In New Zealand, well located properties tend to have
good capital
growth but poor cash flow, and those properties offering good
cash flow tend to have poor capital growth.
Many beginning investors get involved in
positive cash flow properties. They are much easier to buy and keep
because you don’t have to put your hand in your pocket every month.
That is all well and good if you want income. But
income
alone doesn’t make you wealthy, it just provides you spending
money and after tax there isn’t really that much money to spend.
Many beginning investors have
also purchased property that barely shows
positive cash flow. This possibly
will create problems for them in the long term. A number of
other investors have also done this and this has pushed
up prices in some areas giving these investors a false
impression that they have bought well, that their properties are
performing well and they are becoming rich.
The problem arises as some of
these areas are experiencing no growth or negative population growth. Some of these new
property owners are having difficulty finding tenants and their properties
remain vacant for many months. They also find that when their properties require
repairs it
takes a large chunk of money.
This is not to say that positively geared properties are bad.
A property investor should be well informed about where you buy and why you
buy your property. There are other ways to get money out of property
than positively gearing.
Investors must understand there are
four ways to make money
out of property investments and most of the time they only look at one or
two of these. Let’s look at them.
1. Passive Appreciation
That’s when the property value goes up in line with the general property
market, and over time well located properties in New Zealand in good
positions double in value every 7 - 10 years.
2. Active Appreciation
This is when you add value to your property. For example if you buying
well, when you buy below market price and revalue at the correct figure,
or when you renovate or redevelop your property.
3. Rental Return
Rentals from property provide cash flow, but this is only one component of
your overall investment return.
4. Tax Benefits
It has often been said that its not how much money you make that is
important, but how much you keep after tax. In their simplest form these
are things like depreciation allowances.
To invest in a top performing property
you need a balance all
four of the above elements. Don’t focus too strongly on cash
flow. This is because well located residential properties are inherently
high growth, low yielding investments. You really can’t get high growth,
high yielding residential properties without taking a risk.
CAPITAL
GROWTH vs RENTAL RETURN
When
discussing property investment there
are two somewhat conflicting philosophies of property investment. Some
suggest you should invest in property for high
rental return (the income earned
over a year represented as a percentage of the value of the property) while others feel you should invest for capital
growth (the increase in value of the property.)
We
would all like to buy properties that have both great capital growth and a
high rental yield. But if you buy good property, that's just not the way it
works.
Throughout
New Zealand there are locations for the purchase of property investments
(usually the lower value property areas) where you can
achieve higher rental returns but get poor long term capital growth. And
there are also locations (usually the higher cost poperties) where
strong
capital growth usually goes with a lower rental yield .
From
the above definition alone one can see why this inverse relationship exists.
As
the value of a property increases, then it follows that its rental return
decreases. This is of course unless the rent increases by the same
proportion, which does not normally happen. Rents eventually go up but these
increases lag capital increases by a number of years.
So
the situation during any extended period of high capital growth as has
happened in the recent New Zealand property boom is that rental returns fall. This is just the way the
property market works.
And
now in the slower phases of the property cycle as we are experiencing in New
Zealand, when
interest rates are rising and affordability of properties is decreasing,
more potential home owners are turning to renting properties. This
is the stage of the property cycle that rental growth starts to catch up.
Many
investors would prefer a higher yield. They feel they need
the higher rental returns to pay their mortgage. They also believe they
cannot buy many properties because they can't afford to service additional
loans.
It would be true to say
that the property investors who have been the most successful in the long term, and have done
so safely and without speculating, are the ones who bought quality
properties in good locations and allowed them to grow in value. They
bought them for their strong capital growth and they never or rarely sold
their properties. Instead they would refinance their investments as their
equity increased.
The lesson one can learn from these successful investors is to buy the
best quality properties you can, in the best location you can reasonably
afford and never sell them.
Your investment property will perform better when you take advantage of
the opportunities created by purchasing at the right time in the property
cycle. A great time to buy is at the end of the property slump and the
beginning of the upturn stage of the cycle.
You further boost the returns on your investment by purchasing well.
Never overpay – buy at or below ‘fair market price’.
You then add even more value to your investment properties by
renovating or redeveloping your properties.
Strong
capital growth is the key to a successful property investment.
Even though the first year or two of holding an investment property can be
challenging, remember that capital growth builds your equity much faster
than loan re-payments and rental income will.
It
is suggested that property investors should seek a balance between growth and income and view
their
investment as medium to long-term and be prepared to ride out the cycles.
The rental income needs to be high enough to help with your holding
costs such as loan repayments, insurance and rates.
But it should not be the main
reason for investing, unless you are retired and are just looking for
income to maintain your lifestyle.
If
you have any doubt about the importance of capital growth, the calculations
in the table below may change your mind.
Imagine
you bought a property worth $400,000 in a poor growth area delivering 5%
capital growth and 10% gross rental return; in 20 years your property will
be worth just over half a million dollars.
On
the other hand, if you had purchased a property for $400,000 in a high
capital growth area showing 10% per annum capital growth and only 5% rental
return the property this property will be worth $2,691,000
at the end of the same period.
That
is a massive difference in the final
value of your investment property.
In
the meantime the rentals on your property would have grown substantially in
line with its capital growth and they would catch up to the rentals you
would achieve on the first (high return) property.
|
Capital
growth vs rental income on a $400,000 purchase
|
|
|
10%
capital
growth
|
5%
rental
return on property value
|
5%
capital
growth
|
9%
rental
return on property value
|
|
Year
1
|
$440,000
|
$22,000
|
$420,000
|
$37,800
|
|
Year
5
|
$644,204
|
$32,210
|
$510,512
|
$45,946
|
|
Year
10
|
$1,037,497
|
$51,857
|
$651,557
|
$58,640
|
|
Year
15
|
$1,670,899
|
$83,545
|
$831,571
|
$74,841
|
|
Year
20
|
$2,691,000
|
$134,550
|
$1,061,319
|
$95,518
|
The
real bonus for the investor who
bought the high growth property is that he will be able to access the extra
equity in this property and borrow against it to buy further properties.
It
is very hard to do this with properties that have high rental return but
poor capital growth. It is very
difficult to save that deposit to buy your next property.
