremely high.
Cash flow calculations show that at pre-tax, such a property will cost the investor $5888 a year, or $113 a week in the first year. But after tax deductions using the tax rate of 46.5 per cent, and depreciation calculations, the property is cash flow positive, earning $1,185 a year, or $23 a week. In the second year, the property is cash flow positive by $2,099 a year or $40 a week, after tax deductions and depreciation allowances.
If Rockhampton performs as expected according to historical data of previous sales results, the same property will be worth about $983,500 in 10 years. That will produce a profit, reflected in the asset growth or equity of about $533,000.
The power of time
The beauty of a long-term investment strategy is that the power of compound interest works wonders over time. As the value of the properties continues to grow, the debt on them remains the same or decreases, skyrocketing the net value of the assets – and throwing wide open the lifestyle choices that flow from buying the properties as early as possible.
It is a mathematical fact that even one or two properties bought over a 10-year period and allowed to grow naturally in value will be worth more in 20 years than perhaps double the number of properties bought over a shorter timeframe close to the end of the 20 years.
The secret to this outcome is not how much money you have to start with, how many properties you buy or even whether you buy the best investments, even though these factors are important. The real key to this element of the strategy is to buy as early as possible and allow inflation and capital growth to drive the value of your assets over time.
This proves another real estate truth: Time in the market is more valuable than timing when to buy. Investors who try to pick cycles in the market usually do not do better than others who buy as soon as they can. In every sense, time is your friend when you invest in property. The longer timeframe you have, or in other words, the earlier you begin, the better the result.
This in turn is again supporting the longer term objective of Capital Gains, rather than the short term Rental Yield focus. However when looking at a balanced scenario, making both work, is where the magic lies. Optimizing Growth with a simultaneous rental income sufficient for an investment property to carry itself, giving this time to grow is the ultimate, mainly due to the low-risk profile. Asset growth with no influence on cashflow/lifestyle has to be the ideal investment strategy.
Property investment is a great way to earn money, either through direct income or growth in asset values, even better through both. Give this enough time and it can set you free.
But it shouldn’t be done in a way that means you have to put your life on hold for 10 years. It shouldn’t be such a financial burden that you can’t go on holidays or enjoy a few treats because you’re contributing to an investment strategy that aims to only give you those same benefits later in life.
It is by no means a get rich quick strategy and really are any such truly existing? Realistically a time window of 10 years is required to create a serious difference in anyone’s financial position. Sure, short-term gains can be achieved, but only in the long term approach lies predictable outcomes of success.
Investing in property is a way of taking control of your financial destiny and it is vital to do that in today’s changing world where the size of the ageing population is likely to prevent future governments from providing a favourable pension system. As a mentor once said to me, “If it is to be, it’s up to me”, and I agree with him.
Many Baby Boomers will find they have to cater for their own retirement, or else they will end up like the 80 something per cent of Australian retirees on an income of less than $21,000 a year, which is a less than desirable position to find yourself in, especially in the latter years of your life, where time should meet income to produce a generous lifestyle.
Accordingly, our suggested best case strategy is to invest in balanced properties and giving it a long-term window of opportunity.
Property Friends is a specialist Property Investment Advocacy that has been operating for the last 13 years on the basis of 3 principles: Trust, Community & Progress. www.propertyfriends.com.au (03) 9758 5331.