Evaluating rental yield vs capital growth

Written by view.com.au in Investing

Finger points to a graph on a wooden table and evaluates a rental yield.

What is capital growth?

A quick rundown: capital growth is the increase in value of your property, whether it be your home or your investment property, based on a number of factors that relate to changes in the market. Economic conditions, the balance between supply and demand, population fluctuations, improvements you make to your home (renovations), and demographic shifts in your suburb are some of the major influences on the value of your home if you were to sell it today.

Capital growth, or capital appreciation, is often equated with ‘equity’. In a reverse mortgage, for instance, retirees can enjoy an income stream based on the capital growth, or equity, of their home. Meanwhile, investors often use the equity in their investment properties to refinance and reinvest in further investment opportunities.

What is rental yield?

‘Yield’ is another term for returns. This is the return you receive by way of the rent paid by your tenants on an investment property.

Remember that there is your ‘gross rental yield’ and your ‘net rental yield’.

To calculate your gross rental yield you simply divide your annual rental income by the value of your property and multiply this figure by 100. So, a house purchased for $500,000 that receives a weekly rental yield of $400 ($20,800 yearly) has a rental yield of 4.16%. This figure does not reflect the current market value of your home (your capital growth), which can affect the figure.

To calculate your net rental yield, you need to calculate all the ongoing costs of an investment (insurance, repairs, council rates, depreciation, mortgage payments etc.) as well as the initial costs of purchasing the property (deposit, stamp duty, legal fees etc.). Your net rental yield is calculated by subtracting your annual expenses from your annual rental income then dividing this figure by the initial costs of purchasing the property, then finally multiplying this by 100 to get a percentage.

Evaluating the two when deciding on an investment property

As a first investor or as a typical property investor (unlike a speculator), your focus should be on long-term growth, not short-term gains. It is unwise to negatively gear your property just for short term capital growth, but it can be a common approach in long-term investing strategies.

Property investing is usually a long-term strategy, due to the sheer sums involved. This is why you should ultimately favour capital growth in your investments over rental yield, as the ultimate gains you make once you do sell your investment property 20 years down the line will far outweigh those you would receive if you favoured a property that had a ratio that leveraged a higher yield over higher capital growth.

Deciding whether to base your investment strategy on capital growth or rental yield does depend on your financial situation and goals. It is pivotal that you discuss your investments with a financial advisor and accountant, to ensure that you are making the most of available tax breaks (such as negative gearing or if you are in a relationship placing the loan in the name of the individual in a lower tax bracket).