Why capital growth is still king

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Continuing uncertainty about where interest rates are headed is forcing investors and would-be investors to question their approach to property investment and revisit the age-old debate – do you negatively gear and strive for the best capital growth or should you focus on cash-flow positive properties that deliver higher rental yields? Monique Wakelin reports

 

Recent interest rate hikes have left many property investors wondering how they’ll address increasing repayment shortfalls on their investment property loans. Some are also wondering whether escalating repayments make property investment a viable option at all right now.

 

Investors who are sweating the next announcement from the Reserve Bank, as well as those who want to make a move but are simply too scared, need not panic. You can still purchase and hold quality assets over the long term and weather the current inflationary environment if you manage the financial component of your portfolio proactively.

Why go for growth?

Essentially, you need to get the fundamental relationship between interest rates and yields in check, in order to make it viable to fund a property investment given the current conditions. You also need to keep sight of the big picture and avoid chasing returns at the expense of solid and sustainable long-term growth.

 

I always advise clients that capital growth should remain the number one objective in order to truly achieve financial independence using housing as an investment vehicle. This holds true in all types of economic climates.

 

Higher yields produced by cash-flow positive property might be tempting right now. On paper, rental returns of 7%-plus might make interest rates that are climbing towards double-digit figures seem less threatening. But when you do the sums, high yields and low growth equal far less in the long term – and property is a long-term investment.

High yield vs capital growth

For instance, if you purchase a property for $400,000 that yields 10% pa with 5% growth, after 20 years that property will be worth $1,061,319 and provide a yield of $106,132 pa.

 

In comparison, a property bought for $400,000 that produces a 5% yield (current average return on a well-selected inner-urban asset), and capital growth of 10% each year for 20 years, will be worth $2,691,000 and yield $134,550 pa.

 

In the latter example, the high-growth property is worth more than five times what it was initially purchased for after being held as a long-term asset, and is now reaping greater cash yields. Higher percentage yields don’t necessarily translate into higher cash returns. The bottom line is: we live on, and are taxed on, actual dollars and cents – not percentages.

 

This clearly demonstrates that investors who entered the market earlier this decade, when interest rates were at a 40-year low and values were going through the roof, would now be in a better financial position if they bought well-selected assets for growth rather than for yield.

 

Properties that have increased substantially – in many instances well above 10% pa – means that investors should now be reaping the benefits of greater cash yields and be managing to furnish the higher repayments on their property loans quite comfortably.

 

On top of this, these investors have the benefit of compounding equity, which instantly provides a built-in financial buffer to offset higher loan repayments. Higher equity also means they can add to their portfolio sooner.

Narrowing the gap between yield and mortgage repayment

Apart from making astute investment choices, there are other strategies to address the increasing disparity between yields and mortgage repayments. Consider the following calculation that illustrates the interest rates/rental yield relationship.

 

If an investor has a $400,000 mortgage, at an interest rate of 8%, and is earning rental income of 3% of the property’s capital value, the difference between income and loan repayment is $20,000 pa. Should the interest rate rise to 9% but the yield remain the same, this increases the repayment gap to $24,000 pa. The question then becomes: how can investors strengthen this relationship and make rising loan repayments and property investment yields meet in the middle?

 

In order to manage the above scenario, investors need to consider two key issues: level of tax deductibility and rental yield.

 

Level of tax deductibility

The first is the level of tax deductibility the investor can claim against their income level. For instance, an investor who’s paying the highest marginal rate of tax can claim up to almost half of that shortfall. Therefore, each 1% rise is effectively a half per cent rise for the negatively geared investment property owner on that tax level. But, even if an investor is on a lower tax rate, some of the sting will be removed from the repayment gap.

 

Of course, it’s critical that the investor can manage the repayments on their investment across the financial year until they can claim their deductions. Many investors are actively encouraged to borrow 100% of an investment property purchase price, plus entry costs, in order to maximise this tax deductibility. I’d urge new investors to avoid this in the current inflationary climate and instead aim to retain some equity in any purchase made, as a buffer to lessen the impact of further interest rate rises.

 

Some investors choose the Pay As You Go (PAYG) tax variation. This allows a property investor to project their losses for the year and claim the amount by way of reducing net income on whatever basis they’re paid a salary. Under this arrangement, an investor on a salary of $100,000 pa, who is paid monthly, and projects through a PAYG variation that their investment property losses will be $20,000 pa, will have their taxable income varied to $80,000 pa. This would give an extra amount in their net monthly pay.

 

Rental yield

Investors also need to consider the rental yield. Despite rising yields, they’re still below rising rates, adding to the growing financial burden of meeting monthly repayments.

 

Over the longer term, a properly selected inner urban asset should return 3–4% of capital value based on current conditions. In fact, if values stabilise this year, returns may increase slightly as previous interest rate hikes place further upward pressure on already soaring rents. This is because many would-be homeowners are being permanently locked into a rental market that’s already in crisis due to an ever-diminishing supply of stock and constantly growing tenant demand.

 

While investors who have managed to secure a good tenant for their property can be reluctant to ask for a higher rate of rent and risk increased vacancies, it’s essential to review your yield when each term expires.

 

Maintaining a fair and reasonable market rent is vital to ensure you can contend with growing loan repayments. And with the rate of inflation many rental markets are currently experiencing, an increase at every lease renewal isn’t overkill.

 

When considering the appropriate increase for your rental property, don’t merely take your managing agent’s valuation as gospel. Now more than ever it’s essential that investors become proactive with their portfolio management, and that means determining what the property would fetch if placed vacant on the current market for the first time. Even a modest increase could mean the difference between being secure for a further year’s income rather than having to stretch personal finances to cover mortgage repayments.

 

A word of warning: don’t attempt to coerce tenants into paying far beyond what your property is worth. At the end of the day, you’ll end up with a property that sits vacant for an extensive amount of time, thereby robbing yourself of the rental income that could help sustain your loan.

Accessing equity

Of course, none of this will matter in the slightest should investors make the critical error of over-extending themselves when it comes to their borrowing capacity. Unfortunately, lenders were literally throwing cash at investors until recently, offering greater access to funds through equity loans and the like.

 

While equity is the key to growing your portfolio, by leveraging off existing property to buy more, it must be used responsibly. While I’m all for living comfortably, I can’t stress enough that before accessing equity, you need to carefully consider whether it will help or hinder your investment endeavours and funding capability. Now is the time to make every investment move a wise one.

 

Monique Wakelin is a co-founder and director of Melbourne-based Wakelin Property Advisory. She is a noted and independent expert commentator on the residential property market. 

 

 

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