In his regular column in Switzer, John McGrath discusses the difference between rental and capital growth.
Here is what he had to say:
It wasn’t surprising to see a recent Corelogic RP Data report showing rental growth has been slower than capital growth over the past decade.
This is among the reasons why I always recommend prioritising capital growth prospects over rental returns when purchasing an investment property.
The report shows that across the combined capital cities, rents have increased by 50.7% (or 4.2% per annum) over the past decade compared to an increase in capital values of 72% (or 5.6% per annum).
Looking at different property types, house rents increased by 50.3% while apartment rents increased by 53.7%.
Drilling down to the cities, the two capitals with the greatest rental increases were Sydney (no surprise) at 59.4% and Perth at 54.6%.
Rental returns are important because they help you with your loan repayments.
That’s their primary purpose at the beginning of your tenure of an investment property.
In most cases, especially in the high value markets of Sydney and Melbourne, the odds are the rent on a newly acquired investment property will not cover your repayments or other costs in their entirety so you’ll be negatively gearing your investment.
Regardless, the rent will still take care of a sizeable chunk of your outlays, thereby reducing the cost of you holding your investment property while time does its thing to deliver capital gains.
However, over time, if you choose to pay the principal and interest on your investment loan; and your rental returns gradually increase year to year, you will eventually get to a point where your rental returns do in fact cover the whole mortgage.
And throughout all this, tax benefits such as depreciation, will also have a positive impact.
After a bit more time, your rent will start to cover other expenses like strata fees and council rates too.
This would take you into positive cash flow territory and that’s an excellent place to be – it’s the dream scenario for retirees.
The way you get to positive cash flow requires good long-term strategy.
Many people say interest-only loans are the way to go with investments because they keep your repayments to a minimum.
This is entirely true and a good strategy to adopt if your cash flow is tight.
But if you want to get to a point where the rent is covering everything, you’ll generally need to start paying some Principal at some point.
It’s helpful to think about where you want to be in retirement and work backwards from there.
But don’t do it alone – sit down with your accountant or financial advisor.
You might want to keep your loan at interest-only to keep outlays as low as possible, wait for capital growth; then sell in 10 years for a profit.
Another scenario might involve paying the principal and interest to reduce the loan down to positive cash flow as soon as possible, with the intention of creating a strong, debt-free, income-producing asset for life.
Your strategy will depend on your goals and the timeframe you have to achieve them.
But if there’s one piece of advice I hope you take when buying an investment it’s this – capital growth first, rental return second.