Capital growth versus yield

There are two ways to benefit from property investing: through capital growth in the property’s value and through the income you get from renting the property out (yield).

Both are important considerations, but Patrick Casey, managing director at Rethink Wealth, says that because most people who opt to rentvest have the end goal of acquiring their own place of residence in an expensive capital city, growth is more important than yield to achieve this goal.

“If we do want to get into a principal place of residence or build wealth into the future, how are we going to achieve that using residential property? We’re going to predominantly achieve most of that heavy lifting by capital growth, not income,” he says.

Focusing too much on income is a “really, really big risk”, Casey says.

“It can potentially mean that they end up in a low-growth asset which has a high rental yield, but fast-forward five years’ time, and it has significantly underperformed the rest of the market.”

This can then affect your ability to take the next step on the property ladder, which may be to sell or use the equity built up in the property to buy your next one.

Key to a lender’s decision to loan you money is your borrowing capacity; or more specifically, your debt-to-income (DTI) ratio. The smaller your DTI, the stronger your financial position.

As a simple thought experiment to see how this plays out in practice, Ruvinsky says to consider a couple with a combined income of $250,000 and a maximum DTI of five, which means our couple can borrow up to $1.25 million in total.

In scenario A, they buy two $600,000 properties in regional Queensland, which are each growing at about 4 per cent per year on average.

Ruvinsky says that Gladstone Central, a coastal suburb about six hours north of Brisbane, has seen 4.26 per cent growth per year over the last decade and is a popular location among buyers agents. So, too, is Bunbury, a coastal town three hours south of Perth, which has grown on average by 3.86 per cent per year over the last decade.

In scenario B, they use the $1.25 million loan to purchase in Sydney, which has grown by 7 per cent each year over the last 10 years.

Two such suburbs where Ruvinsky and his team have been active are Dulwich Hill and Hurlstone Park, which over 10 years have averaged 8.3 per cent and 7.45 per cent growth per year, respectively. On that basis, 7 per cent growth could be conservative depending on the suburb.

The two Queensland properties earn our couple about $72,000 per year in rent, versus $48,000 for the Sydney – after a decade, that’s a $240,000 difference in total.

But the key point is that the Sydney property’s value has grown at 7 per cent each year, compared to 4 per cent for the regional properties.

This means that 10 years later, the Sydney property has almost doubled in value to $2.36 million, while the Queensland properties are only worth a combined $1.78 million.

The couple own $580,000 more in equity in the Sydney property due to its capital growth, which gives them more options for the future.

“Banks don’t care how many ‘growth suburbs’ you’ve bought in…they care about one number – your DTI ratio,” Ruvinsky says.

“If you max your DTI on a blue-chip Sydney property growing at 7 per cent a year, in a few years you’ve got hundreds of thousands in equity to redeploy. Buy a true growth asset and its equity compounds. You can recycle that into the next deal once your income rises.”

Casey adds that if they have capital enough growth from the Sydney property, an option for our couple could be to sell and then aim for their ideal principal place of residence, perhaps in a more salubrious suburb.

The problem with a high yield

Even though regional Queensland provides more rental income in our thought experiment, Ruvinsky says that it won’t move the needle on your borrowing power when you do ultimately want to settle down in your city of choice (like Sydney or Melbourne).

That’s because while the income you earn from renting out your investment property will be considered when assessing how much you can borrow, Anissa Cavallo, founder of Eda Property, says that some banks will also subtract a portion – usually about 20 per cent – of that rental income when assessing your ability to pay off a home loan.

This is to provide a buffer to cover costs associated with maintaining the property and provides a more conservative estimate for the portion of that income that is actually disposable.

“What’s really important is using that money wisely because if you put it into something that doesn’t grow in 10 years … and in the rest of the market houses have gone up by 8, 9 per cent a year, then you’re just getting further behind from being able to afford [the house you really want] in the future,” she says.

“Of course, there’s no crystal balls, no promises, there are no guarantees. But the more you make on that property, the more options you have in the future because that’s your wealth. That equity is yours. So what you’re doing by choosing high-growth areas is just giving yourself much more choice.”

But Casey says that if the focus is on capital growth rather than income, rentvesting can still be a better option that trying to simply save your way to a large enough deposit to buy in your dream location.

“The market will generally outrun your rate of savings if you’re just going down that path.”

But if you’re chasing yield instead of capital growth, rentvestors could be setting themselves back by as much as a decade. And it’s not only those that bought in regional areas that may have fallen into this trap.

“Anyone who purchased an off-the-plan unit in a high-rise apartment building in Melbourne or Brisbane 10 years ago purchased it because the glossy, shiny brochures made the property look great,” Casey says.

But capital growth has been low and many such properties are being sold close to their original purchase price.

“They’re lucky [if] they would cover their expenses of selling, your stamp duty, agents fees, those things.”

Is there a ‘Goldilocks’ location for rentvestors?

Cavallo says that Eda Property prefers properties with an average growth rate over 10 years of 8 to 9 per cent.

“If somebody can afford to be within the inner urban boundary [of Melbourne], we’ll generally start there as capital growth is their main concern,” she says.

The ultimate prize, of course, would be to secure a property that has both the potential to outperform the market on capital growth and that provides a healthy rental income.

But there is typically a trade-off. High-growth property values usually outpace rents, while high-yielding properties, where there is often a shortage of landlords, result in lower overall returns.

So, is there a “Goldilocks” location where you can strike a balance between both? Cavallo says that over the long term, it’s not likely, but it can be achieved in the short term if you’re lucky enough to pick the right location.

“If you get in at the right time, just before prices go up, then your yields are really good. I don’t think there are suburbs that will consistently have good yield and good capital growth over the long term, and we’ve never seen that in the history of property.”

She says in parts of Brisbane some high-yielding properties have had strong price growth over the last two years. “There’s a strong sense that some of those areas are way overpriced or right at the top. So now what will happen is they’ll level out a bit.”

Cavallo adds that some of her clients who bought on the outskirts of Melbourne in new suburbs like Deanside and Fraser Rise have also been lucky enough to enjoy both strong growth and strong yields because they bought at the right time.

“Whereas if you buy [there at] today’s prices, then you’ve probably got a 3 per cent yield.”

Casey’s top tip for those pursuing a rentvesting strategy is to remember that “supply is the enemy of capital growth”.

So areas that will go strongly are more likely to be existing suburbs with the schools, shops and infrastructure, where opportunities for further housing development are limited.

“In Sydney, we’re largely landlocked by the ocean on the east, and then the Blue Mountains to the west, whereas in somewhere like Melbourne there’s far more open land in and around the outskirts, which are suitable to be redeveloped and therefore there’s potential of increased supply in the future.”