Capital growth or rental return?
It’s important to understand that property investors increase their wealth in four ways:
1. Capital growth – the increase in value of a property and its land
2. Rental returns – to deliver positive cash flow generated from the property’s value
3. Tax benefits – such as depreciation, allowance for deductable costs such as maintenance, interest, etc, and through negative gearing
4. Forced appreciation – by creating capital growth through renovation and/or development
Strategic investors can benefit from a combination of all of these. Ideally, the strategy chosen will support the selection of properties, rather than the property forcing the investor into a strategy after the purchase is completed.
Which strategy is better – capital growth or rental return?
There’s no simple answer. Clearly, if both strategies exist there is a place for each. The location and technical condition of a property is fundamental to whether it will perform on the basis of capital growth or/and rental returns. A positive cashflow property is where the rental yield is higher and income received covers all of the property’s expenses , including interest – putting money in your pocket each month.
Typically, properties with higher capital growth have lower rental returns.
The strategy will always be determined by risk
We see more beginners starting out with cashflow positive properties to achieve higher rental yields immediately. This strategy will always be determined by risk. Higher rental yield which results out of cheaper buildings with poor technical conditions or in underdeveloped areas implies more risk. Properties with vacancies or development required are considerably difficult to finance in Germany and more equity is needed.
Evaluating risk should be supplemented by good market knowledge of locations, which involves careful evaluation of future potential and an understanding of the current cycle of the market in a particular area.
Capital growth always results if a property:
can be purchased under market value in a good location, is going to be managed through development or refurbishment, or sits in an area outperforming average capital growth.
Long-term wealth difficult to achieve on rental income only
If you determine on a strategy of rental returns before capital growth, you can rely on rental income. But it will prove difficult to accelerate long-term wealth, because rental returns must be compared to income such as a salary. Due to inflation, accelerating wealth on salary alone is nearly impossible to achieve.
Cashflow positive properties with lower capital growth should form part of a long-term strategy, given that the incidental costs (notary, tax etc) buying a property must first be recovered. In considering a longer-term strategy, increased maintenance costs and redevelopment should be taken into account. Should interest rates increase over time – as they are expected to – a property that is cashflow positive today could become cashflow negative in the future. Originally agreed fixed-interest period in the current low interest market should therefor be at least 15 years even if the average interest is a bit higher compared to a shorter fixed-interest period.
Investors determine a strategy capital growth before rental returns can benefit on much higher returns in the end and have further tax benefits if they would sell the property after 10 years.